MANAGEMENT ACCOUNTING
STUDY MANUAL
Foundation exam
Management Accounting
ii |
INTRODUCTION | iii
FOUNDATION EXAMS
International Education Standards
CPA Australia is a member of the International Federation of Accountants (IFAC). All foundation exam
education materials are developed in line with IFACs International Education Standards. These
standards provide guidance in establishing the content of professional accounting education
programs together with the associated assessment. The standards also assist in developing the
required passing standard for accounting education and competence of a professional accountant.
The foundation exams provide you with the opportunity to demonstrate your competence in areas
required for Associate membership of CPA Australia. By demonstrating this entry level knowledge you
will be well positioned to succeed at the CPA Program and ultimately attaining the CPA designation.
iv | MANAGEMENT ACCOUNTING
INTRODUCTION | v
CONTENTS
Page
INTRODUCTION
Foundation exams
iii
Chapter features
vi
viii
x
xii
CHAPTER
1
39
Budgeting
63
99
135
171
191
Standard costing
233
Variance analysis
247
10
Capital expenditure
273
11
297
12
323
Revision questions
353
377
395
Glossary of terms
415
Index
423
vi | MANAGEMENT ACCOUNTING
CHAPTER FEATURES
Each chapter contains a number of helpful features to guide you through each topic.
Learning
objectives
Topic list
Introduction
Chapter summary
diagram
Summarises the content of the chapter, helping to set the scene so that you
can gain the bigger picture.
This is a small bank of questions to test any pre-existing knowledge that you
may have of the chapter content. If you get them all correct then you may
be able to reduce the time you need to spend on the particular chapter.
There is a commentary section at the end of the Study Manual called Before
you begin: answers and commentary.
Section overview
This summarises the key content of the particular section that you are about
to start.
Learning objective
reference
LO
1.2
Definition
Exam comments
exam
Worked example
Question
Quick revision
questions
INTRODUCTION | vii
Revision questions
Case study
Formula to learn
These are formulae or equations that you need to learn as you may need to
apply them in the exam.
Bold text
Throughout the Study Manual you will see that some of the text is in bold
type. This is to add emphasis and to help you to grasp the key elements
within a sentence and paragraph.
STUDY TECHNIQUES
In addition to being able to complete the revision and self-assessment questions in the study
manual, ensure you can apply the concepts of the learning objectives rather than just memorising
responses.
Some exams have formulae and discount tables available to candidates throughout the exams. My
Online Learning lists the tools available for each exam under "Useful Resources".
Check My Online Learning on a weekly basis to keep track of announcements or updates to the
study manual.
Step 1
Attempt every question. Read the question thoroughly. You may prefer to work out the
answer before looking at the options, or you may prefer to look at the options at the
beginning. Adopt the method that works best for you.
Step 2
Read the four options and see if one matches your own answer. Be careful with
numerical questions, as some options are designed to match answers that incorporate
common errors. Check that your calculation is correct. Have you followed the
requirement exactly? Have you included every step of the calculation?
Step 3
You may find that none of the options matches your answer.
Re-read the question to ensure that you understand it and are answering the
requirement
Eliminate any obviously wrong answers
Consider which of the remaining answers is the most likely to be correct and select the
option
INTRODUCTION | ix
Step 4
If you are still unsure, you can flag the question and continue to the next question. Some
questions will take you longer to answer than others. Try to reduce the average time per
question, to allow yourself to revisit problem questions at the end of the exam.
Revisit unanswered questions. A review tool is available at the end of the exam, which
allows you to Review Incomplete or Review Flagged questions. When you come back to a
question after a break you often find you are able to answer it correctly straight away. You
are not penalised for incorrect answers, so never leave a question unanswered!
x | MANAGEMENT ACCOUNTING
CHAPTER SUMMARY
This summary provides a snapshot of each of the chapters, to help you to put the Study Manual into
perspective.
CHAPTER 3 BUDGETING
A budget is a quantitative statement, for a defined period of time (often a year) which usually includes
planned revenues, expenses, assets, liabilities and cash flows. When organisations draw up budgets
they have stated objectives and intentions, and the actual results can then be compared with the
budget and differences identified and analysed. This chapter explains the background of budgeting
and then teaches you how to prepare and operations budget and a cash budget.
INTRODUCTION | xi
LEARNING OBJECTIVES
MANAGEMENT ACCOUNTING
CPA Australia's learning objectives for this Study Manual are set out below. They are cross-referenced
to the chapter in the Study Manual where they are covered.
This exam covers an understanding of developments in management accounting and the tools
management accountants use to cost products and services, and to develop and manage budgets. It
also covers performance management and control; planning and assessment of project alternatives;
and an understanding of the nature, functions, structures and operations of management.
CHAPTER(S)
WHERE
COVERED
Topics
LO1. Conceptual issues and behavioural implications
LO1.1
LO1.2
LO1.3
LO1.4
LO1.5
LO1.6
LO1.7
LO1.8
12
LO1.9
LO1.10
LO2.3
10
LO2.4
10
LO2.5
Explain the impact of cash flows and risks on project decision making
2, 10
INTRODUCTION | xiii
CHAPTER(S)
WHERE
COVERED
Topics
LO3. Budgeting
LO3.1
LO3.2
Explain the nature of budgets and the reasons that organisations use
budgets
LO3.3
LO3.4
2, 4
LO4.2
3, 4
LO4.3
LO5.2
LO5.3
LO5.4
LO5.5
LO7.2
Explain how standard costing can be used to assist in cost control and
efficient resource allocation
LO9.2
LO9.3
Calculate a variance
CHAPTER(S)
WHERE
COVERED
Topics
LO10. Capital expenditure
Analyse capital expenditure decisions in organisations using relevant
tools and techniques
Apply capital expenditure analysis to project planning and managing
LO10.2
uncertain scenarios through scenario analysis
LO11. Inventory and pricing decisions
LO10.1
LO11.1
10
10
11
11
11
LO12.1
12
LO12.2
12
LO12.3
12
LO12.4
12
7%
Decision making
13%
Budgeting
10%
Cost behaviour
15%
13%
5%
5%
Standard costing
5%
Variance analysis
5%
10
Capital expenditure
5%
11
5%
12
12%
TOTAL
100%
CHAPTER 1
THE NATURE AND PURPOSE
OF MANAGEMENT
ACCOUNTING
Learning objectives
Reference
LO1
LO1.1
Analyse the key differences between financial, cost and management accounting
LO1.2
LO1.3
LO1.4
Explain the range of theories that underpin management accounting and how they
have an influence on practice
LO1.5
Outline the core parts of management accounting systems and how they enable
strategic management
LO1.6
LO1.7
Explain how organisational behaviour can impact the creation of organisational value
LO1.9
LO1.10
Decision making
LO2
LO2.1
LO2.1.1
LO2.1.2
develop alternatives
LO2.1.3
analyse alternatives
LO2.1.4
select an alternative
LO2.1.5
Topic list
1
2
3
4
5
6
7
8
2 | MANAGEMENT ACCOUNTING
INTRODUCTION
This chapter provides an introduction to Management Accounting.
We begin this first chapter by looking at the role of the management accounting function.
We then examine the differences between management accounting and financial accounting and
introduce cost accounting.
The chapter goes on to look at the importance of information provided by the management
accountant in planning, control and decision making. It also briefly looks at the design and
development of management accounting systems.
This chapter discusses the limitations of some of the traditional methods of management accounting,
and considers how recent developments in management accounting attempt to overcome these
limitations.
Finally we examine the management accountant's role in the creation of organisational value and the
relationship between sustainability and management accounting.
The chapter content is summarised in the diagram below.
Information
Presentation of
information to
management
Planning, control
and decision
making
Management
accounting
systems
Design of management
accounting systems
Developments in management
accounting
The management
accounting function
If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What are the differences between financial accounts and management accounts?
(Section 2.2)
2 What are the differences between cost accounting and management accounting?
(Section 2.3)
(Section 3.2)
(Section 3.6.1)
(Section 3.7)
(Section 3.8)
(Section 4.1)
(Section 4.2)
(Section 4.5)
(Section 5.4)
(Section 5.2)
(Section 7.1)
(Section 7.2)
(Section 7.3)
CHAPTER 1
4 | MANAGEMENT ACCOUNTING
In the 1950s Simons identified three attributes of what could by now be called management
accounting information:
It should be useful for scorekeeping to see how well the organisation is doing overall and to
monitor performance.
It should be attention-directing to indicate problem areas that need to be investigated.
It should be useful for problem-solving to provide a means of evaluating alternative responses
to the situations in which the organisation finds itself.
Management accounting information is therefore used by managers for a number of purposes:
To make decisions.
To plan for the future. Managers have to plan and they need information to do this. Much of this is
provided by management accounting systems.
To monitor the performance of the business. Managers need to understand how they are
performing against goals and targets.
To measure profits and put a value on inventory.
To implement processes and practices that focus on effective and efficient use of organisational
resources to support managers to enhance customer and stakeholder value (IFAC 2002)
LO
1.7
In some organisations, the cost and management accounting function may be organised as a
functional section or department within the organisation. However, because management accountants
provide information to other managers, it has become fairly common to include management
accountants within cross-functional teams, or to assign them to work with non-accounting functions. A
cross-functional team is a small group of individuals, with different expertise, taken from many
different parts and levels of an organisation, which comes together to work towards a common
purpose or goal. The size of each team will vary according to the scale and complexity of the project.
Cross-functional teams are typically formed on the assumption that a small group is better for a
particular task than either individuals acting alone or in a large, permanently structured group.
Benefits of cross-functional teams include:
improved coordination and integration of systems or activities
problem-solving across traditional functional or organisational boundaries
facilitate innovation and product/service development
In addition to contributing their technical expertise as accounting and finance experts and their
functional expertise as information providers, management accountants have a key role to play in
helping maximise the potential of a cross-functional team by:
providing, collecting and assessing critical team information;
helping establish goals and set priorities;
assisting with problem-solving and decision-making, through the application of decision-making
models and other techniques
ensuring the team maintains an organisation-wide perspective.
DETAIL
CHAPTER 1
6 | MANAGEMENT ACCOUNTING
Section overview
Financial accounting systems ensure that the assets and liabilities of a business are properly
accounted for, and provide information about profits and historical financial performance to
shareholders and to external stakeholders such as ATO and ASIC; and other interested
parties including interest groups, potential shareholders, unions and NGOs.
Management accounting systems provide information specifically for the use of managers
within an organisation. Corporate Performance Management (CPM) software and Business
Intelligence (BI) software are management accounting tools used by management
accountants.
Cost accounting is part of management accounting. The purpose of cost accounting is to
determine the cost of products and services.
Financial accounting systems ensure that the assets and liabilities of a business are properly
accounted for. They are used to provide information to shareholders and other interested parties in
the form of (published) financial statements. Management accounting systems provide information
specifically for the use of managers within an organisation.
Management information provides a common source from which information for two groups of
people is drawn.
a. Financial accounts are prepared for individuals external to an organisation: for example
shareholders, customers, suppliers, regulatory authorities, employees.
b. Management accounts are prepared for internal use by managers of the organisation.
Much of the data used to prepare financial accounts and management accounts are the same but
differences between the financial accounts and the management accounts arise because the data are
analysed differently. In addition, management accounting systems draw on a wider range of data,
including non-financial data, data from external sources, and data relating to the future.
MANAGEMENT ACCOUNTS
CHAPTER 1
8 | MANAGEMENT ACCOUNTING
FINANCIAL ACCOUNTS
MANAGEMENT ACCOUNTS
3.1 PLANNING
LO
1.9
Planning forces management to think ahead systematically in both the short term and the long term.
Planning involves the following:
Establishing overall objectives.
Selecting appropriate strategies to achieve those objectives.
Setting targets for each strategy.
Formulating detailed plans for achieving those targets.
When expected changes are gradual, planning occurs in a fairly stable environment, and routine
budget planning procedures may be used.
Organisations often start by setting out their vision. This is a succinct statement of the organisation's
future aspirations e.g. Microsoft's vision is 'to help people and businesses throughout the world
realise their full potential'.
A mission statement is then created, setting out the organisation's fundamental purpose and
including references to its strategy, standards of behaviour and values.
The mission sets the overall direction of the organisation and the organisation's goals and more
detailed objectives then follow from this. The strategies identified as a result of the planning process
are designed to achieve these objectives.
CHAPTER 1
Cost accounting systems are not restricted to manufacturing operations, although they are probably
more fully developed in this area. Service industries, government departments and non-profit making
organisations all make use of cost accounting information. Within a manufacturing organisation, the
cost accounting system should be applied not only to manufacturing but also to administration, selling
and distribution, research and development and all other departments and functions.
10 | MANAGEMENT ACCOUNTING
Note that in practice, the terms objective, goal and aim are often used interchangeably.
The two main types of organisation that you are likely to come across in practice are as follows:
Profit making
Non-profit making
It is often assumed that the main objective of profit making organisations is to maximise profits. A
secondary objective of profit making organisations might be growth, for example by increasing the
output and sales of its goods/services. Instead of maximising profit, an organisation may seek to
maximise the wealth of its shareholders. Unfortunately, the aim of profit maximisation may encourage
decisions that compromise the long term viability of the business in the attempt to maximise
immediate profit outcomes.
The main objective of non-profit making organisations is usually to provide goods and services. A
secondary objective of these organisations might be to minimise the costs involved in providing the
goods/services.
The stated objectives of an organisation might include one or more of the following:
Maximise profits
Maximise revenue
Maximise shareholder value
Increase market share
Minimise costs
Management accounting techniques often assume one of these objectives when recommending a
course of action to management. Remember however that decisions have consequences for the
longer term as well as the short term, and decisions to maximise profit may have high associated risks.
The management accounting function supports the short-term planning process, for example by
providing information for setting targets and standards, and helping to establish the assumptions on
which the short-term plan is based, such as growth rates, costs, efficiency savings and cost inflation.
Assess the
organisation
Assess the
future
Assess
expectations
CHAPTER 1
THE
ASSESSMENT
STAGE
Evaluate
corporate
objectives
THE
OBJECTIVE
STAGE
THE
EVALUATION
STAGE
Consider
alternative
ways of achieving
objectives
THE
CORPORATE
PLAN
Agree a
corporate
plan
Production
planning
Resource
planning
Product
planning
LONGTERM
STRATEGY
PLANNING
Research and
development
planning
SHORTTERM
PLANNING
3.5 CONTROL
As well as providing information for planning, management accounting also provides information to
assist with monitoring and control. There are two stages in the control process.
a. The planned performance of the organisation (set out as targets or expectations in the detailed
operational plans) is compared with the actual performance of the organisation on a regular and
continuous basis. Significant deviations from the plans can then be identified and appropriate
corrective action can be taken where possible.
b. The corporate (strategic) plan is reviewed in the light of the comparisons made and any changes
in the parameters on which the plan was based, (such as new competitors, government instructions
and so on), to assess whether the objectives of the plan can be achieved. The plan is modified to
ensure the organisation's future success.
Effective control is not practical without planning, and planning and control are interrelated. Targets
and objectives will not be achieved without monitoring and control measures when needed.
An established organisation should have a system of management reporting that produces control
information in a specified format at regular intervals.
Smaller organisations may rely on informal information flows or ad-hoc reports being produced as
required.
12 | MANAGEMENT ACCOUNTING
3.6 DECISION-MAKING
LO
2.1
PLANNING
Select an alternative
State the expected outcome
and check that the expected
outcome is in keeping with
the overall goals or objectives.
The sequence of steps can be applied to form decision making. Note the role of relevant and reliable
information is critical to the decision making process.
Define the problem. A decision is made only when a problem is recognised. If a manager is
unaware that a problem exists, they will not feel the need to make any decision. A workflow for
decision making has been set out above.
Identify the decision-making criteria. Having recognised that there is a problem for which a
decision must be made, the next step is to recognise the decision-making criteria. What are we
trying to achieve? In the planning process, the criteria may be to maximise profits over the next 12
months, given the available resources and subject to limitations on the risks that should be taken.
The criterion for control decisions may be to reduce excessive spending. In management
accounting, the decision-making criterion is often to maximise profitability, but as explained
earlier, consideration must be given to the longer term and risk.
Analyse the alternatives. Each of the alternatives should be analysed and evaluated. If the
decision-making criterion is to maximise short-term profit, each alternative should be evaluated
financially, to estimate the profit that would result from choosing that alternative. Although a
management decision is often based on financial considerations, other non-financial factors may
also be considered if they are a part of the decision-making criteria.
Select an alternative. A decision involves selecting one alternative from the two or more that have
been analysed. The recommended choice should satisfy the goals of the organisation.
These steps in the decision-making process should be apparent in later chapters, when specific
management accounting techniques for analysis are described.
Author Robert N Anthony (Management Control Systems, 1972) divided management activities into
three levels: strategic planning, management control and operational control. This is sometimes
known as the Anthony hierarchy.
a. Strategic planning is 'the process of deciding on the objectives of the organisation, on changes in
these objectives, on the resources required to attain these objectives, and on the policies that are
to govern the acquisition, use and disposition of these resources'.
b. Management control is 'the process by which managers assure that resources are obtained and
used effectively and efficiently in the accomplishment of the organisation's objectives'.
c. Operational control is 'the process of assuring that specific tasks are carried out effectively and
efficiently'.
A management accounting system provides information to management for strategic planning and
management control, and for some aspects of operational control.
CHAPTER 1
Develop alternatives. The next step is to recognise different ways in which the problem might be
resolved in a way that is consistent with the decision-making criteria. For a simple decision, there
may be just two alternatives 'Do it', or 'Don't do it.' However there may be a number of different
alternatives, and the process of developing alternatives involves:
recognising the range of possible options and
from these, selecting a small number of alternatives for evaluation.
14 | MANAGEMENT ACCOUNTING
4 INFORMATION
Section overview
Data is the raw material for data processing. Data relates to facts, events and transactions.
Information is data that has been processed so as to be meaningful.
Good information is relevant, complete, accurate and clear. It inspires confidence, is
appropriately communicated, its volume is manageable, it is timely to produce and it costs
less to produce than the benefits it provides.
CHAPTER 1
16 | MANAGEMENT ACCOUNTING
Information is sometimes referred to as processed data. The terms 'information' and 'data' are often
used interchangeably. It is important to understand the difference between these two terms.
For example, researchers who conduct market research surveys might ask members of the public to
complete questionnaires about a product or a service. These completed questionnaires are data; they
are processed and analysed in order to prepare a report on the survey. This resulting report is
information and may be used by management for decision-making purposes.
Management accounting systems provide information, and the quality of the management accounting
system depends on the quality of the information that it provides.
h. Timing. Information should be timely. If it is not available until after a decision is made, it will be
useful only for comparisons and longer-term control. Information prepared too frequently can be a
serious disadvantage. If, for example, a decision is taken at a monthly meeting about a certain
aspect of a company's operations, information to make the decision is only required once a month,
and weekly reports would be a time-consuming waste of effort.
i. Channel of communication. Information should be communicated or should be accessible
through appropriate channels of communication. There are occasions when using one particular
method of communication will be better than others. Some internal memoranda may be better
sent by 'electronic mail'. Some information is best communicated informally by telephone or
word-of-mouth, whereas other information ought to be formally communicated in writing or
figures. Electronic methods of data transmission, data storage and data access are integral parts of
most management accounting systems.
j. Cost. Information should have some value, otherwise it would not be worth the cost of collecting
and filing it. The benefits obtainable from the information must also exceed the costs of acquiring
it. Whenever management is trying to decide whether or not to produce information for a
particular purpose, for example, whether to computerise an operation or to build a financial
planning model, a cost/benefit analysis ought to be undertaken.
k. Comparability. Information needs to be measured and reported in a similar manner so that
meaningful comparisons can be made over time.
Question 2: Value of information
Managers receive a monthly performance report indicating that costs in the previous month were 15%
more than expected. Which one of the following would be the most appropriate response by
management to this information?
A Control action should be taken to deal with the problem and reduce costs by 15%.
B The overspend indicates that planning targets will not be met, and forecasts should be revised.
C The reasons for the overspend may be controllable; therefore they should be investigated with a
view to reducing the overspend as much as possible.
D The reasons for the overspend may be controllable or uncontrollable; therefore they should be
investigated with a view either to reducing the overspend as much as possible or revising forecasts
or targets.
(The answer is at the end of the chapter)
CHAPTER 1
many systems, control action works basically on the 'exception' principle, with reports only being
produced if there is an issue that needs to be brought to management attention or investigated
further .
18 | MANAGEMENT ACCOUNTING
In solving these and a wide variety of other problems, management needs information.
a. In problem (a) above, management would need information about the cost of the new product.
b. Faced with problem (b), management would need information on the cost of repairing, buying and
hiring the machine.
c. To calculate the cost of the discount offer described in (c), information would be required about
current sales settlement patterns and expected changes to the pattern if discounts were offered.
The successful management of any organisation depends on information: organisations in the public
sector, such as hospitals and local authorities and other non-profit making organisations such as
charities and clubs need information for decision making and for reporting the results of their activities
just as multi-nationals do. For example, a local government authority needs to know what resources
are being used to deliver services to residents. A tennis club needs to know the cost of undertaking its
various activities so that it can determine the amount of annual subscription it should charge its
members.
If the recipients of the report have any comments or queries, it is important that they know who to
contact.
DATE
We have already mentioned that information should be communicated at the most appropriate
time. It is also important to show this timeliness by giving your report a date.
SUBJECT: REPORT HEADING
What is the report about? Managers are likely to receive a great number of reports that they need
to review. It is useful to know what a report is about before you read it! A report should therefore
have a clear heading or title.
SUB-HEADINGS
Unless they are very brief, reports should be divided into sections, each with a clear sub-heading.
The first heading may be an introduction (explaining the purpose of the report), followed by an
executive summary (setting out both the purpose and the findings of the report). The final subheading may be for a summary, conclusion or recommendation.
APPENDIX
In general, information is summarised in a report and the more detailed calculations and data are
included in an appendix at the end of the report.
We start this section by briefly looking at how management accounting systems have developed, and
we consider the implications of systems not developing quickly enough to keep pace with changes in
the business world.
CHAPTER 1
20 | MANAGEMENT ACCOUNTING
A significant development in management accounting was the use of marginal costing, and the
separation of costs into fixed and variable costs. Marginal costing concepts were applied to planning
and other aspects of decision-making. Management accounting systems became more relevant and
reliable in providing information to management for decision-making, through the application of
concepts and techniques such as relevant costs and discounted cash flow analysis.
More recently, management accounting systems have developed quite rapidly, in a variety of different
ways. Service industries and non-manufacturing activities became more important for many
companies, and management accounting systems were developed within service industries, and also
for activities such as marketing and distribution.
Management accounting techniques have also been developed to analyse costs in different ways,
particularly overhead costs, and techniques such as activity based costing and customer profitability
analysis have emerged.
The importance of information for strategic planning has also been recognised, and management
accounting has expanded from the provision of information at the management control level to
information provision for strategic planning and control. Management accounting systems must now
gather non-financial as well as financial information, and information from external as well as internal
sources. Corporate Performance Management (CPM) and Business Intelligence (BI) software are
examples of such systems.
There have also been changes in manufacturing techniques, such as Total Quality Management and
Just-in-Time (JIT) production. As manufacturing management has changed, the information to
support management management accounting has also had to change so that it remains relevant
and useful.
The expansion and increased sophistication of many management accounting systems would not have
been possible without technological change, and enormous improvements in the capabilities of IT
systems.
Management information may be unduly focused on financial costs and short-term profits that can
easily be measured. Non-financial information may be overlooked. At a strategic level, for example,
the objective of a company may be to increase profitability, but in order to grow the business and its
profits, it may be necessary to consider factors such as quality, flexibility, customer satisfaction and
employee skills.
CHAPTER 1
22 | MANAGEMENT ACCOUNTING
5.4.1 TIMING
In trying to improve profitability, management will often look for ways of reducing costs. However, as
we will see later, the cost of a new product is substantially determined when it is being designed, not
at the time it goes into production. The materials that will be used, the machines and labour required,
are largely determined at the design stage. In the car industry, 85 per cent of all future product costs
are determined during the design stage and by the end of the testing stage. Target costing is a
management accounting technique that draws attention to control of product costs at the design
stage. Traditional management accounting, however, continues to direct its attention to the
production stage.
5.4.2 CONTROLLABILITY
Traditionally, management accounting systems have provided more information about direct costs of
operations (material and labour) than about indirect costs (overheads), for example, by the
preparation of cost cards. This may result in an organisation focussing on controlling direct labour and
direct material costs and directing insufficient attention to overheads. However for many modern
organisations the controllable element of overhead costs, such as power, may be more significant and
offer more scope for savings than the direct costs of material or labour. There are techniques for
analysing overhead costs more closely, such as activity based costing and customer profitability
analysis, but traditional management accounting systems do not provide information of this quality.
In this section we focus on the factors determining the design of management accounting systems,
and assessing the adequacy of existing management accounting systems. The most important factor
is for the output to meet the needs of management, for various decision making purposes.
DETAIL
A starting point for design or assessment should be the output from the
management accounting system. For what purposes do management need
the information? The management accountant must identify the information
needs of managers making planning and control decisions, and monitoring
progress. Levels of detail and accuracy of output must be determined in each
case, and also the speed or frequency with which the information should be
provided or made available.
Processing involved
Decisions should be made about how the data will be processed to provide
the information, and how frequently it should be provided (for example, in
monthly routine reports, continuously accessible online, or prepared in
response to specific requests from management). Decisions should also be
made about which methods or techniques of management accounting should
be used to process the data.
Response required
Question 3: Information
Management accounting information should be relevant to the user's needs, and should be reliable. It
should also be timely, appropriately communicated and cost-effective.
Which one of the following best describes the consequences if management accounting information
does not have these qualities?
A
B
C
D
CHAPTER 1
The following factors should be considered when designing a management accounting system:
24 | MANAGEMENT ACCOUNTING
Some examples of strategic information that may be provided by a management accounting system
are found in the table below.
ITEM
COMMENT
Competitors' costs
What are they? How do they compare with ours? Can we beat them?
Are competitors vulnerable because of their cost structure?
Product profitability
A company should want to know not just what profits or losses are
being made by each of its products, but why one product is making
good profits whereas another equally good product might be
making a loss.
Customer profitability
Pricing decisions
Capacity expansion
Brand values
Shareholder wealth
Cash flow
Management accounting information is provided for management in service industries, not just
manufacturing industries. The management accountant must take into account the characteristics of
the service businesses, including the fact that (unlike manufacturing) production and consumption of
services occur at the same time and there are no finished goods inventories. Customer satisfaction
may be difficult to measure in service businesses, and there may also be problems with identifying
which parts of the service the customer values most, and providing relevant information about
meeting customer needs.
In the service sector, performance evaluation (and information about performance) may have several
dimensions:
Flexibility
Excellence
Innovation
Financial performance
Resource utilisation
Competitiveness
7 DEVELOPMENTS IN MANAGEMENT
ACCOUNTING
Section overview
Management accountants have responded to developments such as JIT, TQM and lean
management accounting by using techniques such as target costing, life cycle costing and
Kaizen.
LOs
1.4
1.5
In this section we look at changes in the business environment and manufacturing methods, and how
management accounting techniques have been developed in response to them. Many of the
'modern' manufacturing methods are grouped around the concept of World-Class Manufacturing
(WCM), which sets as its objective achieving and sustaining competitive advantage in an environment
of strategic cost reduction. We shall revisit these concepts of manufacturing management, and the
associated management accounting techniques, in more detail later in the Study Manual.
CHAPTER 1
26 | MANAGEMENT ACCOUNTING
Definition
Just-in-time (JIT) is a system whose objective is to produce or to procure products or components
as they are required by a customer or for use, rather than for inventory. A JIT system is a 'pull'
system, which responds to demand, in contrast to a 'push' system, in which stocks act as buffers
between the different elements of the system, such as purchasing, production and sales.
Just-in-time production is a system which is driven by demand for finished products whereby each
component on a production line is produced only when needed for the next stage.
Just-in-time purchasing is a system in which material purchases are contracted so that the receipt
and usage of material, to the maximum extent possible, coincide.
The implications of JIT for the management accounting systems is that they have to be reorganised to
include or highlight items that are seen as costs under JIT but are not included in traditional systems.
Systems must highlight excessive inventory levels, machinery set ups and long lead times. The
changes in organisation resulting from JIT, such as the regroupings of workings, will also result in
changes in accounting systems to adjust to new demands and changed sources of information.
JIT is considered in more detail in chapter 11.
7.3 KAIZEN
Definition
The Kaizen method is applied during the production process when it is difficult to make really big
changes. Kaizen focuses on the key elements of operations: production, purchasing and distribution.
Kaizen aims to achieve a specified cost reduction, but to do so through continuous improvements
rather than one-off changes.
Though managers may set the targets, employees working in the production process will ensure that
those targets are met. The logic of this approach is that those involved in production will be best able
to see how to achieve the necessary economies effectively but with minimum disruption. Often these
targets will be achieved in collaboration with suppliers.
CHAPTER 1
Kaizen is a Japanese term for continuous improvement in all aspects of an entity's performance at
every level. Kaizen is a feature of Total Quality Management.
28 | MANAGEMENT ACCOUNTING
Organisational behaviour is about the impact that individuals, groups and organisational structure
have on behaviour within an organisation and on that organisation's effectiveness or ability to create
value.
It is possible to identify three components that have an impact on organisational behaviour:
People
Structure
Technology and systems
To realise its full potential, an organisation needs to exploit the potential of its individual employees
and ensure that their goals are aligned with those of the organisation. The way that an organisation is
structured and its systems for planning, control and decision-making will affect the motivation of its
staff and hence the achievement of its results.
In today's fast-changing environment, a successful company is often one that is outward looking and
always looking to the future towards new markets, innovative products or services, better designs, new
processes, improved quality and increased productivity.
Create a culture that supports individual and team abilities and promotes and rewards the drivers
of organisational success.
Recognise the power and value of knowledge and ensure that this is captured and then shared to
improve competitive advantage, eg through the use of knowledge management systems.
Implement a management style and organisational structure that is consistent with all of the above.
Develop and maintain an information system to support management.
The management accountant plays a vital role in organisational behaviour.
Earlier in this chapter we examined the role of the management accounting function and the
contribution of management accounting to strategic management.
Management accounting is a value added process. This value added process:
Guides management action
Motivates behaviour
Supports and creates the cultural values required to achieve the organisation's objectives
The management accountant plays a key role in providing relevant and timely information to the
management of the organisation, explaining the impact of that information and participating in the
managerial decision-making process.
The information provided by management accountants and the management accounting system:
supports the strategic planning process which ensures the organisation adapts to its competitive
environment (planning)
helps senior management to evaluate performance (control) and
provides timely and accurate information about activities required for success (decision making)
and
helps maximise the effective use of resources over time
Thus the management accountant helps create organisational value by:
providing relevant information for planning and decision making
assisting management in direction and control activities
motivating managers and other employees towards organisational objectives
measuring the performance of the activities of managers and other employees
assessing the organisation's competitive position
CHAPTER 1
30 | MANAGEMENT ACCOUNTING
LO
1.10
In this section we examine one of the newer concepts in management accounting, that of
sustainability and sustainability accounting. In recent years there has been an increasing awareness of
sustainability. The section begins by looking at what is meant by sustainability both on a global scale
and at an organisational level. The objectives of sustainability are then considered and its relationship
to management accounting.
Definition
In relation to the development of the world's resources, sustainability has been defined as
ensuring that development meets the needs of the present without compromising the ability of
future generations to meet their own needs.
For organisations, sustainability involves developing strategies so that the organisation only uses
resources at a rate that allows them to be replenished (in order to ensure that they will continue to
be available). At the same time emissions of waste are confined to levels that do not exceed the
capacity of the environment to absorb them.
(Brundtland report)
The concept of sustainability should not be confused with environmental protection and the scarcity of
natural resources, although for many industries there is a direct connection between these. The
concept of sustainable business applies to all types of business banks and retail businesses as well as
mining and oil companies.
However it is important to recognise that business organisations do not exist primarily to benefit
society as a whole. It is all too easy to become nave and unrealistic when thinking about sustainability!
ENVIRONMENTAL
SOCIAL
Materials used
Energy consumption
Water use
Child labour
Training undertaken
CHAPTER 1
32 | MANAGEMENT ACCOUNTING
ECONOMIC
ENVIRONMENTAL
SOCIAL
Significant spillages
Community relations
Impact of activities on
biodiversity
Complaints re breaches of
customer privacy
Standard of Product labelling
(Source: GRI 2006)
The GRI Reporting Framework sets out the principles and Performance Indicators that organisations
can use to measure and report their economic, environmental, and social performance. There are
Sustainability Reporting Guidelines for different industries. The third version of the Guidelines known
as the G3 Guidelines - was published in 2006.
Many organisations around the world have declared their use of the GRI Guidelines as the basis for
sustainability reporting, including companies such as Coca Cola, Bayer, British American Tobacco,
Dell, and MTR Corporation. There are GRI guides for different industries, because the nature of
sustainability information differs according to the nature of the industry.
CHAPTER 1
47% of leaders in reporting organisations say there was no pressure to commence sustainability
reporting it was deemed to be the right thing to do
34 | MANAGEMENT ACCOUNTING
CHAPTER 1
The term 'sustainability accounting' encompasses a range of new accounting and reporting tools
and approaches which are part of a transition towards a different kind of organisational decisionmaking focused not just on economic rationality, but consistent with ecological and social
sustainability.
36 | MANAGEMENT ACCOUNTING
It should be timely
It should be completely accurate
It should be relevant for its purposes
It should be communicated to the right person
2 The sales manager has prepared a direct labour plan to ensure that sales targets for the year are
achieved. This is an example of
A tactical planning.
B strategic planning.
C corporate planning.
D operational planning.
3 Which of the following statements is/are correct?
I Information is data that has been processed into a form meaningful to the recipient.
II An objective is a course of action that an organisation might pursue in order to achieve its strategy.
III A management control system is a term used to describe the hardware and software used to drive a
database system which produces information outputs that are easily assimilated by management.
A
B
C
D
I only
I, II and III
I and II only
I and III only
4 Monthly variance reports are an example of which of the following types of management
information?
A Tactical only
B Strategic only
C Operational only
D Tactical, strategic and operational
5 The three main types of accounting are management accounting, financial accounting and cost
accounting. Which of the following sequences is correct?
A Management accounting: immediate; financial accounting: quick; cost accounting: delayed
B Financial accounting: immediate; cost accounting: quick; management accounting: delayed
C Management accounting: immediate; cost accounting: quick; financial accounting: delayed
D Cost accounting: immediate; management accounting: quick; financial accounting: delayed
6 Which of the following describes a Just-in-time system?
A Sustaining a culture of continuous improvement
B Aiming to produce goods when required by customers or for use
C Using resources to create outputs that are in line with the intended objectives or targets
D Developing a product concept and determining the price customers would be willing to pay for
that concept
7 Which one of the following statements is not correct?
A Financial accounting information can be used for internal reporting purposes.
B Cost accounting can only be used to provide inventory valuations for internal reporting.
C Routine information can be used to make decisions regarding both the long term and the short term.
D Management accounting provides information relevant to decision making, planning, control
and evaluation of performances.
CHAPTER 1
38 | MANAGEMENT ACCOUNTING
39
CHAPTER 2
DECISION MAKING AND
RELEVANT COSTING
Learning objectives
Reference
Decision making
LO2
LO2.2
Explain the impact of cash flows and risks on project decision making
LO2.5
Cost behaviour
LO4
LO4.1
Topic list
1
2
3
4
Relevant costs
Choice of product (product mix) decisions
Make or buy decisions
Outsourcing
40 | MANAGEMENT ACCOUNTING
INTRODUCTION
Management at all levels within an organisation take decisions. The overriding requirement of the
information that should be supplied by the cost/management accountant to aid decision making is
that of relevance. This chapter therefore begins by looking at the concept of relevant costing, and
explains how to decide which costs need taking into account when a decision is being made.
We then go on to see how to apply relevant costing to product mix decisions, and make or buy
decisions.
Finally, the important area of outsourcing is considered.
The chapter content is summarised in the diagram below.
Decision making
and
relevant costing
Relevant
costs
Choice of product
(product mix) decisions
Outsourcing
Make or buy
decisions
(Section 1.1)
(Section 1.2)
(Section 1.3)
(Section 1.5)
(Section 1.9)
6 A limiting factor is anything which limits the activity of an entity. What are the
possible limiting factors for an organisation?
(Section 2.1)
CHAPTER 2
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
42 | MANAGEMENT ACCOUNTING
1 RELEVANT COSTS
Section overview
Relevant costs are future cash flows arising as a direct consequence of a decision.
Decisions should be based on future incremental cash flows.
Relevant costs are future cash flows arising as a direct consequence of a decision and which are
therefore pertinent to the decision making process.
b. Cash flows. Only cash flow information is required. This means that costs or charges which do not
reflect additional cash spending, such as depreciation or arbitrarily apportioned costs, should be
ignored for the purpose of decision-making.
c. Incremental costs. Incremental costs are additional costs incurred due to particular decision or
alternative course of action. For example, an employee is expected to have no work to do next
week, but will continue to be paid the basic wage, of $100 per week for attending. A manager
wants to decide whether to give the employee a job which earns the organisation $40 revenue. The
$100 is irrelevant to the decision because although it is a future cash flow, it will be incurred anyway
whether the employee is given work or not. Therefore the job would generate a net gain of $40
and should be given to the employee.
One situation in which it is necessary to identify avoidable costs, is in deciding whether to discontinue
a product. The only costs which would be saved are the avoidable costs which are usually the
variable costs and some specific costs. Costs which would be incurred whether or not the product is
discontinued are known as unavoidable costs.
$
100
80
20
The decision to choose option B would not be taken simply because it offers a profit of $100, but
because it offers a differential profit of $20 in excess of the next best alternative.
Controllable costs are items of expenditure which can be directly influenced by a given manager
within a given time span.
As a general rule, committed fixed costs such as rental costs arising from the possession of plant,
equipment and building, are largely uncontrollable in the short term because they have been
committed by long term decisions.
Discretionary fixed costs, for example, advertising and research and development costs can be
thought of as being controllable because they are incurred as a result of decisions made by
management and can be increased or decreased at fairly short notice.
The principle underlying decision making is that management decisions can only affect the future. In
decision making, managers therefore require information about future costs and revenues which
would be affected by the decision under review. Managers must consider decisions in light of future
costs and avoid incorporating sunk costs when comparing alternatives.
Sunk costs are irrelevant to decision-making because the expenditure has already been incurred.
Worked Example: Sunk costs
An example of a sunk cost is development costs which have already been incurred. Suppose that a
company has spent $250 000 in developing a new service for customers, but the marketing
department's most recent findings are that the service might not gain customer acceptance and could
be a commercial failure. The company needs to decide whether to abandon the development of the
new service, but the $250 000 spent so far should be ignored by the decision makers because it is a
sunk cost.
CHAPTER 2
44 | MANAGEMENT ACCOUNTING
This is not always the case, however, and you should analyse variable and fixed cost data carefully. Do
not forget that 'fixed' costs may only be fixed in the short term.
Total units
required
A
B
C
D
1 000
1 000
1 000
200
Units already
in inventory
0
600
700
200
Book value of
units in inventory
$/unit
2
3
4
Realisable
value
$/unit
2.50
2.50
6.00
Replacement
cost
$/unit
6
5
4
9
Materials C and D are in inventory as the result of previous excessive-buying, and they have a
restricted use.
No other use could be found for material C. The units of material D could be used in another job as
substitute for 300 units of material E, which currently costs $5 per unit (of which the company has no
units in inventory at the moment).
Calculate the relevant costs of material for deciding whether or not to accept the contract.
(The answer is at the end of the chapter)
$/unit
20
30
50
72
22
a. What is the relevant cost of labour if the labour must be hired from outside the organisation?
b. What is the relevant cost of labour if LW expects to have five hours' spare capacity?
c. What is the relevant cost of labour if labour is in short supply?
CHAPTER 2
Material B is used regularly by O'Reilly, and if units of B are required for this job, they would need to
be replaced to meet other production demand.
46 | MANAGEMENT ACCOUNTING
Solution
a. Where labour must be hired from outside the organisation, the relevant cost of labour will be the
variable costs incurred.
Relevant cost of labour on new contract = 15 hours @ $6 = $90
b. It is assumed that the five hours spare capacity will be paid anyway, and so if these five hours are
used on another contract, there is no additional cost to LW.
Relevant cost of labour on new contract
$
60
0
60
$
90
66
156
It is important that you are able to identify the relevant costs which are appropriate to a decision.
Check your understanding by attempting the following question.
Question 3: Customer order
A company has been making a machine to order for a customer, but the customer has since gone into
liquidation, and there is no prospect that any money will be obtained from the winding up of the
company.
Costs incurred to date in manufacturing the machine are $50 000 and progress payments of $15 000
had been received from the customer prior to the liquidation.
The sales department has found another company willing to buy the machine for $34 000 once it has
been completed.
To complete the work, the following costs would be incurred:
a. Materials: these have been bought at a cost of $6 000. They have no other use, and if the machine
is not finished, they would be sold for scrap for $2 000.
b. Further labour costs would be $8 000. Labour is in short supply, and if the machine is not finished,
the work force would be switched to another job, which would earn $30 000 in revenue, and incur
direct costs of $12 000 and absorbed (fixed) overhead of $8 000.
c. Consultancy fees $4 000. If the work is not completed, the consultant's contract would be cancelled
at a cost of $1 500.
d. General overheads of $8 000 would be added to the cost of the additional work.
Assess whether the new customer's offer should be accepted.
(The answer is at the end of the chapter)
REPLACEMENT
COST
($9 000)
CHAPTER 2
LOWER OF
HIGHER OF
($10 000)
NRV
($8 000)
REVENUES
EXPECTED
($10 000)
Therefore, the deprival value of the machine is the lower of the $9 000 replacement cost and the $10
000 future revenues. The deprival value is therefore $9 000.
LO
2.2
Section overview
A limiting factor is any factor which limits the organisation's activities. In a limiting factor
situation, contribution will be maximised by earning the biggest possible contribution per
unit of limiting factor.
48 | MANAGEMENT ACCOUNTING
One of the more common decision-making problems is a situation where there are not enough
resources to meet the potential sales demand. A decision has to be made about what mix of products
to produce, to ensure the available resources are used as efficiently as possible.
It is assumed in limiting factor decision making that management wishes to maximise profit and that
profit will be maximised when total contribution is maximised and that there is no change in fixed cost
expenditure incurred. Contribution is equal to sales revenue less variable costs.
Contribution will be maximised by earning the biggest possible contribution from each unit of
limiting factor. For example, if grade A labour is the limiting factor, contribution will be maximised by
earning the biggest contribution from each hour of grade A labour worked.
The limiting factor decision therefore involves the determination of the contribution earned by
each different product from each unit of the limiting factor.
Worked Example: Profit-maximising production mix
Colour makes two products, the Red and the Blue. Unit variable costs are as follows:
Red
$
1
6
1
8
Direct materials
Direct labour ($3 per hour)
Variable overhead
Blue
$
3
3
1
7
The sales price per unit is $14 per Red and $11 per Blue. During July 20X2 the available direct labour is
limited to 8 000 hours. Sales demand in July is expected to be 3 000 units for Reds and 5 000 units for
Blues.
Determine the profit-maximising production mix, assuming that monthly fixed costs are $20 000, and
that opening inventories of finished goods and work in progress are nil.
Solution
Step 1
Confirm that the limiting factor is something other than sales demand.
Labour hours per unit
Sales demand
Labour hours needed
Labour hours available
Shortfall
Reds
2 hrs
3 000 units
6 000 hrs
Blues
1 hr
5 000 units
5 000 hrs
Total
11 000 hrs
8 000 hrs
3 000 hrs
Step 2
Identify the contribution earned by each product per unit of limiting factor, that is per
labour hour worked.
Sales price
Variable cost
Unit contribution
Labour hours per unit
Contribution per labour hour (= unit of limiting factor)
Reds
$
14
8
6
2 hrs
$3
Blues
$
11
7
4
1 hr
$4
Although Reds have a higher unit contribution than Blues ($8 versus $7), two Blues can be
made in the time it takes to make one Red. Because labour is in short supply it is more
profitable to make Blues than Reds.
Determine the optimum production plan. Sufficient Blues will be made to meet the full
sales demand, and the remaining labour hours available will then be used to make Reds.
(a)
Hours
required
5 000
6 000
11 000
Sales
Demand
5 000
3 000
Product
Blues
Reds
Hours
available
5 000
3 000(bal)
8 000
Hours
Needed
(b)
Product
Units
Blues
Reds
5 000
1 500
Contribution
per unit
$
4
6
5 000
3 000
8 000
Priority of
manufacture
1st
2nd
Total
$
20 000
9 000
29 000
20 000
9 000
In conclusion:
a. Unit contribution is not the correct way to decide priorities.
b. Labour hours are the scarce resource, and therefore contribution per labour hour is the correct
way to decide priorities.
c. The Blue earns $4 contribution per labour hour, and the Red earns $3 contribution per labour hour.
Blues therefore make more profitable use of the scarce resource, and should be manufactured first.
Selling price
Direct materials
Direct labour
Variable overhead
Fixed overhead
Profit
40
A
$ per unit
170
40
30
16
32
118
52
L
$ per unit
176
60
20
20
40
140
36
All three products use the same direct labour and direct materials, but in different quantities.
In a period when the direct labour used on these products is in short supply, the most profitable and
least profitable use of the direct labour is:
A
B
C
D
Most profitable
L
L
V
A
Least profitable
V
A
A
L
CHAPTER 2
Step 3
50 | MANAGEMENT ACCOUNTING
K
250 units
625 units
750 units
1 250 units
L
625 units
250 units
1 250 units
750 units
LO
2.2
3.1 INTRODUCTION
Section overview
In deciding whether to make internally or buy externally, and assuming no scarce resources,
the relevant costs for the decision will be the differential costs between the two options.
One example of a make or buy decision is whether a company should manufacture its own
components, or buy the components in from an outside supplier.
The 'make' option should give management more direct control over the work, but the 'buy' option
often has the benefit that the external organisation has a specialist skill and expertise in the work.
Make or buy decisions should not be based exclusively on cost considerations. The following should
also be considered:
a. How can spare capacity freed up by the 'buy' option be used most profitably?
b. Could the decision to use an outside supplier cause an industrial dispute?
c. Would the subcontractor be reliable with delivery times and product quality?
d. Does the company wish to be flexible and maintain better control over operations by making
everything itself?
Where the organisation has a choice about whether to make internally or buy externally, and scarce
resources are not a factor, the relevant cost is the differential cost between sourcing internally and
sourcing externally.
The organisation will need to consider differences in both variable and fixed costs. For example the
variable cost per unit of buying externally may be higher than the variable cost of making in-house,
but the use of an outside supplier may give rise to savings in directly attributable fixed costs. As a
result, if only a small number of units are required, it may be cheaper overall for an organisation to buy
externally, because the saving in fixed costs may outweigh the additional variable costs incurred.
W
1 000
$
4
8
2
14
X
2 000
$
5
9
3
17
Y
4 000
$
2
4
1
7
Z
3 000
$
4
6
2
12
Directly attributable fixed costs per annum and committed fixed costs are as follows:
CHAPTER 2
$
1 000
5 000
6 000
8 000
30 000
50 000
A subcontractor can supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively.
Decide whether the organisation should make or buy the components.
Solution
a. The relevant costs are the differential costs between making and buying. They consist of
differences in unit variable costs plus differences in directly attributable fixed costs. Buying will
result in some fixed cost savings.
W
$
14
12
$(2)
X
$
17
21
$4
Y
$
7
10
$3
1 000
(2 000)
1 000
(3 000)
2 000
8 000
5 000
3 000
4 000
12 000
6 000
6 000
Z
$
12
14
$2
3 000
6 000
8 000
(2 000)
b. The company would save $3 000 pa by buying component W, where the purchase cost would be
less than the marginal cost per unit to make internally. It would save $2 000 pa by subcontracting
component Z. This is because of the saving in fixed costs of $8 000.
c. Important further considerations would be as follows:
i. If components W and Z are subcontracted, the company will have spare capacity. How should
that spare capacity be profitably used? Are there hidden benefits to be obtained from
buying? Would the company's workforce resent the loss of work to an outside supplier, and
might such a decision cause an industrial dispute?
ii. Would the supplier be reliable with delivery times, and would they supply components of the
same quality as those manufactured internally?
iii. Does the company wish to be flexible and maintain better control over operations by making
everything itself?
iv. Are the estimates of fixed cost savings reliable? In the case of product W, buying is clearly
cheaper than making in-house. In the case of product Z, the decision to buy rather than make
would only be financially beneficial if the fixed cost savings of $8,000 could really be 'delivered'
by management.
52 | MANAGEMENT ACCOUNTING
4 OUTSOURCING
LO
2.2
Section overview
An organisation's value chain refers to the sequence of activities by which inputs are
converted into outputs and includes its supply chain and distribution network.
An organisation should concentrate on retaining those core activities that enhance its
competitive advantage and should consider outsourcing all other activities where it cannot
achieve benchmarked levels of performance.
To minimise the risks associated with outsourcing, organisations generally build close longterm partnerships or alliances with a few key suppliers.
4.1 INTRODUCTION
A significant trend in recent years has been for organisations and government bodies to concentrate
on their core competences, what they are really good at, and turn other activities over to specialist
contractors. Facilities management companies have grown in response to this. An organisation that
earns its profits from manufacturing bicycles does not also need to have expertise in mass catering or
office cleaning.
Definition
Outsourcing is the use of external suppliers as a source of finished products, components or services.
This is also known as contract manufacturing or sub-contracting.
Within the value chain, both primary activities and support activities are candidates for outsourcing,
although many can be eliminated from the list immediately either because the activity cannot be
contracted out or because the organisation must control it to maintain its competitive position. For
instance, Coca Cola does not outsource the manufacture of its concentrate to safeguard its formula
and retain control of the product.
Of the remaining activities, an organisation should carry out only those that it can deliver on a
level comparable with the best organisations in the world. If the organisation cannot achieve
benchmarked levels of performance, the activity should be outsourced so that the organisation is only
concentrating on those core activities that enhance its competitive advantage.
CHAPTER 2
retaining control of the activity is vital to maintain its competitive position and
the activity can be delivered internally on a level comparable with the best organisations in the
world.
An organisation's value chain refers to the sequence of activities by which inputs are converted into
outputs and includes its supply chain and distribution network. The concept of a value chain was
suggested by Michael Porter (1985) to demonstrate how value for the customer is added to the
products or services produced by an organisation. The chain consists of primary activities (such as
inbound logistics, operations, outbound logistics, marketing and service) and secondary activities
(such as infrastructure, human resources, technology and procurement).
54 | MANAGEMENT ACCOUNTING
Case study
Albright and Davis ('The Elements of Supply Chain Management') describe the extreme outsourcing
approach adopted by Mercedes.
Instead of contracting with suppliers for parts, Mercedes outsourced the modules making up a
completed M-class to suppliers who purchase the subcomponents and assemble the modules for
Mercedes.
This has led to a reduction in plant and warehouse space needed, and a dramatic reduction in the
number of suppliers used (from 35 to one for the cockpit, for example).
At the beginning of the production process Mercedes maintained strict control in terms of quality and
cost on both the first tier suppliers, who provide finished modules, and the second tier suppliers, from
whom the first tier suppliers purchase parts. As the level of trust grew between Mercedes and the first
tier suppliers, Mercedes allowed them to make their own arrangements with second tier suppliers.
Benefits of this approach for Mercedes
i. Reduction in purchasing overhead.
ii. Reduction in labour and employee-related costs.
iii. Higher level of service from suppliers.
iv. Supplier expertise in seeking ways to improve current operations.
v. Suppliers working together to continuously improve both their own module and the integrated
product.
A limiting factor is any factor which limits the organisation's activities. In a limiting factor situation,
contribution will be maximised by earning the biggest possible contribution per unit of limiting
factor.
In deciding whether to make internally or buy externally, and assuming no scarce resources, the
relevant costs for the decision will be the differential costs between the two options.
An organisation's value chain refers to the sequence of activities by which inputs are converted into
outputs and includes its supply chain and distribution network.
An organisation should concentrate on retaining those core activities that enhance its competitive
advantage and should consider outsourcing all other activities where it cannot achieve
benchmarked levels of performance.
To minimise the risks associated with outsourcing, organisations generally build close long-term
partnerships or alliances with a few key suppliers.
CHAPTER 2
The relevant cost of an asset represents the amount of money that a company would have to
receive if it were deprived of an asset in order to be no worse off than it already is. We can call this
the deprival value.
56 | MANAGEMENT ACCOUNTING
$1 325
$1 825
$1 950
$3 250
3 A company is considering its option with regard to a machine which cost $60 000 four years ago.
If sold, the machine would generate scrap proceeds of $75 000. If kept, this machine would
generate net income of $90 000.
The current replacement cost for this machine is $105 000.
What is the relevant cost of the machine?
A
B
C
D
$60 000
$75 000
$90 000
$105 000
4 A company manufactures and sells two products (X and Y) both of which utilise the same skilled
labour. For the coming period, the supply of skilled labour is limited to 2,000 hours. Data relating
to each product are as follows:
Product
Selling price per unit
Variable cost per unit
Skilled labour hours per unit
Maximum demand (units) per period
X
$20
$12
2
800
Y
$40
$30
4
400
In order to maximise profit in the coming period, how many units of each product should the
company manufacture and sell?
A
B
C
D
5 In the short-term decision-making context, which one of the following would be a relevant cost?
A Specific development costs already incurred
B The cost of special material which will be purchased
C The cost of a report that has been carried out but not yet paid for
D The original cost of raw materials currently in inventory which will be used on the project
6 A company manufactures and sells a single product. The variable cost of the product is $2.50 per
unit and all production each month is sold at a price of $3.70 per unit. A potential new customer
has offered to buy 6,000 units per month at a price of $2.95 per unit. The company has sufficient
spare capacity to produce this quantity. If the new business is accepted, sales to existing customers
are expected to fall by two units for every 15 units sold to the new customer.
What would be the overall increase in monthly profit which would result from accepting the new
business?
A
B
C
D
$1 740
$2 220
$2 340
$2 700
7 A company is evaluating a project that requires two types of material (T and V). Data relating to the
material requirements are as follows:
T
V
Quantity
needed for
project
kg
500
400
Quantity
currently in
inventory
kg
100
200
Original cost
of quantity in
inventory
$/kg
40
55
Current
purchase
price
$/kg
45
52
Current
resale price
$/kg
44
40
Material T is regularly used by the company in normal production. Material V is no longer in use by
the company and has no alternative use within the business.
What is the total relevant cost of materials for the project?
A
B
C
D
$40 400
$40 900
$43 400
$43 900
8 A machine owned by a company has been idle for some months but could now be used on a one
year contract which is under consideration. The net book value of the machine is $1 000. If not used
on this contract, the machine could be sold now for a net amount of $1 200. After use on the
contract, the machine would have no saleable value and the cost of disposing of it in one year's
time would be $800.
What is the total relevant cost of the machine to the contract?
A
B
C
D
$400
$800
$1 200
$2 000
9 A company has just secured a new contract which requires 500 hours of labour.
There are 400 hours of spare labour capacity. The remaining hours could be worked as overtime at
time and a half or labour could be diverted from the production of product X. Product X currently
earns a contribution of $4 in two labour hours and direct labour is currently paid at a rate of $12 per
normal hour.
What is the relevant cost of labour for the contract?
A
B
C
D
$200
$1 200
$1 400
$1 800
CHAPTER 2
Material type
58 | MANAGEMENT ACCOUNTING
10 A company uses limiting factor analysis to calculate an optimal production plan given a scarce
resource.
The following applies to the three products of the company:
Product
Direct materials (at $6/kg)
Direct labour (at $10/hour)
Variable overheads ($2/hour)
Maximum demand (units)
Optimal production plan
I
$
36
40
8
84
II
$
24
25
5
54
III
$
15
10
2
27
2 000
2 000
4 000
1 500
4 000
4 000
15 750 kg
28 000 kg
30 000 kg
38 000 kg
Option B values the inventory items at their original purchase price, but this is a sunk or past
cost.
Option D is the cost of the 1 000 kgs that must be purchased, but since the material is in
regular use the excess can be kept in inventory until needed.
3 C When calculating the relevant cost of an asset, use the following diagram.
LOWER OF = $90 000
REPLACEMENT
COST
($105 000)
HIGHER OF
= ($90 000)
NRV
($75 000)
REVENUES
EXPECTED
($90 000)
4 D
Product
X
$
20
12
8
4
1st
Y
$
40
30
10
( 4)
2.5
2nd
Manufacture and sell: 800 units of Product X (using 800 2 hours = 1 600 hours); 100 units of
Product Y (using the remaining 400 hours* (2 000 1 600).
* 400 hours 4 hours skilled labour per unit = 100 units.
5 B The cost of special material which will be purchased is a relevant cost in a short-term decisionmaking context.
CHAPTER 2
2 C The material is in regular use and so 1,000 kgs will be purchased. 500 kgs of this will replace the
500 kg in inventory that is used, 100 kgs will be purchased and used and the remaining 400 kgs
will be kept in inventory until needed. The relevant cost is therefore 600 $3.25 = $1,950.
If you selected option A you valued the inventory items at their resale price. However, the items
are in regular use therefore they would not be resold.
60 | MANAGEMENT ACCOUNTING
6 A
$
1.20
0.45
$
2 700
(960)
1 740
22 500
8 000
10 400
40 900
8 D
$
1 200
800
2 000
9 C
500
400
100
1 If the 100 hours are from worked overtime, then the cost
= 100 hours 1.5 $12 = $1 800
2 If labour is diverted from the production of Product X, then the cost
= 100 hours $12 + (100/2 $4)
= $1 200 + $200
= $1 400
Option 2 is cheaper and therefore the relevant cost of labour for the contract is $1 400.
10 B
Optimal production plan (units)
Kgs required per unit
Kgs material available
I
2 000
6
12 000
II
1 500
4
6 000
III
4 000
2.5
10 000
Total
28 000
The required units of material D are already in inventory and will not be replaced. There is an
opportunity cost of using D in the contract because there are alternative opportunities either to sell
the existing inventories for $6 per unit ($1 200 in total) or avoid other purchases (of material E),
which would cost 300 $5 = $1 500. Since substitution for E is more beneficial, $1 500 is the
opportunity cost.
Summary of relevant costs
Material A (1 000 $6)
$
6 000
5 000
2 950
1 500
15 450
2 D The material is in regular use and so 200 kg will be purchased. The relevant cost is therefore
200 $4 = $800.
3 Costs incurred in the past, or revenue received in the past, are not relevant because they cannot
affect a decision about what is best for the future. Costs incurred to date of $50 000 and revenue
received of $15 000 are not relevant and should be ignored.
Similarly, the price paid in the past for the materials is irrelevant. The only relevant cost of
materials affecting the decision is the opportunity cost of the revenue from scrap which would be
forgone $2 000.
Labour costs
Labour costs required to complete work
Opportunity costs: contribution forgone by losing
other work $(30 000 12 000)
Relevant cost of labour
$
8 000
18 000
26 000
$
4 000
1 500
2 500
Absorbed overhead is a notional accounting cost and should be ignored. Actual overhead
incurred is the only overhead cost to consider. General overhead costs and the absorbed overhead
of the alternative work for the labour force should be ignored.
CHAPTER 2
1 000 units of material C are needed and 700 are already in inventory. If used for the contract, a
further 300 units must be bought at $4 each. The existing inventories of 700 will not be replaced. If
they are used for the contract, they could not be sold at $2.50 each. The realisable value of these
700 units is an opportunity cost of sales revenue forgone.
62 | MANAGEMENT ACCOUNTING
$
34 000
2 000
8 000
18 000
2 500
30 500
3 500
4 B As direct labour is in short supply the contribution per $ of direct labour is used to rank the
products:
V
$
120
A
$
170
L
$
176
60
60
20
3
86
84
30
2.80
100
76
20
3.80
5 B
Contribution per unit
Contribution per unit of limiting factor
Ranking
Production plan
Contracted supply of K (500 2 kg)
Meet demand for L (250 3 kg)
Remainder of resource for K (125 2 kg)
K
$15
$15/2 = $7.50
L
$30
$30/3 = $10
1
Raw material used
kg
1 000
750
250
2 000
63
CHAPTER 3
BUDGETING
Learning objectives
Reference
Budgeting
LO3
Identify and analyse the human behavioural challenges to the budgeting process in
organisations
LO3.1
Explain the nature of budgets and the reasons that organisations use budgets
LO3.2
LO3.3
LO3.4
Cost Behaviour
LO4
Apply relevant techniques to separate costs into their fixed and variable components
LO4.2
Topic list
1
2
3
4
5
6
7
8
9
10
64 | MANAGEMENT ACCOUNTING
INTRODUCTION
This chapter begins by explaining the reasons why an organisation might prepare a budget and goes
on to detail the steps in the preparation of a budget. The method of preparing, and the relationship
between the various functional budgets is then set out.
The chapter also considers the construction of cash budgets and the budgeted statement of
comprehensive income and statement of financial position, which make up what is known as a master
budget. Two different budgeting systems are described: the more traditional incremental approach,
and a more recent development zero-based budgeting (ZBB). The first builds on the previous year's
budgets, while ZBB begins from scratch each time the budget is prepared.
Finally, we will look at the way in which budgets can affect the behaviour and performance of
employees, for better and for worse.
The chapter content is summarised in the diagram below.
Budgeting
Purposes and
benefits
Preparation
Flexible
budgets
Performance
and motivation
Functional
budgets
Cost
estimation
Budgeting
and quality
Cash
budgets
Statement of
comprehensive
income
Statement of
financial position
Incremental budgeting
and ZBB
BUDGETING | 65
(Section 1)
(Section 2.1)
(Section 2.5)
(Section 6)
(Section 8)
(Section 9.2)
(Section 9.5)
(Section 9.5)
(Section 10.1)
(Section 10.2)
CHAPTER 3
66 | MANAGEMENT ACCOUNTING
Definition
LO
3.2
A budget is a quantitative statement, for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows.
BUDGETING | 67
Allocation of resources
Allocation of scarce resources among competing uses.
The remainder of the chapter explain further how budgets are used to achieve these benefits. We will
begin by looking at the planning and control aspects of budgeting.
Planning
process
Control
process
Step 1
Identify objectives
Step 1
Step 2
Step 3
Choose alternative
courses of action
Step 4
Step 5
Step 6
Respond to
divergences from plan
Step 7
Identify objectives
Objectives establish the direction in which the management of the organisation wish it to
be heading. Typical objectives include the following:
To maximise profits.
To increase market share.
To produce a better quality product than anyone else.
Objectives answer the question: 'where do we want to be?'.
Step 2
CHAPTER 3
68 | MANAGEMENT ACCOUNTING
It must also gather external information so that it can assess its position in the
environment. Just as it has assessed its own strengths and weaknesses, it must do
likewise for its competitors (threats). Its current market must be analysed. It must also
analyse any other markets that it is intending to enter, to identify possible new
opportunities. This process is known as SWOT analysis: Strengths, Weaknesses,
Opportunities and Threats. The state of the world economy must be considered. Is it
in recession or is it booming? What is likely to happen in the future and over what
timescale? This is known as assessing the business cycle.
Having carried out a strategic analysis, alternative strategies can be identified.
Step 3
Evaluate strategies
The strategies must then be evaluated in terms of suitability, feasibility and
acceptability in the context of the strategic analysis. Management should select those
strategies that have the greatest potential for achieving the organisation's objectives.
One strategy may be chosen or several.
Step 4
Step 5
Steps 6
Measure actual results and compare with plan. Respond to divergences from plan
and 7
At the end of the year actual results should be compared with those expected under the
long-term plan. The long-term plan should be reviewed in the light of this comparison
and the progress that has been made towards achieving the organisation's objectives
should be assessed. Management can also consider the feasibility of achieving the
objectives in the light of circumstances which have arisen during the year. If the plans are
now no longer attainable then alternative strategies must be considered for achieving the
organisation's objectives, as indicated by the feedback loop (the arrowed line) linking
step 7 to step 2. This aspect of control is carried out by senior management, normally on
an annual basis.
The control of day-to-day operations is exercised by lower-level managers. At frequent
intervals they must be provided with performance reports which consist of detailed
comparisons of actual results and budgeted results. Performance reports provide
feedback information by comparing planned and actual outcomes. Such reports should
highlight those activities that do not conform to plan, so that managers can devote their
scarce time to focusing on these items. Effective control requires that corrective action is
taken so that actual outcomes conform to planned outcomes, as indicated by the
feedback loop linking steps 5 and 7. Isolating past inefficiencies and the reasons for them
will enable managers to take action that will avoid the same inefficiencies being repeated
in the future. The system that provides reports that compare actual performance with
budget figures and holds managers responsible is known as responsibility accounting.
We will return to this topic below.
BUDGETING | 69
CHAPTER 3
70 | MANAGEMENT ACCOUNTING
The first task in the budgetary process is to identify the principal budget factor. This is also known as
the key budget factor or limiting budget factor.
The principal budget factor is usually 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 the principal budget factor is defined then the remainder of the budgets can be prepared. For
example, if sales are the principal budget factor then the production manager can only prepare the
production budget after the sales budget is complete.
A useful assumption for preparing the first draft of the functional budgets is to assume that sales
demand is the principal budget factor. If it then becomes apparent that a scarce resource is the
principal budget factor, the functional budgets can be revised and new drafts prepared.
The stages involved in the preparation of a budget with sales as the limiting factor can be summarised
as follows.
a. The sales budget (revenue budget) is prepared by calculating units of product (volume) multiplied
by sales price. The finished goods inventory budget can be prepared at the same time. This
budget decides the planned increase or decrease in finished goods inventory levels.
b. With the information from the sales and inventory budgets, the production budget can be
prepared. This is, in effect, the sales budget in units plus (or minus) the increase (or decrease) in
finished goods inventory. The production budget will be stated in terms of units.
c. This leads on to budgeting the resources for production. This involves preparing a materials
usage budget, machine usage budget and a labour budget.
BUDGETING | 71
d. In addition to the materials usage budget, a materials inventory budget will be prepared, to
decide the planned increase or decrease in the level of inventories held. Once the raw materials
usage requirements and the raw materials inventory budget are known, the purchasing department
can prepare a raw materials purchases budget in quantities and value for each type of material
purchased.
e. During the preparation of the sales and production budgets, the managers of the cost centres of
the organisation will prepare their draft budgets for the department overhead costs. (A cost
centre is any division, department, or subsidiary of a company that has expenses but is not directly
producing revenues). Such overheads will include maintenance, stores, administration, selling and
research and development.
f. From the above information a budgeted statement of comprehensive income can be produced.
g. In addition several other budgets must be prepared in order to arrive at the budgeted statement
of financial position. These are the capital expenditure budget (for non-current assets), the
working capital budget (for budgeted increases or decreases in the level of receivables and
payables as well as inventories), and a cash budget.
LO
3.3
ECO Ltd manufactures two products, S and T, which use the same raw materials, D and E. One unit of
S uses 3 litres of D and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of E. A litre of
D is expected to cost $3 and a kilogram of E $7.
The sales budget for 20X2 comprises 8,000 units of S and 6,000 units of T; finished goods in stock at 1
January 20X2 are 1 500 units of S and 300 units of T, and the company plans to hold inventories of 600
units of each product at 31 December 20X2.
Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company
plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for damages
and deterioration of items held in store, as follows:
Product S:
Product T:
Material D:
Material E:
loss of 50 units
loss of 100 units
loss of 500 litres
loss of 200 kilograms
CHAPTER 3
72 | MANAGEMENT ACCOUNTING
Solution
To calculate material purchases requirements first it is necessary to calculate the material usage
requirements. That in turn depends on calculating the budgeted production volumes.
Product S
Units
Production required
To meet sales demand
To provide for inventory loss
For closing inventory
Product T
Units
8 000
50
600
8 650
1 500
7 150
6 000
100
600
6 700
300
6 400
Material D
Litres
Usage requirements
To produce 7 150 units of S
To produce 6 400 units of T
To provide for inventory loss
For closing inventory
Less inventory already in hand
Budgeted material purchases
Unit cost
Cost of material purchases
Total cost of material purchases
Material E
Kgs
21 450
32 000
500
5 000
58 950
6 000
52 950
28 600
12 800
200
3 500
45 100
2 800
42 300
$3
$7
$158 850
$296 100
$454 950
The basics of the preparation of each functional budget are similar to the above.
4 CASH BUDGETS
Section overview
The cash budget is one of the most important planning tools that an organisation can use.
It shows the cash effect of all plans made within the budgetary process.
Definition
A cash budget is a statement in which estimated future cash receipts and payments are tabulated
in such a way as to show the forecast cash balance of a business at defined intervals.
In December 20X2 an accounts department might wish to estimate the cash position of the business
for the following months, January to March 20X3. A cash budget might be drawn up in the following
format:
Jan
$
Feb
$
Mar
$
14 000
3 000
16 500
4 000
2 200
22 700
17 000
4 500
17 000
21 500
BUDGETING | 73
Jan
$
Feb
$
Mar
$
8 000
3 000
7 800
3 500
16 000
10 500
3 500
1 200
2 500
14 700
1 200
1 000
1 200
28 500
16 200
2 300
1 200
3 500
(5 800)
3 500
(2 300)
5 300
(2 300)
3 000
In the example above, where the figures are purely for illustration, the accounts department has
calculated that the cash balance at the beginning of the budget period, 1 January, will be $1 200.
Estimates have been made of the cash which is likely to be received by the business (from cash and
credit sales, and from a planned disposal of non-current assets in February). Similar estimates have
been made of cash due to be paid out by the business - payments to suppliers and employees,
payments for rent, rates and other overheads, payment for a planned purchase of non-current assets in
February and a loan repayment due in January.
The last part of the cash budget above shows how the business's estimated cash balance can then be
rolled along from month to month. Starting with the opening balance of $1 200 at 1 January a cash
surplus of
$2 300 is generated in January. This leads to a closing January balance of $3 500 which becomes the
opening balance for February. The deficit of $5 800 in February puts the business's cash position into
overdraft and the overdrawn balance of $2 300 becomes the opening balance for March. Finally, the
healthy cash surplus of $5 300 in March leaves the business with a favourable cash position of $3 000 at
the end of the budget period.
Short-term surplus
Short-term deficit
Increase payables
Reduce receivables
Arrange an overdraft
CHAPTER 3
From these estimates it is a simple step to calculate the excess of cash receipts over cash payments in
each month. In some months cash payments may exceed cash receipts and there will be a deficit for
the month; this occurs during February in the above example because of the large investment in noncurrent assets in that month.
74 | MANAGEMENT ACCOUNTING
CASH POSITION
Long-term surplus
Long-term deficit
BUDGETING | 75
Payments
Suppliers (W1)
Running expenses
Drawings
Receipts
Debtors (W1)
Surplus/(shortfall)
Opening balance
Closing balance
Workings
W1 Suppliers
Purchased
Paid for in
W2 Receipts
Sales made
Cash received
Oct
$
Nov
$
Dec
$
Jan
$
Feb
$
Mar
$
5 000
1 600
1 000
7 600
2 000
1 600
1 000
4 600
4 000
1 600
1 000
6 600
4 000
1 600
1 000
6 600
7 000
1 600
1 000
9 600
7 000
1 600
1 000
9 600
(7 600)
7 000
(600)
(4 600)
(600)
(5 200)
3 000
(3 600)
(5 200)
(8 800)
6 000
(600)
(8 800)
(9 400)
6 000
(3 600)
(9 400)
(13 000)
10 500
900
(13 000)
(12 100)
Sept
Oct
Nov
Dec
Jan
Feb
Mar
5000
0
2000
5000
4000
2000
4000
4000
7000
4000
7000
7000
7000
7000
0
0
3000
0
6000
0
6000
3000
10500
6000
10500
6000
10500
10500
Sales
Purchases
Wages
Overheads
Dividends
Capital
expenditure
Nov X4
$
80 000
40 000
10 000
10 000
Dec X4
$
100 000
60 000
12 000
10 000
20 000
Jan X5
$
110 000
80 000
16 000
15 500
30 000
Annex A
Feb X5
Mar X5
$
$
130 000
140 000
90 000
110 000
20 000
24 000
15 500
15 500
Apr X5
$
150 000
130 000
28 000
20 000
40 000
May X5
$
160 000
140 000
32 000
20 000
Jun X5
$
180 000
150 000
36 000
20 000
CHAPTER 3
76 | MANAGEMENT ACCOUNTING
Requirements:
a. How much cash will be received from sales in February 20X5?
A
B
C
D
$100 000
$112 000
$118 000
$130 000
c. What is the total budgeted cash spending on overheads in the six month period January June
20X5?
A
B
C
D
$81 000
$87 000
$95 000
$99 000
d. What is the total budgeted receipts from sales in the six month period January to June 20X5?
A
B
C
D
$666 000
$742 000
$774 000
$822 000
e. What are the total budgeted payments for purchases in the six month period January to June
20X5?
A
B
C
D
$610 000
$690 000
$700 000
$790 000
f. If the cash budget indicates a large bank overdraft at the end of June, which one of the following
measures might be the most practical for reducing the budgeted cash deficit?
A Postpone the capital expenditure
B Increase the speed of debt collection
C Take on extra staff to reduce the amount of overtime working.
D Persuade staff to work at a lower rate in return for an annual bonus or a profit-sharing
agreement
(The answers are at the end of the chapter)
BUDGETING | 77
LO
3.3
Section overview
As well as wishing to forecast its cash position, a business might want to estimate its
profitability and its financial position for a coming period. This would involve the
preparation of a budgeted statement of comprehensive income and statement of financial
position, both of which form the master budget.
Worked Example: Budgeted financial statements
Using the information in the previous example involving Petra Blair (section 4.1) you are required to
prepare Petra's budgeted statement of comprehensive income for the six months ending on 31 March
20X4 and a budgeted statement of financial position as at that date.
Solution
The statement of comprehensive income is straightforward. The first figure is sales, which can be
computed very easily from the information in paragraph (c) in the original question. It is sufficient to
add up the monthly sales figures given there; for this statement there is no need to worry about any
closing receivables. Similarly, cost of sales is calculated directly from the information on gross margin
contained in the example above.
$
46 500
31 000
15 500
9 600
800
10 400
5 100
CHAPTER 3
INCOME STATEMENT
FORECAST TRADING AND COMPREHENSIVE INCOME STATEMENT
FOR THE SIX MONTHS ENDING 31 MARCH 20X4
78 | MANAGEMENT ACCOUNTING
$
7 200
5 000
21 000
26 000
Current liabilities
Bank overdraft
Trade payables (March purchases)
Net current assets
Total assets
Proprietor's interest
Capital introduced
Profit for the period
Less drawings
Retained loss
Total equity
12 100
7 000
19 100
6 900
14 100
15 000
5 100
6 000
(900)
14 100
Budget questions are often accompanied by a large amount of sometimes confusing detail. This
should not blind you to the fact that many figures can be entered very simply from the logic of the
trading situation described. For example, in the case of Petra Blair you might feel tempted to begin a
T-account to compute the figure for closing receivables. This kind of working is rarely necessary, since
you are told that credit customers take two months to pay. Closing receivables will equal total credit
sales in the last two months of the period.
Similarly, you may be given a simple statement that a business pays rates at $1 500 a year, followed by
a lot of detail to enable you to calculate a prepayment at the beginning and end of the year. If you are
preparing a budgeted comprehensive income statement for the year do not lose sight of the fact that
the rates expense can be entered as $1 500 without any calculation at all.
6 FLEXIBLE BUDGETS
LO
3.2
3.3
Section overview
A flexible budget is a budget which is designed to change as volume of activity changes.
Definitions
A fixed (static) budget is a budget which is set for a single activity level.
A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to
change as volume of activity changes.
Master budgets are based on planned volumes of production and sales but do not include any
provision for the event that actual volumes may differ from the budget. In this sense they may be
described as fixed (static) budgets.
A flexible budget has two advantages:
a. At the planning stage, it may be helpful to know what the effects would be if the actual outcome
differs from the prediction. For example, a company may budget to sell 10 000 units of its product,
but may prepare flexible budgets based on sales of, say, 8 000 and 12 000 units. This would enable
contingency plans to be drawn up if necessary.
b. At the end of each month or year, actual results may be compared with the relevant activity level in
the flexible budget as a control procedure.
BUDGETING | 79
Flexible budgeting uses the principles of marginal costing. In estimating future costs it is often
necessary to begin by looking at cost behaviour in the past. For costs which are wholly fixed or wholly
variable no problem arises. But you may be presented with a cost which appears to have behaved in
the past as a semi-variable cost (partly fixed and partly variable). A technique for estimating the level
of the cost for the future is called the high-low method. This is discussed in more detail in Chapter 4,
section 4.2
Worked Example: High-low method
The cost of factory power has behaved as follows in past years:
Units of output produced
20X1
20X2
20X3
20X4
7 900
7 700
9 800
9 100
Budgeted production for 20X5 is 10 200 units. Estimate the cost of factory power which will be
incurred. Ignore inflation.
Solution
20X3 (highest output)
20X2 (lowest output)
Units
9 800
7 700
2 100
$
44 400
38 100
6 300
15 000
Fixed cost
Variable cost of budgeted production (10 200 $3)
Total budgeted cost of factory power
45 600
CHAPTER 3
The level of fixed cost can be calculated by looking at any output level.
80 | MANAGEMENT ACCOUNTING
Semi-variable costs are expected to relate to the direct labour hours in the same manner as for
the last five years.
Direct labour
hours
Year
20X1
20X2
20X3
20X4
20X5
Semi-variable
costs
$
20 800
19 800
18 600
17 800
16 000 (estimate)
64 000
59 000
53 000
49 000
40 000 (estimate)
Fixed costs
$
18 000
10 000
4 000
15 000
25 000
Depreciation
Maintenance
Insurance
Rates
Management salaries
Inflation is to be ignored.
b. Compile a flexible manufacturing budget for 20X6 assuming that 57,000 direct labour hours are
worked.
Solution
a.
80% level
48 000 hrs
$ 000
90% level
54 000 hrs
$ 000
100% level
60 000 hrs
$ 000
180.00
202.50
225.00
36.00
18.00
12.96
246.96
17.60
40.50
20.25
14.58
277.83
18.80
45.00
22.50
16.20
308.70
20.00
18.00
10.00
4.00
15.00
25.00
336.56
18.00
10.00
4.00
15.00
25.00
368.63
18.00
10.00
4.00
15.00
25.00
400.70
Working
Using the high/low method:
$
20 800
16 000
4 800
$0.20
$
20 800
12 800
8 000
=
=
=
$
20 000
18 800
17 600
BUDGETING | 81
b. The budget manufacturing cost for 57,000 direct labour hours of work would be as follows:
$
293 265
Variable costs
Semi-variable costs
Fixed costs
19 400
72 000
384 665
Budget
2 000
$
20 000
6 000
4 000
1 000
2 000
1 500
3 600
18 100
1 900
Actual results
3 000
$
30 000
8 500
4 500
1 400
2 200
1 600
5 000
23 200
6 800
Variance
1 000F
$
10 000 (F)
2 500 (U)
500 (U)
400 (U)
200 (U)
100 (U)
1 400 (U)
5 100
4 900 (F)
Note. (F) denotes a favourable variance and (U) an unfavourable variance. Unfavourable variances are
sometimes denoted as (A) for 'adverse'.
a. In this example, some of the variances calculated above are not useful for the purposes of control.
Windy Ltd has earned $10 000 more revenue than budgeted but spent $5 100 more on costs.
However actual revenue and costs would inevitably be expected to be higher than the original
budget because the volume of output was also 50% higher. For example, even if the unit costs
were as budgeted, total variable costs such as direct material and direct labour would be expected
to increase by 50% above the budgeted costs in the fixed (static) budget, whereas fixed costs such
as rent and rates would be unaffected by the volume change.
b. For control purposes, it is necessary to adjust the original budget to ascertain the answers to
questions such as the following:
Were actual costs higher than they should have been to produce and sell 3 000 clouds? As
explained above, the unfavourable direct materials variance of $2 500 is misleading. It would be
more meaningful to compare the actual material cost of $8 500 to a restated budget figure of
$9 000 ($6 000 x 3 000/2 000), resulting in a favourable variance of $500 which implies that Windy
Ltd has in fact saved money on materials.
CHAPTER 3
Windy Ltd manufactures a single product, the cloud. Budgeted results and actual results for June 20X2
are shown below:
82 | MANAGEMENT ACCOUNTING
Was actual revenue satisfactory from the sale of 3 000 clouds? The budgeted selling price is $10
per cloud ($20 000/2 000 units), so budgeted revenue for 3 000 clouds would be $30 000
indicating that Windy Ltd has performed exactly as expected.
A more desirable approach to budgetary control which helps an organisation to identify where
corrective action needs to be taken can be seen in the worked example below:
a. Identify fixed and variable costs.
b. Produce a flexible budget using marginal costing techniques.
c. Ascertain the variances by comparing the actual result with the flexible budget.
Fixed
(static)
budget
(a)
2 000
Flexible
budget
(b)
3 000
Actual
results
(c)
3 000
Budget
variance
(b) (c)
$
20 000
$
30 000
$
30 000
6 000
4 000
1 000
9 000
6 000
1 500
8 500
4 500
1 400
500 (F)
1 500 (F)
100 (F)
3 600
4 600
5 000
400 (U)
2 000
1 500
18 100
1 900
2 000
1 500
24 600
5 400
2 200
1 600
23 200
6 800
200 (U)
100 (U)
1 400 (F)
1 400 (F)
BUDGETING | 83
b. Another reason for the improvement in profit above the fixed (static) budget profit is the sales
volume. Windy Ltd sold 3 000 clouds instead of 2 000 clouds, with the following result:
$
Budgeted sales revenue increased by
Budgeted variable costs increased by
direct materials
direct labour
maintenance
variable element of other costs
Budgeted fixed costs are unchanged
Budgeted profit increased by
$
10 000
3 000
2 000
500
1 000
6 500
3 500
Budgeted profit was therefore increased by $3 500 because sales volumes increased. This can be
calculated by comparing the fixed (static) budget to the flexible budget (5 400 1 900 = 3 500).
c. A full variance analysis statement would be as follows:
$
Fixed (static) budget profit
Variances
Sales volume (as calculated in (b) above)
Direct materials cost
Direct labour cost
Maintenance cost
Other costs
Depreciation
Rent and rates
Actual profit
$
1 900
3 500 (F)
500 (F)
1 500 (F)
100 (F)
400 (U)
200 (U)
100 (U)
4 900
6 800
(F)
CHAPTER 3
If management believes that any of these variances are large enough to justify it, they will
investigate the reasons for them to see whether any corrective action is necessary.
84 | MANAGEMENT ACCOUNTING
7 COST ESTIMATION
LO
4.2
Section overview
The production of a budget calls for the preparation of cost estimates and sales forecasts.
Cost estimation involves the measurement of historical costs to predict future costs.
In this section we will consider various cost estimation techniques.
Step 1
Step 2
Step 3
Step 4
Total cost at high activity level _ total cost at low activity level
_
Total units at high activity level total units at low activity level
The major drawback to the high/low method is that only two historical cost records from previous
periods are used in the cost estimation. Unless these two records are a reliable indicator of costs
throughout the relevant range of levels of activity, which is unlikely, only a 'loose approximation' of
fixed and variable costs will be obtained. The advantage of the method is its relative simplicity.
BUDGETING | 85
The advantage of the scatter graph over the high/low method is that a greater quantity of historical
data is used in the estimation, but its disadvantage is that the cost line is drawn by visual judgment
and so is a subjective approximation.
A more accurate technique for plotting a line of best fit is to use regression analysis. This statistical
technique uses data from past periods to establish the relationship between costs and level of activity
as the equation of a straight line:
y = a + bx,
where a = fixed costs, b= variable cost per unit and x = volume of output.
The regression line can then be used to forecast costs for future periods.
LOs
3.1
3.2
Section overview
Incremental budgeting is concerned mainly with the increments in costs and revenues
which will occur in a coming period.
Zero-based budgeting involves preparing a budget for each cost centre from a zero base.
The traditional approach to budgeting is to base next year's budget on the current year's results
plus an extra amount for estimated growth or inflation next year. This approach is known as
incremental budgeting since it is concerned mainly with the increments in costs and revenues which
will occur in the coming period.
Incremental budgeting is a reasonable procedure if current operations are as effective, efficient and
economical as they can be, and the organisation and the environment are largely unchanged.
In general, however, it is an inefficient form of budgeting as it encourages slack and wasteful spending
to creep into budgets: managers will spend to budget, even if the amount added for inflation proved
not to be necessary, so that the level of next year's budget is maintained. The result is that past
inefficiencies are perpetuated because cost levels are rarely subjected to close scrutiny.
To ensure that inefficiencies are not concealed, alternative approaches to budgeting have been
developed. One such approach is zero-based budgeting (ZBB).
Zero-based budgeting involves preparing a budget for each cost centre from a zero base. Every item
of expenditure has to be justified in its entirety in order to be included in the next year's budget.
CHAPTER 3
86 | MANAGEMENT ACCOUNTING
Step 1
Step 2
Step 3
Allocate resources
Resources in the budget are then allocated according to the funds available and the
evaluation and ranking of the competing packages.
Employees or trade union representatives may resist management ideas for changing the ways
in which work is done.
BUDGETING | 87
The organisation's information systems may not be capable of providing suitable cost and
benefit analysis.
The ranking process can be difficult. Managers face three common problems:
A large number of packages may have to be ranked.
There is often a conceptual difficulty in having to rank packages which managers regard as
being equally vital, for legal or operational reasons.
It is difficult to rank completely different types of activity, especially where activities have
qualitative rather than quantitative benefits, such as spending on staff welfare and working
conditions, where ranking must usually be entirely subjective.
In summary, perhaps the most serious drawback to ZBB is that it requires a lot of management
time and effort. One way of obtaining the benefits of ZBB and overcoming the drawbacks, is to apply
it selectively on a rolling basis throughout the organisation. For example, this year it applies to the
finance department, next year marketing department, the year after personnel department and so on.
In this way all activities will be thoroughly scrutinised over a period of time.
CHAPTER 3
The procedures of ZBB do not lend themselves easily to direct manufacturing costs where standard
costing, work study and the techniques of management planning and control have long been
established as a means of budgeting expenditure.
88 | MANAGEMENT ACCOUNTING
Disadvantages include:
The budget preparation process may be more costly
Managers may be de-motivated by the additional volume of work involved, for example if standard
costs or stock valuations need to be revised.
In this chapter we have concentrated on the importance of the budgeting process for planning and
control by management. A further aspect of the budgeting process is the human behavioural aspect,
the effect that the budgeting process and resulting budgets has on the performance of managers and
other employees alike.
Management must decide which of the four types of standard is most appropriate as a benchmark for
measuring performance.
BUDGETING | 89
Standards can be used as aspirational targets to drive improvements in performance, but when
benchmarking actual performance against such standards, management need to be aware that this
may result in de-motivated employees:
The impact on employee behaviour of budgets based on these different standards is summarised in
the table below:
TYPE OF STANDARD
IMPACT
Ideal standards
Some say that they provide employees with an incentive to be more efficient
even though it is highly unlikely that the standard will be achieved. Others
argue that they are likely to have an unfavourable effect on employee
motivation because the differences between standards and actual results will
always be adverse. The employees may feel that the goals are unattainable and
so they will not work so hard.
Attainable standards
Current standards
Will not motivate employees to do anything more than they are currently doing.
Basic standards
The various research projects into the behavioural effects of budgeting have given conflicting views on
certain points. However, there appears to be general agreement that a target must fulfil certain
conditions if it is to motivate employees to work towards it:
It must be sufficiently difficult to be a challenging target.
It must not be so difficult that it is not achievable.
It must be accepted by the employees as their personal goal.
9.3 PARTICIPATION
There are basically two ways in which a budget can be set: from the top down (imposed budget) or
from the bottom up (participatory budget).
There are, of course, advantages and disadvantages to this style of setting budgets.
Advantages
The aims of long-term plans are more likely to be incorporated into short-term plans.
They improve the co-ordination between the plans and objectives.
CHAPTER 3
Budgets and standards are more likely to motivate employees if employees accept that the budget or
standard is achievable. If it can be achieved too easily, it will not provide sufficient motivation. If it is too
difficult, employees will not accept it because they will believe it to be unachievable. In extreme
circumstances, if employees believe a budget is impossible to achieve, they might be so de-motivated
that they attempt to prove that the budget is wrong. This is obviously the completely opposite effect to
that intended.
90 | MANAGEMENT ACCOUNTING
Disadvantages
Dissatisfaction, defensiveness and low morale amongst employees who have to work to meet the
targets. It is hard for people to be motivated to achieve targets set by somebody else. Employees
might put in only just enough effort to achieve targets, without trying to beat them.
The feeling of team spirit may disappear.
Organisational goals and objectives might not be accepted so readily and/or employees will not
be aware of them.
Employees might see the budget as part of a system of trying to find fault with their work: if they
cannot achieve a target that has been imposed on them they may be punished.
If consideration is not given to local operating and political environments, unachievable budgets
for overseas divisions could be produced.
Lower-level management initiative may be stifled if they are not invited to participate.
The research projects do not appear to provide definite conclusions about the motivational effects of
budgeting. The attitudes of the individuals involved have an impact.
BUDGETING | 91
Some managers may complain that they are too busy to spend time on setting standards and
budgeting.
Others may feel that they do not have the necessary skills.
Some may think that any budget they set will be used against them.
In such circumstances participation could be seen as an added pressure rather than as an opportunity.
For such employees an imposed approach might be better.
A typical situation is for a manager to pad the budget and waste money on non-essential expenses so
that all the budget allowances are used. The reason behind this action is the fear that unless the
allowance is fully spent it will be reduced in future periods, making the future budget more difficult to
attain. If inefficiency and slack are allowed for in budgets, achieving a budget target means only that
costs have remained within the accepted levels of inefficient spending.
Budget bias can work in the other direction too. It has been noted that, after a run of mediocre
results, some managers deliberately overstate revenues and understate cost estimates, no doubt
feeling the need to make an immediate favourable impact by promising better performance in the
future. They may merely delay problems, however, as the managers may well be censured when they
fail to hit these optimistic targets.
CHAPTER 3
In controlling actual operations, managers must then ensure that their spending rises to meet their
budget, otherwise they will be 'blamed' for careless budgeting.
92 | MANAGEMENT ACCOUNTING
A well designed standard costing and budgetary control system can help to ensure goal congruence.
Continuous feedback prompting appropriate control action should steer the organisation in the right
direction.
Question 3: Eskafield
Eskafield Industrial Museum opened ten years ago and soon became a market leader with many
working exhibits. In the early years there was a rapid growth in the number of visitors but with no
further investment in new exhibits, this growth has not been maintained in recent years.
Two years ago, John Derbyshire was appointed as the museum's chief executive. His initial task was to
increase the number of visitors to the museum and, following his appointment, he had made several
improvements to make the museum more successful.
Another of John's tasks is to provide effective financial management. This year the museum's Board of
Management has asked him to take full responsibility for producing the 20X3 budget. He has asked
you to prepare estimates of the number of visitors next year.
Shortly after receiving your notes, John Derbyshire contacts you. He explains that he had prepared a
draft budget for the Board of Management based on the estimated numbers for 20X3. This had been
prepared on the basis that:
Most of the museum's expenses such as salaries and rates are fixed costs;
The museum has always budgeted for a deficit;
b. Which of the following factors would affect whether or not a top-down approach to budgeting is
appropriate for the museum?
I Financial awareness of the management team
II The level in the management hierarchy where spending decisions are made
III The size and culture of the organisation
A I only
B I and III only
C II and III only
D I, II and III
(The answer is at the end of the chapter)
BUDGETING | 93
CHAPTER 3
However, since TQM seeks continuous improvement, it is not altogether consistent with a budget
approach to planning that uses current or attainable standards as a target.
94 | MANAGEMENT ACCOUNTING
A budget is one of the most important planning tools that an organisations can use. It shows the
cash effect of all plans made within the budgetary process.
In addition to forecasting its cash position, a business may want to estimate its profitability and its
financial position for a coming period.
Budgeted statements of comprehensive income and financial position form the master budget.
A fixed (static) budget is a budget which is set for a single activity level, whereas a flexible budget
is a budget which is designed to change as volume of activity changes.
Cost estimation involves the measurement of historical costs to predict future costs.
Incremental budgeting is concerned mainly with the increments in costs and revenues which will
occur in a coming period.
Zero-based budgeting involves preparing a budget for each cost centre from a zero base.
Human behaviour affects the budgeting process, the resulting budgets and the performance of
managers and employees alike.
BUDGETING | 95
5 In comparing a fixed budget with a flexible budget, what is the reason for the difference between
the profit figures in the two budgets?
A
B
C
D
6 When budget allowances are set without the involvement of the budget owner, the budgeting
process can be described as
A
B
C
D
7 For which of the following would zero based budgeting be most suitable?
A
B
C
D
Building construction
Mining company operations
Transport company operations
Government department activities
CHAPTER 3
96 | MANAGEMENT ACCOUNTING
BUDGETING | 97
$
52 000
60 000
112 000
(b) D
$
Cash sales: (40% $110 000)
From credit sales in November: (60% $80 000)
Total cash receipts in January
Payments for Decembers purchases
Payments for wages (Dec: 25% 12 000) + (Jan:
75% 16 000)
Payments for Decembers overheads (10 000
2 000)*
Total cash payments in January
Excess of cash receipts over payments
Cash balance at beginning of January
Cash balance at end of January
$
44 000
48 000
92 000
60 000
15 000
8 000
83 000
9 000
15 000
24 000
(c) A Overheads are paid the month after they are incurred so payments in January-June 20X5
relate to overheads incurred in December-May. Depreciation is not a cash cost and
therefore needs to be excluded:
Payments in:
January (10 000 2 000)
February April: [3 (15 500 2 500)]
May June: [2 (20 000 3 000)]
Total payments
$
8 000
39 000
34 000
81 000
(d) C
Receivables at 1 January: 60% (80 000 + 100
000)
Sales January to June
Less
Receivables at 30 June: 60% (160 000 + 180
000)
Cash receipts from sales
$
108 000
870 000
978 000
(204 000)
774 000
CHAPTER 3
98 | MANAGEMENT ACCOUNTING
(e) A
Payables at 1 January
Purchases January to June
Less Payables at 30 June
Cash payments for purchases
$
60 000
700 000
760 000
(150 000)
610 000
Alternatively since purchases are paid in the month after they are incurred, cash payments
Jan-June relate to purchases from Dec-May: (60+80+90+110+130+140) = 610 000
(f) A Budgeted wages costs are expected to rise substantially, but extra staff should not be taken
on unless they are expected to do simple casual work, or unless they are expected to remain
with the organisation for a long time. Otherwise training costs would be high. It would take
too long to re-negotiate wages and salary arrangements, and it will not be easy to speed up
collections from customers unless customers are in breach of their credit arrangements and
paying later than they should. Deferring some or all of the capital expenditure is likely to be
the easiest and most practical option.
2 A
Total expenditure
Variable cost, as expected (18 000 $2.75)
Actual fixed costs incurred
Unfavourable fixed overhead expenditure variance
Budgeted fixed costs
$
98 000
49 500
48 500
11 000
37 500
3 (a) A If John is aware of padding in the budget, he will be able to cut budgeted expenditure
without too much trouble simply by reducing the amount of padding. He may need to
consider the attitudes of staff and whether they are likely to have the commitment to cut
costs further. Most costs are fixed costs: some of these may be discretionary, and so
controllable. Since variable costs are small, they are unlikely to be a key factor in trying to
reduce the deficit, since potential savings in variable costs will not be significant.
(b) D If the management team is financially aware, they should be more capable of drafting
bottom-up budgets. However, responsibility for budgeting expenditures should not go
lower in the management hierarchy than the managers who make the spending decisions. If
John Derbyshire makes most of the spending decisions himself, and has the responsibility
for expenditures, he should retain the responsibility for budgeting. The approach to
budgeting, top-down or bottom-up, also depends on the culture and size of the
organisation. Very small organisations and large bureaucratic organisations are likely to have
a strong top-down culture.
99
CHAPTER 4
COST BEHAVIOUR AND
CVP ANALYSIS
Learning objectives
Reference
Cost behaviour
LO4
LO4.1
Apply relevant techniques to separate costs into their fixed and variable components
LO4.2
LO4.3
Topic list
INTRODUCTION
This chapter introduces the concept of the separation of costs into those that vary directly with
changes in activity levels (variable costs) and those that do not (fixed costs). This chapter examines
further this two-way split of cost behaviours and explains the high-low method as one method of
splitting semi-variable costs into these two elements.
The cost accountant, must also be fully aware of cost behaviour because, to be able to estimate
costs, he or she must know what a particular cost will do given particular conditions.
The application of cost-volume-profit analysis, which is based on the cost behaviour principles and
marginal costing ideas, is sometimes necessary so that the appropriate decision-making information
can be provided to management. This chapter is going to conclude with that very topic, cost-volumeprofit analysis or break-even analysis.
The chapter content is summarised in the diagram below.
Cost behaviour
and
CVP analysis
Fixed and
variable costs
Cost behaviour
patterns
CVP
analysis
Contribution to Sales
(C/S) ratio
Safety margin
Breakeven
(Section 1)
(Section 1)
(Section 3)
4 What are the steps to follow to estimate the fixed and variable elements
of semi-variable costs?
(Section 4.2)
(Section 5.1)
(Section 6)
(Section 8.1)
(Section 9.1)
(Section 10)
CHAPTER 4
LO
4.1
Section overview
Costs may be classified into fixed costs and variable costs. Many items of expenditure are
part-fixed and part-variable and are so termed step-fixed or semi-variable (or mixed)
costs.
Definitions
Cost is a measure of the resources given up to achieve an objective.
A fixed cost is a cost which is incurred for a particular period of time and which, within certain activity
levels, is unaffected by changes in the level of activity.
A variable cost is a cost which varies with the level of activity. Variable costs tend to be constant per
unit but total variable costs will increase or decrease with changes in production or service volume.
A semi-variable (or mixed) cost is a cost that contains both a fixed cost and a variable cost
component.
A step-fixed cost is a cost that is fixed for a certain range of activity but increases to a new fixed level
once a critical level of activity is reached.
LO
4.1
Management decisions will often be based on how costs and revenues vary at different activity levels.
Examples of such decisions are as follows:
What should the planned activity level be for the next period?
Should the selling price be reduced in order to sell more units?
Should a particular component be manufactured internally or bought in?
Should a contract be undertaken?
There are many factors which may influence costs. The major influence is volume of output, or the
level of activity. Examples of cost drivers or level of activity may include one of the following:
Number of units produced.
Number of invoices issued.
Number of units of electricity consumed.
Value of items sold.
Number of items sold.
An understanding of cost behaviour is useful for:
Cost control - the level of costs incurred, will in part, be a result of an organisation's activities.
Budgeting - knowledge of cost behaviour is essential for the tasks of budgeting, decision making
and management control.
Cents per km
15.0
0.8
15.8
CHAPTER 4
c. Tyres cost $300 per set to replace; replacement occurs every 15 000 kms.
b. Fixed costs
$ per annum
3 000
325
400
3 725
c. Step-fixed costs are tyre replacement costs, which are $300 after every 15 000 kms.
The estimated costs per annum of cars travelling 15 000 kms per annum and 30 000 kms per annum
would therefore be:
15 000 kms
per annum
$
2 370
3 725
300
6 395
30 000 kms
per annum
$
4 740
3 725
600
9 065
Fixed costs are a period charge, in that they relate to a span of time; as the time span increases, so
too will the fixed costs (which are sometimes referred to as period costs for this reason). It is important
to understand that fixed costs always have a variable element, since an increase or decrease in
production may also bring about an increase or decrease in per unit fixed costs.
A sketch graph of fixed cost would look like this:
$
Total cost
Volume of output
Volume of output
A constant variable cost per unit implies that the price per unit of say, material purchased is constant,
and that the rate of material usage is also constant.
a. The most important variable cost is the cost of raw materials (where there is no discount for bulk
purchasing since bulk purchase discounts reduce the cost of purchases).
b. Direct labour costs are most often classed as a variable cost even though basic wages are usually
fixed.
c. Sales commission is variable in relation to the volume or value of sales.
CHAPTER 4
$
Cost
d. Bonus payments for productivity to employees might be variable once a certain level of output is
achieved, as the following diagram illustrates.
Graph of variable cost (2)
$
Cost
nu
Bo
Volume of output
b.
$
Cost
$
Cost
Volume of output
Volume of output
Each extra unit of output in graph (a) causes a less than proportionate increase in cost whereas in
graph (b), each extra unit of output causes a more than proportionate increase in cost.
The cost of a piecework scheme for individual workers with differential rates could behave in a
curvilinear fashion if the rates increase by small amounts at progressively higher output levels.
b.
$
Cost
Maximum
cost
Minimum
charge
Volume of output
Volume of output
Graph (a) represents an item of cost which is variable with output up to a certain maximum level of
cost.
Graph (b) represents a cost which is variable with output, subject to a minimum (fixed) charge.
10 zeds
$
50
5
5 000
500
5 050
505
50 zeds
$
250
5
5 000
100
5 250
105
Number of units
Total cost
Cost per
unit
$
Number of units
CHAPTER 4
Variable cost
Cost per
unit
$
Number of units
Step 1
Step 2
Step 3
Total cost at high activity level _ total cost at low activity level
= variable cost per unit (v)
_
Total units at high activity level total units at low activity level
Step 4
Demonstration of high-low
method
st
tal co
d to
sume
As
Variable costs
High
Level of activity
a = Total cost at high activity level - Total cost at low activity level.
Note. As only two data points are used to estimate the cost behaviour, we have no assurance that it
accurately represents cost behaviour across or within the relevant range
Worked Example: The high-low method
DG Co has recorded the following total costs during the last five years:
Year
Output volume
Units
65 000
80 000
90 000
60 000
75 000
20X0
20X1
20X2
20X3
20X4
Total cost
$
145 000
162 000
170 000
140 000
160 000
Required
Calculate the total cost that should be expected in 20X5 if output is 85 000 units.
Solution
Step 1
Step 2
Step 3
Step 4
Total cost at high activity level _ total cost at low activity level
_
Total units at high activity level total units at low activity level
90 000 60 000
30 000
Fixed costs = (total cost at high activity level) (total units at high activity level variable
cost per unit)
= 170 000 (90 000 $1) = 170 000 90 000 = $80 000
CHAPTER 4
Therefore the costs in 20X5 for output of 85 000 units are as follows:
$
85 000
80 000
165 000
The following data relate to the overhead expenditure of contract cleaners (for industrial cleaning) at
two activity levels.
Square metres cleaned 12 750
Overheads
$73 950
15 100
$83 585
When more than 14 000 square metres are industrially cleaned, there will be a step up in fixed costs of
$4 700.
Required
Calculate the estimated total cost if 14 500 square metres are to be industrially cleaned.
Solution
Before we can compare high activity level costs with low activity level costs in the normal way, we must
eliminate the part of the high activity level costs that are due to the step up in fixed costs:
Total cost for 15 100 without step up in fixed costs = $83 585 $4 700 = $78 885
We can now proceed in the normal way using the revised cost above.
Units
15 100
12 750
2 350
Variable cost
Total cost
Total cost
$
78 885
73 950
4 935
$4 935
2 350
$
83 585
31 710
51 875
$
51 875
30 450
82 325
Worked Example: The high-low method with a change in the variable cost
per unit
Solution
Variable cost
Additional wages cost (variable)
Total variable cost
Fixed
Variable costs (14 500 $3.10)
The valuation department of a large firm of surveyors wishes to develop a method of predicting its
total costs in a period. The following costs have been previously recorded at two activity levels:
Number of valuations
(V)
420
515
Period 1
Period 2
Total cost
(TC)
82 200
90 275
Section overview
Cost-volume-profit (CVP)/break-even analysis is the study of the interrelationships between
costs, volume and profit at various levels of activity.
LO
4.3
The management of an organisation usually wishes to know the profit likely to be made if the
budgeted/target production and sales for the year are achieved. Management may also be interested
to know:
a. The break-even point which is the activity level at which there is neither profit nor loss.
b. The amount by which actual sales can fall below anticipated sales, without a loss being incurred
(the safety margin).
CHAPTER 4
5.1 INTRODUCTION
Break-even point
Please note, contribution per unit = sales price per unit variable cost per unit
Worked Example: Break-even point
Expected sales
Variable cost
Fixed costs
Required
= $3
= 21 000 3
= 7 000 units
In revenue, BEP
Sales above $56 000 will result in profit of $3 per unit of additional sales and sales below $56 000 will
mean a loss of $3 per unit for each unit by which sales fall short of 7 000 units. In other words, profit
will improve or worsen by the amount of contribution per unit.
Revenue
Less variable costs
Contribution
Less fixed costs
Profit
7 000 units
$
56 000
35 000
21 000
21 000
0
7 001 units
$
56 008
35 005
21 003
21 000
3
(The contribution/sales (C/S) ratio is also sometimes called a profit/volume or P/V ratio.)
$3
= 37.5%
$8
$21 000
= $56 000
37.5%
Assume the C/S ratio of product W is 20%. IB, the manufacturer of product W, wishes to make a
contribution of $50 000 towards fixed costs. How many units of product W must be sold if the selling
price is $10 per unit?
Solution
Required contribution
$50 000
=
= $250 000
C / S ratio
20%
Therefore the number of units = $250 000 $10 = 25 000
A company manufactures a single product with a variable cost of $44. The contribution to sales ratio is
45%. Monthly fixed costs are $396 000. What is the break-even point in units?
Solution
CHAPTER 4
Mal de Mer makes and sells a product which has a variable cost of $30 and which sells for $40.
Budgeted fixed costs are $70 000 and budgeted sales are 8 000 units.
Calculate the break-even point and the safety margin.
Solution
a. Break-even point
= 7 000 units
b. Safety margin
1000 units
100% = 12.5% of budget
8 000 units
c. The safety margin indicates to management that actual sales can fall short of budget by 1 000 units
or 12.5% before the break-even point is reached and no profit at all is made.
S=V+F
where
S = break-even sales revenue
V = total variable costs
F = total fixed costs
Subtracting V from each side of the equation, we get:
S V = F, that is, total contribution = fixed costs
= $63 000
= 12 000 units $7
= $84 000
A business will breakeven when total contribution (S V) = total fixed costs (F)
SV
=F
S $84 000
= $63 000
S
S
= $147 000
= $12.25 per unit
P = required profit
= F + P, so
=F+P
Riding Breeches makes and sells a single product, for which variable costs are as follows:
$
10
8
6
24
Direct materials
Direct labour
Variable production overhead
The sales price is $30 per unit, and fixed costs per annum are $68 000. The company wishes to make a
profit of $16 000 per annum.
Solution
Required contribution = fixed costs + profit = $68 000 + $16 000 = $84 000
Required sales can be calculated in one of two ways:
(a)
Required contribution
Contribution per unit
$84 000
= 14 000 units, or $420 000 in revenue
$(30 24)
(b)
Required contribution
C / S ratio
$84 000
= $420 000 of revenue, or 14 000 units
20% *
* C/S ratio =
$30 $24
$6
=
= 0.2 = 20%
$30
$30
CHAPTER 4
Seven League Boots wishes to sell 14 000 units of its product, which has a variable cost of $15 to make
and sell. Fixed costs are $119 000 and the required profit is $70 000.
Required
What sales price per unit is required to achieve this target profit?
A
$13.50
B
$20.00
C
$23.50
D
$28.50
(The answer is at the end of the chapter)
Stomer Cakes bake and sell a single type of cake. The variable cost of production is 15c and the
current sales price is 25c. Fixed costs are $2 600 per month, and the annual profit for the company at
current sales volume is $36 000. The volume of sales demand is constant throughout the year.
The sales manager, Ian Digestion, wishes to raise the sales price to 29c per cake, but considers that a
price rise will result in some loss of sales.
Ascertain the minimum volume of sales required each month to raise the price to 29c.
Solution
The minimum volume of sales which would justify a price of 29c is one which would leave total profit at
least the same as before, ie $3 000 per month. Required profit should be converted into required
contribution, as follows:
Monthly fixed costs
Monthly profit, minimum required
Current monthly contribution
Contribution per unit (25c 15c)
Current monthly sales
$
2 600
3 000
5 600
10c
56 000 cakes
The minimum volume of sales required after the price rise will be an amount which earns a
contribution of $5 600 per month. The contribution per cake at a sales price of 29c would be 14c.
Required sales =
$5 600
required contribution
= 40 000 cakes per month.
=
14c
contribution per unit
Close Brickett makes a product which has a variable production cost of $8 and a variable sales cost of
$2 per unit. Fixed costs are $40 000 per annum, the sales price per unit is $18, and the current volume
of output and sales is 6 000 units.
The company is considering hiring an improved machine for production. Annual hire costs would be
$10 000 and it is expected that the variable cost of production would fall to $6 per unit.
a. Determine the number of units that must be produced and sold to achieve the same profit as is
currently earned, if the machine is hired.
b. Calculate the annual profit with the machine if output and sales remain at 6 000 units per annum.
Solution
With the new machine fixed costs will go up by $10 000 to $50 000 per annum. The variable cost
per unit will fall to $(6 + 2) = $8, and the contribution per unit will be $10.
$
8 000
50 000
58 000
$10
5 800 units
$
108 000
36 000
12 000
48 000
60 000
50 000
10 000
Alternative calculation
Profit at 5 800 units of sale (see (a))
Contribution from sale of extra 200 units ( $10)
Profit at 6 000 units of sale
$
8 000
2 000
10 000
Given no change in fixed costs, total profit is maximised when the total contribution is at its maximum.
Total contribution in turn depends on the unit contribution and on the sales volume.
An increase in the sales price will increase unit contribution, but sales volume is likely to fall because
fewer customers will be prepared to pay the higher price. A decrease in sales price will reduce the unit
contribution, but sales volume may increase because the goods on offer are now cheaper. The
optimum combination of sales price and sales volume is arguably the one which maximises total
contribution.
Worked Example: Profit maximisation
High Ladders has developed a new product which is about to be launched on to the market. The
variable cost of selling the product is $12 per unit. The marketing department has estimated that at a
sales price of $20, annual demand would be 10 000 units.
However, if the sales price is set above $20, sales demand would fall by 500 units for each 50c increase
above $20. Similarly, if the price is set below $20, demand would increase by 500 units for each 50c
stepped reduction in price below $20.
Determine the price which would maximise High Ladder's profit in the next year.
CHAPTER 4
Solution
At a sales price of $20 per unit, the unit contribution would be $(20 12) = $8. Each 50c increase (or
decrease) in price would raise (or lower) the unit contribution by 50c. The total contribution is
calculated at each sales price by multiplying the unit contribution by the expected sales volume.
Unit price
$
20.00
Unit contribution
$
8.00
Sales volume
units
10 000
7.50
7.00
10 500
11 000
Total contribution
$
80 000
a. Reduce price
19.50
19.00
78 750
77 000
b. Increase price
Unit price
$
20.50
21.00
21.50
22.00
22.50
Unit contribution
$
8.50
9.00
9.50
10.00
10.50
Sales volume
units
9 500
9 000
8 500
8 000
7 500
Total contribution
$
80 750
81 000
80 750
80 000
78 750
The total contribution would be maximised, and therefore profit maximised, at a sales price of $21 per
unit, and sales demand of 9 000 units.
Question 4: Break-even output level
Betty Battle manufactures a product which has a selling price of $20 and a variable cost of $10 per
unit. The company incurs annual fixed costs of $29 000. Annual sales demand is 9,000 units.
New production methods are under consideration, which would cause a $1 000 increase in fixed costs
and a reduction in variable cost to $9 per unit. The new production methods would result in a superior
product and would enable sales to be increased to 9 750 units per annum at a price of $21 each.
If the change in production methods were to take place, the break-even output level would be
A 100 units higher.
B 100 units lower.
C 400 units higher.
D 400 units lower.
(The answer is at the end of the chapter)
The budgeted annual output of a factory is 120 000 units. The fixed overheads amount to $40 000 and
the variable costs are 50c per unit. The sales price is $1 per unit.
Construct a break-even chart showing the current break-even point and profit earned up to the
present maximum capacity.
Solution
$
120 000
60 000
60 000
40 000
20 000
$
40 000
60 000
100 000
CHAPTER 4
LO
4.3
d. The sales line is also drawn by plotting two points and joining them up.
i. At zero sales, revenue is nil.
ii. At the budgeted output and sales of 120 000 units, revenue is $120 000.
-
$000
120
es
l
Sa
Budgeted profit
100
Break-even point
80
60
a
Tot
ts
cos
Fixed costs
40
Safety
margin
20
20
40
60
80
100
120
Units
The break-even point is where total costs are matched exactly by total revenue. From the chart,
this can be seen to occur at output and sales of 80 000 units, when revenue and costs are both $80
000. This break-even point can be proved mathematically as:
$40 000
Required contribution (= fixed costs)
= 80 000 units
=
50c per unit
Contribution per unit
The safety margin can be seen on the chart as the difference between the budgeted level of activity
and the break-even level.
Break-even charts can be used to show variations in the possible sales price, variable costs or fixed
costs. Suppose that a company sells a product which has a variable cost of $2 per unit. Fixed costs are
$15 000. It has been estimated that if the sales price is set at $4.40 per unit, the expected sales volume
would be 7 500 units; whereas if the sales price is lower, at $4 per unit, the expected sales volume
would be 10 000 units.
Draw a break-even chart to show the budgeted profit, the break-even point and the safety margin at
each of the possible sales prices.
Solution
Workings
Sales price $4.40 per unit
$
15 000
15 000
(10 000 $2.00)
30 000
Fixed costs
Variable costs (7 500 $2.00)
Total costs
Budgeted revenue (7 500 $4.40)
33 000
40 000
$000
Profit
40
Revenue ($4.00)
Profit
35
Break-even point A
Total costs
Revenue ($4.40)
30
Break-even point B
25
20
Fixed costs
15
10
5
8
Safety
margin A
10
Units
(000s)
Safety
margin B
(check:
$15 000
Required contribution to break - even
= 6 250 units)
$2.40 per unit
Contribution per unit
The safety margin (A) is 7 500 units 6 250 units = 1 250 units or 16.7% of expected sales.
b. Break-even point B is the break-even point at a sales price of $4 per unit which is 7 500 units or
$30 000 in costs and revenues.
(check:
The safety margin (B) = 10 000 units 7 500 units = 2 500 units or 25% of expected sales.
Since a price of $4 per unit gives a higher expected profit and a wider safety margin, this price will
probably be preferred even though the break-even point is higher than at a sales price of $4.40 per
unit.
CHAPTER 4
a. Break-even point A is the break-even point at a sales price of $4.40 per unit, which is 6 250 units or
$27 500 in costs and revenues.
Contribution chart
$000
120
Profit
Break-even point
Contribution
Fixed
costs
80
al
Tot
ts
cos
ue
n
ve
40
e
sr
e
al
t
cos
ble
Safety
margin
ia
Var
Fixed
costs
0
40
80
120
Units
One of the advantages of the contribution chart is that is shows clearly the contribution for different
levels of production (indicated here at 120 000 units, the budgeted level of output) as the 'wedge'
shape between the sales revenue line and the variable costs line. At the break-even point, the
contribution equals fixed costs exactly. At levels of output above the break-even point, the
contribution is larger, and not only covers fixed costs, but also leaves a profit. Below the break-even
point, the loss is the amount by which contribution fails to cover fixed costs.
Let us draw a P/V chart for our example (Paragraph 9.1). At sales of 120 000 units, total contribution
will be
120 000 $(1 0.5) = $60 000 and total profit will be $20 000.
P/V chart (1)
Profit/loss
$000
20
PROFIT
Budgeted
profit
Sales volume
(units)
10
BREAK-EVEN
120,000
Break-even point
10
LOSS
Budgeted
contribution
Fixed
costs
20
30
40
20
PROFIT
10
Break-even point 2
Sales volume
000 (units)
BREAK-EVEN
10
LOSS 20
30
40 x
50 x
105
Break-even point 1
120
CHAPTER 4
The diagram shows that if the selling price is increased, the break-even point occurs at a lower level of
sales revenue (71 429 units instead of 80 000 units), although this is not a particularly large increase
when viewed in the context of the projected sales volume. It is also possible to see that for sales
above 50 000 units, the profit achieved will be higher (and the loss achieved lower) if the price is $1.20.
For sales volumes below 50 000 units the first option will yield lower losses.
The P/V chart is the clearest way of presenting such information; two conventional break-even charts
on one set of axes would be very confusing.
Changes in the variable cost per unit or in fixed costs at certain activity levels can also be easily
incorporated into a P/V chart. The profit or loss at each point where the cost structure changes should
be calculated and plotted on the graph so that the profit/volume line becomes a series of straight lines.
For example, suppose that in our example, at sales levels in excess of 120 000 units the variable cost
per unit increases to $0.60 (perhaps because of overtime premiums that are incurred when production
exceeds a certain level). At sales of 130 000 units, contribution would therefore be 130 000 $(1 0.60)
= $52 000 and total profit would be $12 000.
P/V chart (3)
Profit/loss
$000
20
PROFIT 10
Sales volume
000 (units)
Break-even point
BREAK-EVEN
120
10
Fixed
costs
LOSS 20
30
40
500
(60)
130
CHAPTER 4
It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.
The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each $1 of sales.
C/S ratio
The safety margin is the difference in units between the budgeted sales volume and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. The
safety margin may also be expressed in sales revenue terms.
At the break-even point, sales revenue = total costs and there is no profit. At the break-even point
total contribution = fixed costs.
The target profit is achieved when S = V + F + P. Therefore the total contribution required for a
target profit = fixed costs + required profit.
The break-even point can also be determined graphically using a break-even chart or a
contribution break-even chart. These charts show approximate levels of profit or loss at different
sales volume levels within a limited range.
The profit/volume (PV) chart is a variation of the break-even chart which illustrates the relationship
of costs and profits to sales and the safety margin.
The P/V chart shows clearly the effect on profit and break-even point of any changes in selling
price, variable cost, fixed cost and/or sales demand.
CHAPTER 4
Break-even analysis is a useful technique for managers as it can provide simple and quick
estimates. Break-even charts provide a graphical representation of break-even calculations. Breakeven analysis does, however, have a number of limitations.
Level of activity
Level of activity
Graph 1
$
Graph 2
$
Level of activity
Graph 4
Level of activity
Graph 3
$
Level of activity
Graph 5
Level of activity
Graph 6
Which one of the above graphs illustrates the costs described in questions 1 to 3?
1 A linear variable cost when the vertical axis represents cost incurred.
A graph 1
B graph 2
C graph 4
D graph 5
2 A fixed cost when the vertical axis represents cost incurred.
A graph 1
B graph 2
C graph 3
D graph 6
3 A step fixed cost when the vertical axis represents cost incurred.
A graph 3
B graph 4
C graph 5
D graph 6
4 A company manufactures a single product. The total cost of making 4 000 units is $20 000 and the
total cost of making 20 000 units is $40 000. Within this range of activity the total fixed costs remain
unchanged.
What is the variable cost per unit of the product?
A
B
C
D
$0.80
$1.20
$1.25
$2.00
5 A production worker is paid a salary of $650 per month, plus an extra 5 cents for each unit
produced during the month. This labour cost is best described as
A a fixed cost.
B a variable cost.
C a step-fixed cost.
D a semi-variable cost.
THE FOLLOWING DATA RELATES TO QUESTIONS 6 AND 7
$ per unit
6.00
1.20
0.40
4.00
0.80
Budgeted production and sales for the year are 10 000 units.
6 What is the company's break-even point, to the nearest whole unit?
A
B
C
D
8 000 units
8 333 units
10 000 units
10 909 units
7 It is now expected that the variable production cost per unit and the selling price per unit will each
increase by 10%, and fixed production costs will rise by 25%.
What will be the new break-even point, to the nearest whole unit?
A
B
C
D
8 788 units
11 600 units
11 885 units
12 397 units
A
B
C
D
I and II only
I and III only
II and III only
I, II and III
9 A company's break-even point is 6 000 units per annum. The selling price is $90 per unit and the
variable cost is $40 per unit. What are the company's annual fixed costs?
A
B
C
D
$120
$240 000
$300 000
$540 000
10 A company makes a single product which it sells for $16 per unit. Fixed costs are $76 800 per
month and the product has a profit/volume ratio of 40%. In a period when actual sales were
$224 000, the company's safety margin, in units, was
A 2 000.
B 12 000.
C 14 000.
D 32 000
.
CHAPTER 4
III Any point on the profit-volume line above the x axis indicates the profit (as measured on the
vertical axis) at that level of activity.
Cost
$
40 000
20 000
20 000
20 000
4 000
16 000
$20 000
= $1.25
16 000 units
5 D The salary is part fixed ($650 per month) and part variable (5 cents per unit). Therefore it is a
semi-variable cost and answer D is correct.
If you chose option A or option B you were considering only part of the cost.
Option C, a step cost, involves a cost which remains constant up to a certain level and then
increases to a new, higher, constant fixed cost.
6 D Breakeven point =
=
Fixed costs
Contributi on per unit
If you selected option A you divided the fixed cost by the selling price, but the selling price
also has to cover the variable cost.
Option B ignores the selling costs, but these are costs that must be covered before the
breakeven point is reached.
Option C is the budgeted sales volume, which happens to be below the breakeven point.
7 C
New selling price ($6 1.1)
New variable cost ($1.20 1.1) + $0.40
Revised contribution per unit
$ per unit
6.60
1.72
4.88
$58 000
= 11 885 units
$4.88
If you selected option A you divided the fixed cost by the selling price, but the selling price
also has to cover the variable cost.
Option B fails to allow for the increase in variable production cost
Option D increases all of the costs by the percentages given, rather than the production costs
only.
Fixed costs
$76 800
= $192 000
=
P/V ratio
0.40
Actual sales =
Margin of safety in terms of sales value
selling price per unit
Margin of safety in units
$224 000
$32 000
$16
2 000
If you selected option B you calculated the breakeven point in units, but forgot to take the next
step to calculate the margin of safety.
Option C is the actual sales in units.
CHAPTER 4
Period 2
Period 1
Change due to variable cost
Total cost
$
90 275
82 200
8 075
$
70 000
119 000
189 000
13.50
15.00
28.50
4 D
Selling price
Variable costs
Contribution per unit
Current
$
20
10
10
Revised
$
21
9
12
Fixed costs
Break-even point (units)
$29 000
2 900
$30 000
2 500
Break-even point =
Current BEP =
$29 000
= 2 900 units
$10
Revised BEP =
$30 000
= 2 500 units
$10
Difference
400 lower
5 C The profit/volume graph shows levels of profit at different levels of sales. In order to answer the
question, you must determine contribution for $500 000 sales revenue.
Remember that profit = contribution fixed costs.
When sales revenue = 0, contribution = 0 and the graph shows a loss of $60 000 at zero sales
revenue. This means that fixed costs must be $60 000.
Contribution at $500 000 sales revenue = $140 000 (profit) + $60 000 (fixed costs)
= $200 000
CHAPTER 4
Contribution to sales ratio = contribution/sales revenue = ($200 000/$500 000) = 0.4 or 40%
135
CHAPTER 5
OVERHEADS, ABSORPTION
AND MARGINAL COSTING
Learning objectives
Reference
LO5
LO5.1
LO5.2
LO5.3
Evaluate the difference between direct production costs and indirect overhead costs
LO5.4
Apply the principles of absorption and variable costing to product costing analysis
LO5.5
Topic list
1
2
3
4
5
6
7
8
9
10
Cost classification
Overheads
Absorption costing: an introduction
Overhead allocation
Overhead apportionment
Overhead absorption
Blanket absorption rates and departmental absorption rates
Marginal cost and marginal costing
The principles of marginal costing
Marginal costing, absorption costing and the calculation of profit
INTRODUCTION
The classification of costs, as either direct or indirect for example, is essential to determine the cost of
a unit of product or service.
Absorption costing is a method of accounting for overheads. It is basically a method of sharing out
overheads incurred amongst units produced.
This chapter explains why absorption costing might be necessary and then provides an overview of
how the cost of a unit of product is built up under a system of absorption costing. A detailed analysis
of this costing method is then provided, covering the three stages of absorption costing: allocation,
apportionment and absorption.
This chapter concludes when it defines marginal costing and compares it with absorption costing.
Whereas absorption costing recognises fixed costs, usually fixed production costs, as part of the cost
of a unit of output and hence as product costs, marginal costing treats all fixed costs as period costs.
Two such different costing methods obviously each have their supporters and detractors so we will be
looking at the arguments both in favour of and against each method. Each costing method, because
of the different inventory valuation used, produces a different profit figure and we will be looking at
this particular point in detail.
The chapter content is summarised in the diagram below.
Overheads, absorption
and marginal costing
Cost
classification
Overhead
allocation
Overheads
Overhead
apportionment
Overhead
absorption
Marginal cost
and marginal
costing
Principles of
marginal costing
(Section 1.2)
(Section 1.2)
(Section 1.2)
(Section 2)
(Section 3.2)
(Section 3.4)
7 What are the steps involved in the calculation of overhead absorption rates?
(Section 6.2)
(Section 8)
(Section 9)
CHAPTER 5
4 What is an overhead?
1 COST CLASSIFICATION
Section overview
Materials, labour costs and other expenses can be classified as either direct costs or
indirect costs.
Classification by function involves classifying costs as production/manufacturing costs,
administration costs or marketing and distribution costs.
The total cost of making a product or providing a service consists of the following:
a. Cost of materials.
b. Cost of the wages and salaries (labour costs).
c. Cost of other expenses such as:
i. Rent and rates.
ii. Electricity and gas bills.
iii. Depreciation.
An indirect cost, or overhead is a cost that is incurred in the course of making a product, providing a
service or running a department, but which cannot be traced directly and in full to the product, service
or department.
Materials, labour costs and other expenses can be classified as either direct costs or indirect costs.
a. Direct material costs are the costs of materials that are known to have been used in making a
product, or providing a service.
b. Direct labour costs are the specific costs of the labour used to make a product or provide a
service. Direct labour costs are established by measuring the time taken for a job, or the time taken
in 'direct production work'.
c. Other direct expenses are those expenses that have been incurred in full as a direct consequence
of making a product, or providing a service, or running a department.
Examples of indirect costs include supervisors' wages, cleaning materials and buildings insurance.
=
=
=
=
Direct materials
+
Direct labour
+
Direct expenses
Direct cost
+
+
+
+
Indirect materials
+
Indirect labour
+
Indirect expenses
Overhead
Direct wages costs are charged to the product as part of the prime cost. Prime costs are the total of
all direct costs.
Examples of groups of labour receiving payment as direct wages are as follows:
Workers engaged in altering the condition or composition of the product.
Inspectors, analysts and testers specifically required for such production.
Supervisors, shop clerks and anyone else whose wages are specifically identified as working on a
particular product.
As production becomes more capital intensive:
The ratio of direct labour costs to total product cost falls as the use of machinery increases, and
hence depreciation charges increase.
Skilled labour costs and sub-contractors' costs increase as direct labour costs decrease.
Question 1: Labour costs
Which of the following labour costs are normally treated as indirect labour costs?
I
II
III
IV
V
A I, II and IV only
B I, IV and V only
C II, III and IV only
D III, IV and V only
(The answer is at the end of the chapter)
Direct expenses are any expenses which are incurred on a specific product other than direct material
cost and direct labour.
Direct expenses are charged to the product as part of the prime cost. Examples of direct expenses
are as follows:
The hire of tools or equipment for a particular job.
Maintenance costs of tools, fixtures and so on.
CHAPTER 5
Definition
$
144
24
6
30
204
A
B
C
A+B+C
D
A+B+C+D
E
F
A+B+C+D+E+F
CHAPTER 5
LO
5.3
REFERENCE NUMBER
Production costs
Marketing and distribution costs
Administration costs
Research and development costs
Each type of expense should appear only once in your response. You may use the reference numbers
in your response.
(The answer is at the end of the chapter)
2 OVERHEADS
Section overview
Overhead is the cost incurred in the course of making a product, providing a service or
running a department, but which cannot be traced directly and in full to the product,
service or department.
Overhead is actually the total of the following:
Indirect materials
Indirect labour
Indirect expenses
The total of these indirect costs is usually split into the following categories:
Production
Marketing and distribution
Administration
In cost accounting there are two schools of thought as to the correct method of dealing with
overheads:
Absorption costing
Marginal costing
An organisation with one production department that produces identical units will divide the total
overheads among the total units produced. Absorption costing is a method for sharing overheads
between different products on a fair basis.
Profit
600
200
150
950
50
CHAPTER 5
$
1 000
In absorption costing, overhead costs will be added to each unit of product manufactured and
sold.
Prime cost per unit
Production overhead ($200 per week for 100 units)
Full factory cost
$ per unit
6
2
8
$
1 000
800
200
150
50
Sometimes, but not always, the overhead costs of administration, marketing and distribution are also
added to unit costs, to obtain a full cost of sales.
Prime cost per unit
Factory overhead cost per unit
Administration costs per unit ($150 per week for 100 units)
Full cost of sales
$ per unit
6.00
2.00
1.50
9.50
$
1 000
950
50
It may already be apparent that the weekly profit is $50 no matter how the figures have been
presented.
So, how does absorption costing serve any useful purpose in accounting?
The theoretical justification for using absorption costing is that all production overheads are incurred
in the production of the organisation's output and so each unit of the product receives some benefit
from these costs. Each unit of output should therefore be charged with some of the overhead costs.
companies which do contract work, where each job or contract is different, so that a standard unit
sales price cannot be fixed. Without using absorption costing, a full cost is difficult to ascertain.
c. Establishing the profitability of different products. This argument in favour of absorption costing
is more contentious. If a company sells more than one product, it will be difficult to judge how
profitable each individual product is, unless overhead costs are shared on a fair basis and charged
to the cost of sales of each product.
4 OVERHEAD ALLOCATION
4.1 INTRODUCTION
Section overview
Allocation is the process by which whole cost items are charged direct to a product unit or
cost centre.
Cost centres may be one of the following types:
a. A production department, to which production overheads, such as the wages of factory
supervisor, are charged.
b. A service department, such as quality control or maintenance, to which overheads incurred in
providing that service are charged.
c. An administrative department, to which administration overheads are charged.
d. A marketing or a distribution department, to which marketing and distribution overheads are
charged.
e. An overhead cost centre, to which items of expense, such as rent and rates, heating and lighting,
which will ultimately be shared by a number of departments, are charged.
CHAPTER 5
LO
5.1
Where a cost is specifically attributable to a cost centre, it is allocated directly to the cost centre that
caused the cost to be incurred, for example:
Direct labour for the packing staff will be allocated to the packing department (production) cost
centre.
The cost of a warehouse security guard will be charged to the warehouse cost centre.
Paper (recording computer output) will be charged to the computer department.
Worked Example: Overhead allocation
Consider the following costs of a company.
Wages of the foreman of department A
Wages of the foreman of department B
Indirect materials consumed in department A
Rent of the premises shared by departments A and B
$200
$150
$50
$300
The cost accounting system might have the below three overhead cost centres.
Cost centre:
101
102
201
Department A
Department B
Rent
Solution
Overhead costs would be allocated directly to each cost centre, i.e. $200 + $50 to cost centre 101,
$150 to cost centre 102 and $300 to cost centre 201. The rent of the factory will be subsequently
shared between the two production departments, but for the purpose of day to day cost recording,
the rent will first of all be charged in full to a separate cost centre (201).
5 OVERHEAD APPORTIONMENT
Section overview
Apportionment is a procedure whereby indirect costs are spread fairly between cost
centres. Service cost centre costs may be apportioned to production cost centres by using
the reciprocal method.
The following data will be used to illustrate the overhead apportionment process.
Worked Example:
Cups Inc has two production departments (A and B) and two service departments (maintenance and
stores). Details of next year's budgeted overheads are shown below:
Total
$
19 200
9 600
54 000
38 400
9 000
25 000
A
6 000
48
50
15
B
4 000
20
40
20
Maintenance
3 000
8
20
12
Stores
2 000
4
10
5
Total
15 000
80
120
52
A
5 000
3 000
B
4 000
1 000
Maintenance
-------
Stores
1 000
----
Total
10 000
4 000
BASIS
Note that heating and lighting may also be apportioned using volume of space occupied by each cost
centre.
Worked Example:
Using the Cups question above, show how overheads should be apportioned between the four
departments.
Solution
Item of cost
Basis of apportionment
Floor area
Floor area
Book value of machinery
Floor area
No of employees
Book value of machinery
A
$
7 680
3 840
32 400
15 360
3 750
15 000
78 030
Department
B
Maintenance
$
$
5 120
3 840
2 560
1 920
13 500
5 400
10 240
7 680
3 000
1 500
6 250
2 500
40 670
22 840
Stores
$
2 560
1 280
2 700
5 120
750
1 250
13 660
Workings
For example:
Heat and light apportioned to dept A =
6 000
19 200 = $7 680
15 000
CHAPTER 5
Value of department'smachinery
total overhead
Total value of machinery
No of employees in department
total overhead
Total no of employees
Question 4: Apportionment
Match the following overheads with the most appropriate basis of apportionment.
OVERHEAD
Cafeteria costs
Heat and light costs
Insurance of computers
Depreciation of equipment
A
B
C
D
I
II
III
IV
BASIS OF APPORTIONMENT
Floor area
Number of employees
Book value of computers
Book value of equipment
Stores
Maintenance
Production planning
Although both the direct and step-down methods are not in your syllabus, the following illustration
will give you an idea of how to carry out simple apportionments before we move onto the more
complex reciprocal method.
Worked Example: Simple apportionment using the step-down method
Using the information contained in the Cups Worked Example regarding allocated overheads (section
5) and the results of the overhead apportionment calculations in 5.2 above, apportion the
maintenance and stores departments' overheads to production departments A and B and calculate
the total overheads for each of these production departments.
Solution
1. Decide how the service departments' overheads will be apportioned. The table above tells us that
maintenance overheads can be apportioned according to the hours of maintenance work done,
while we can use the number or cost value of stores/material requisitions for apportioning stores.
The question gives us information about maintenance hours worked and the number of stores
requisitions.
2. Apportion the overheads of the service department whose services are also used by another
service department (in this case, maintenance). This allows us to obtain a total overhead cost for
stores.
Total overheads for maintenance department
$
22 840
12 000
General overheads
Allocated overheads
34 840
Apportioned as follows:
Maintenance hours worked in department
$34 840
Total maintenance hours worked
Production department A =
5 000
$34 840 = $17 420
10 000
Production department B =
4 000
$34 840 = $13 936
10 000
Stores department =
1 000
$34 840 = $3 484
10 000
General overheads
Allocated overheads
Apportioned from maintenance
3 484
22 144
Apportioned as follows:
Production department A =
3 000
$22 144 = $16 608
4 000
Production department B =
1 000
$22 144 = $5 536
4 000
CHAPTER 5
General overheads
Allocated overheads
Maintenance
Stores
A
$
78 030
15 000
B
$
40 670
20 000
17 420
16 608
127 058
13 936
5 536
80 142
Assume the usage of Cups's service departments' services were amended to be as follows:
Maintenance hours used
Number of stores requisitions
A
5 000
3 000
B
4 000
1 000
Maintenance
1 000
Stores
1 000
Total
10 000
5 000
Show how the maintenance and stores departments' overheads would be apportioned to the two
production departments and calculate total overheads for each of the production departments.
Solution
Remember to apportion both the general and allocated overheads (see above). The bases of
apportionment for maintenance and stores are the same as for the example above, that is,
maintenance hours worked and number of stores requisitions.
A
$
B
$
Maintenance
$
Stores
$
93 030
17 420
60 670
13 936
13 286
4 429
2 215
1 772
332
126 283
110
80 917
34 840
(34 840)
NIL
4 429
4 429
(4 429)
NIL
NIL
NIL
18 660
3 484
22 144
(22 144)
NIL
442
442
(442)
NIL
Notes
a. It does not matter which department you choose to apportion first. Maintenance overheads were
apportioned using the calculations illustrated above.
b. Stores overheads are apportioned using the same formula as used above but with the amended
number of stores requisitions given above. For example A = 3 000/5 000 $22 144 = $ 13 286
c. Then the new figure for maintenance overheads is reapportioned. For example
A= 5 000/10 000 $4 429 = $2 215
d. The problem with the repeated distribution method is that you can keep performing the same
calculations many times. When you are dealing with a small number (such as $442 above) you can
take the decision to apportion the figure between the production departments only. In this case,
we ignore the stores requisitions for maintenance and base the apportionment on the total stores
requisitions for the production departments, that is, 4 000. The amount apportioned to production
department A was calculated as follows:
Stores requisitions for A
3 000
stores overheads =
$442 = $332
Total stores requisitions (A + B)
4 000
Whenever you are using equations you must define each variable.
Let M = total overheads for the maintenance department
S = total overheads for the stores department
Remember that total overheads for the maintenance department consist of general overheads
apportioned, allocated overheads and the share of stores overheads (1 000/5 000 = 20%).
Similarly, total overheads for stores will be the total of general overheads apportioned, allocated
overheads and the 1 000/10 000 (10%) share of maintenance overheads.
M = 0.2S + $34 840
S = 0.1M + $18 660
1
2
S = 5M 174 200
S = 0.1M + 18 660
192 860
= $39 359
4.9
Overhead costs
Apportion maintenance
Apportion stores
Total
A
$
93 030
19 680
13 558
126 268
B
$
60 670
15 743
4 519
80 932
Maintenance
$
34 840
(39 359)
4 519
Nil
Stores
$
18 660
3 936
(22 596)
Nil
You will notice that the total overheads for production departments A and B are the same regardless
of the method used (minor difference is due to rounding).
CHAPTER 5
These overheads can now be apportioned to the production departments using the proportions in
Section 5.2.1 above.
Question 5: Reapportionment
Sandstorm is a contracting engineering company which has three production departments (forming,
machines and assembly) and two service departments (maintenance and general).
The following analysis of overhead costs has been made for the year just ended.
$
Rent and rates
Power
Light, heat
Repairs, maintenance:
Forming
Machines
Assembly
Maintenance
General
$
8 000
750
5 000
800
1 800
300
200
100
3 200
Departmental expenses:
Forming
Machines
Assembly
Maintenance
General
1 500
2 300
1 100
900
1 500
7 300
Depreciation:
Plant
Fixtures and fittings
Insurance:
Plant
Buildings
Indirect labour:
Forming
Machines
Assembly
Maintenance
General
10 000
250
2 000
500
3 000
5 000
1 500
4 000
2 000
15 500
52 500
Forming
Machines
Assembly
Maintenance
General
Floor
area
Plant
value
sq. ft
2 000
4 000
3 000
500
500
10 000
$
25 000
60 000
7 500
7 500
100 000
Fixtures
& fittings
value
$
Effective
horsepower
1 000
500
2 000
1 000
500
5 000
40
90
15
5
150
Direct
Labour
cost for
Hours
year
Worked
$
20 500
14 400
30 300
20 500
24 200
20 200
75 000
Machine
hours
worked
12 000
21 600
2 000
55 100
35 600
Forming
Machines
Assembly
General
Maintenance
Maintenance
%
20
50
20
10
100
General
%
20
60
10
10
100
Using the data provided prepare an analysis showing the distribution of overhead costs to
departments. Reapportion service cost centre costs (maintenance and general) using the repeated
reciprocal method.
(The answer is at the end of the chapter)
6 OVERHEAD ABSORPTION
Section overview
Overhead absorption is the process whereby overhead costs allocated and apportioned to
production cost centres are added to unit, job or batch costs. Overhead absorption is
sometimes called overhead recovery.
6.1 INTRODUCTION
Having allocated and/or apportioned all overheads, the next stage in the costing treatment of
overheads is to add them to, or absorb them into the cost of the product.
Overheads are usually added to the cost of the product using a predetermined overhead
absorption rate, which is calculated using figures from the budget.
Step 3
Divide the estimated overhead by the budgeted activity level. This produces the
overhead absorption rate.
Step 4
Absorb the overhead into the product cost by applying the calculated overhead
absorption rate.
Estimate the activity level for the period. This could be total labour hours, units, or direct
costs or whatever basis is to be used for the overhead absorption rates.
Athena Co makes two products, the Greek and the Roman. Greeks take 2 labour hours each to make
and Romans take 5 labour hours. Athena Co budgets its total overhead for the coming year at $50
000, and estimates that 100 000 labour hours will be worked. What is the overhead cost per unit for
Greeks and Romans respectively if overheads are absorbed on the basis of labour hours?
Solution
Step 1
Step 2
$50 000
= $0.50 per direct labour hour
100 000hrs
CHAPTER 5
Step 3
Step 4
Absorb the overhead into the product cost by applying the calculated absorption rate.
Labour hours per unit
Absorption rate per labour hour
Overhead absorbed per unit
Greek
2
$0.50
$1
Roman
5
$0.50
$2.50
It should be obvious that, even if a company is trying to be 'fair', there is a great lack of precision
about the way the absorption base is chosen and overhead is absorbed.
This arbitrariness is one of the main criticisms of absorption costing. If absorption costing is to be
used, because of its other virtues, then it is important that the methods used are kept under regular
review where necessary. Changes in working conditions should lead to changes in the way in which
work is accounted for.
For example, a labour intensive department may become mechanised. If a direct labour hour rate of
absorption had been used prior to the mechanisation, it would probably now be more appropriate to
change to using a machine hour rate.
The choice of an absorption basis is a matter of judgment. What is required is an absorption basis
which realistically reflects the characteristics of a given cost centre and which avoids undue anomalies.
Many factories use a direct labour hour rate or machine hour rate in preference to a rate based on a
percentage of direct materials cost, wages or prime cost.
a. A direct labour hour basis is most appropriate in a labour intensive environment.
b. A machine hour rate would be used in departments where production is controlled or dictated by
machines.
c. A rate per unit of product would be effective only if all units were identical.
Worked Example: Bridge Cottage
The budgeted production overheads and other budget data of Bridge Cottage are as follows:
Budget
Overhead cost
Direct materials cost
Direct labour cost
Machine hours
Direct labour hours
Units of production
Production
dept A
$36 000
$32 000
$40 000
10 000
18 000
Production
dept B
$5 000
1 000
Calculate the absorption rate for Department A using the bases of apportionment below:
Percentage of direct materials cost.
Percentage of direct labour cost.
Percentage of prime cost.
Rate per machine hour.
Calculate an absorption rate for Department B using units of output as the absorption rate.
Solution
Department A
i. Percentage of direct materials cost
$36 000
100% = 112.5%
$32 000
$36 000
100% = 90%
$40 000
$36 000
100% = 50%
$72 000
$36 000
= $3.60 per machine hour
10 000 hrs
$36 000
= $2 per direct labour hour
18 000 hrs
= $90.00
= $76.50
= $82.50
= $82.80
CHAPTER 5
For example, if total overheads were $500 000 and there were 250 000 direct machine hours during the
period, the blanket overhead rate would be $2 per direct machine hour and all jobs passing through
the factory would be charged at that rate.
Blanket overhead rates are not appropriate in the following circumstances:
Products or jobs pass through more than one department, and
products/jobs do not spend an equal amount of time in each department.
If a single factory overhead absorption rate is used, some products will receive a higher overhead
charge than they ought 'fairly' to bear, whereas other products will be under-charged.
If a separate absorption rate is used for each department, charging of overheads will be more fair
and the full cost of production of items will more closely represent the amount of the effort and
resources used to make them.
Worked Example: Stoakley
Stoakley Ltd has two production departments, for which the following budgeted information is
available:
Budgeted overheads
Budgeted direct labour hours
Department A
$360 000
200 000 hrs
Department B
$200 000
40 000 hrs
Total
$560 000
240 000 hrs
If a single factory overhead absorption rate is applied, the rate of overhead recovery would be:
$560 000
= $2.33 per direct labour hour
240 000 hours
If separate departmental rates are applied, these would be:
Department A =
Department B =
$360 000
= $1.80 per direct labour hour
200 000 hours
$200 000
= $5 per direct labour hour
40 000 hours
Jobs using Department B would get charged a higher overhead rate in terms of cost per hour worked
than department A.
Now let us consider two separate jobs.
Job X has a prime cost of $100, takes 30 hours in department B and does not involve any work in
department A.
Job Y has a prime cost of $100, takes 28 hours in department A and 2 hours in department B.
What would be the factory cost of each job, using the following rates of overhead recovery?
a. A single factory rate of overhead recovery
b. Separate departmental rates of overhead recovery
Solution
a. Single factory rate
Prime cost
Factory overhead (30 $2.33)
Factory cost
(30 $5)
Job X
$
100.00
69.90
Job Y
$
100.00
69.90
169.90
169.90
$
100.00
0
150.00
$
100.00
50.40
10.00
(28 $1.80)
(2 $5)
250.00
160.40
Using a single factory overhead absorption rate, both jobs would cost the same. However, since job X
is done entirely within department B where overhead costs are higher, whereas job Y is done mostly
within department A, where overhead costs are lower, it is arguable that job X should cost more than
job Y. This will occur if separate departmental overhead recovery rates are used to reflect the work
done on each job in each department separately.
If all jobs do not spend approximately the same time in each department then, to ensure that all jobs
are charged with their fair share of overheads, it is necessary to establish separate overhead rates for
each department.
What is the problem with using a single factory overhead absorption rate?
(The answer is at the end of the chapter)
Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only
variable costs are charged as a cost of sale and a contribution is calculated (sales revenue minus
variable cost of sales). Closing inventories of work in progress or finished goods are valued at marginal
(variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the
statement of comprehensive income in the accounting period in which they are incurred.
The marginal production cost per unit of an item usually consists of the following:
Direct materials
Variable production overheads
Direct labour costs might be excluded from marginal costs when the work force is a given number of
employees on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a
variable cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you
should treat direct labour as a variable cost unless given clear indications to the contrary. Direct labour
is often a step-fixed cost, usually with sufficiently short steps to make labour costs act in a variable
fashion.
CHAPTER 5
Direct labour
The marginal cost of sales usually consists of the marginal cost of production adjusted for inventory
movements plus the variable marketing costs, which would include items such as sales commission,
and possibly some variable distribution costs.
8.1 CONTRIBUTION
Contribution is an important measure in marginal costing, and it is calculated as the difference
between sales price and marginal or variable cost of sales.
Contribution is of fundamental importance in marginal costing, and the term 'contribution' is really
short for 'contribution towards covering fixed overheads and making a profit'.
Rain Until September Co makes a product, the Splash, which has a variable production cost of $6 per
unit and a sales price of $10 per unit. At the beginning of September 20X0, there were no opening
inventories and production during the month was 20 000 units. Fixed costs for the month were $45 000
(production, administration, sales and distribution). There were no variable marketing costs.
Calculate the contribution and profit for September 20X0, using marginal costing principles, if sales
were as follows:
a. 10 000 Splashes
b. 15 000 Splashes
c. 20 000 Splashes
Solution
10 000 Splashes
$
$
100 000
0
120 000
120 000
60 000
15 000 Splashes
$
$
150 000
0
120 000
120 000
20 000 Splashes
$
$
200 000
0
120 000
120 000
0
30 000
60 000
40 000
45 000
(5 000)
90 000
60 000
45 000
15 000
120 000
80 000
45 000
35 000
$(0.50)
$1
$1.75
$4
$4
$4
The conclusions which may be drawn from this example are as follows:
a. The profit per unit varies at differing levels of sales, because the average fixed overhead cost per
unit changes with the volume of output and sales.
b. The contribution per unit is constant at all levels of output and sales. Total contribution, which is
the contribution per unit multiplied by the number of units sold, increases in direct proportion to
the volume of sales.
c. Since the contribution per unit does not change, the most effective way of calculating the
expected profit at any level of output and sales would be as follows:
i. First calculate the total contribution.
ii. Then deduct fixed costs as a period charge in order to find the profit.
d. In our example the expected profit from the sale of 17 000 Splashes would be as follows:
$
Total contribution (17 000 $4)
Less fixed costs
Profit
68 000
45 000
23 000
CHAPTER 5
Mill Stream makes two products, the Mill and the Stream. Information relating to each of these
products for April 20X1 is as follows:
Opening inventory
Production (units)
Sales (units)
Mill
Nil
15 000
10 000
$20
Unit costs
Direct materials
Direct labour
Variable production overhead
Variable sales overhead
Fixed costs for the month
Production costs
Administration costs
Sales and distribution costs
$
8
4
2
2
Stream
Nil
6 000
5 000
$30
$
14
2
1
3
$
40 000
15 000
25 000
Using marginal costing principles, what was the profit in April 20X1?
A $10 000
B $40 000
C $45 000
D $70 000
(The answer is at the end of the chapter)
Marginal costing as a cost accounting system is significantly different from absorption costing. It is an
alternative method of accounting for costs and profit, which rejects the principles of absorbing fixed
overheads into unit costs.
MARGINAL COSTING
ABSORPTION COSTING
Note. The share of fixed overheads included in cost of sales are from the previous period (in opening
inventory values). Some of the fixed overheads from the current period will be excluded by being
carried forward in closing inventory values.
In absorption costing (sometimes known as full costing), it is not necessary to distinguish variable
costs from fixed costs.
Worked Example: Marginal and absorption costing compared
This example will lead you through the various steps in calculating marginal and absorption costing
profits, and will highlight the differences between the two techniques.
Big Possum Ltd manufactures a single product, the Bark, details of which are as follows:
Per unit
Selling price
Direct materials
Direct labour
Variable overheads
$
180.00
40.00
16.00
10.00
Annual fixed production overheads are budgeted to be $1.6 million and Big Possum Ltd expects to
produce 1 280 000 units of the Bark each year. Overheads are absorbed on a per unit basis. Actual
overheads are $1.6 million for the year.
Budgeted fixed marketing costs are $320 000 per quarter.
Actual sales and production units for the first quarter of 20X8 are given below:
January March
240 000
280 000
Sales
Production
Also be careful with your calculations. You are dealing with a three-month period but the
figures in the question are for a whole year. You will have to convert these to quarterly
figures.
Budgeted overheads (quarterly) =
$1.6 million
= $400 000
4
CHAPTER 5
Step 1
1280 000
= 320 000 units
4
Step 2
$400 000
= $1.25 per unit
320 000
Step 3
Step 4
Step 5
Marginal costing
$ 000
$ 000
43 200
0
18 480
18 830
(2 640)
(2 690)
16 140
50
Contribution
Gross profit
Less
Fixed production O/H
Fixed marketing O/H
Net profit
Absorption costing
$ 000
$ 000
43 200
(16 190)
27 010
400
320
Nil
320
(720)
26 640
(320)
26 690
A company makes a single product. Its budgeted data for a period is as follows.
Opening inventory
Variable production cost per unit of opening
inventory
Production
Sales
Variable production cost per unit produced in
the period
Variable selling cost per unit
Sales price per unit
Production fixed costs
Other fixed overhead costs
3 000 units
$6
16 000 units
17 000 units
$7
$1
$20
$80 000
$60 000
The company uses marginal costing, but is considering whether to use absorption costing instead. If
absorption costing were to be used, the fixed production overhead in the opening inventory would
have been $4 per unit. Inventory is valued using the FIFO (first in, first out) method.
a. Using marginal costing principles, what is the budgeted profit for the period?
A
B
C
D
$55 000
$64 000
$67 000
$69 000
b. If absorption costing were to be used instead of marginal costing, by how much would the
reported profit for the period be higher or lower?
CHAPTER 5
A $2 000 lower
B $2 000 higher
C $10 000 lower
D $10 000 higher
(The answer is at the end of the chapter)
direct expense.
marketing expense.
production overhead.
administrative overhead.
4 The following extract of information is available concerning the four cost centres of EG Limited.
Service cost
centre
Cafeteria
4
$8 400
The overhead cost of the cafeteria is to be re-apportioned to the production cost centres on the
basis of the number of employees in each production cost centre. After the re-apportionment, the
total overhead cost of the packing department, to the nearest $, will be
$1 200.
$9 968.
$10 080.
$10 160.
CHAPTER 5
A
B
C
D
Budgeted information relating to two departments in a company for the next period is as follows:
Department
1
2
Production
overhead
$
27 000
18 000
Direct
material cost
$
67 500
36 000
Direct
labour cost
$
13 500
100 000
Direct
Labour hours
2 700
25 000
Machine
hours
45 000
300
Individual direct labour employees within each department earn differing rates of pay, according to
their skills, grade and experience.
5 What is the most appropriate production overhead absorption rate for department 1?
A $0.60 per machine hour
B $10 per direct labour hour
C 40% of direct material cost
D 200% of direct labour cost
6 What is the most appropriate production overhead absorption rate for department 2?
A $0.72 per direct labour hour
B 18% of direct labour cost
C 50% of direct material cost
D $60 per machine hour
7 Which of the following statements about predetermined overhead absorption rates are true?
I Using a predetermined absorption rate offers the administrative convenience of being able to
record full production costs sooner.
II Using a predetermined absorption rate avoids fluctuations in unit costs caused by abnormally
high or low overhead expenditure or activity levels.
III Using a predetermined absorption rate avoids problems of under/over absorption of overheads
because a constant overhead rate is available.
A
B
C
D
I, II and III
I and II only
I and III only
II and III only
8 A direct labour hour basis is most appropriate in which of the following environments?
A Labour-intensive
B Machine-intensive
C When all units produced are identical
D When there are several production departments
=
=
=
$8 400
3
21
$1 200
$8 960
$10 160
If you selected option A you forgot to include the original overhead allocated and apportioned
to the packing department.
If you selected option B you included the four cafeteria employees in your calculation, but the
question states that the basis for apportionment is the number of employees in each
production cost centre. If you selected option C you based your calculations on the direct
employees only.
5 A Department 1 appears to undertake primarily machine-based work, therefore a machine-hour
rate would be most appropriate.
$27 000
= $0.60 per machine hour
45 000
$18 000
= $0.72 per direct labour hour
25 000
Option B is based on labour therefore it could be suitable. However differential wage rates
exist and this could lead to inequitable overhead absorption.
Option C is not the most appropriate because it is not time-based.
Option D is not suitable because machine activity is not significant in department 2.
CHAPTER 5
7 B Statement (I) is correct because a constant unit absorption rate is used throughout the period.
Statement (II) is correct because 'actual' overhead costs, based on actual overhead
expenditure and actual activity for the period, cannot be determined until after the end of the
period. Statement (III) is incorrect because under/over absorption of overheads is caused by
the use of predetermined overhead absorption rates.
8 A A direct labour hour absorption rate is most appropriate for labour-intensive work when output
consists of non-standard units.
REFERENCE NUMBER
Production costs
14
10
11
Administration costs
13
15
12
Maint.
$
General
$
Total
$
4 D IV
A II
BI
16
C III
1
2
1
3
4
3
1
Forming Machines
$
$
Ass
$
800
1 500
3 000
1 800
2 300
5 000
300
1 100
1 500
200
900
4 000
100
1 500
2 000
3 200
7 300
15 500
1 600
200
1 000
2 500
50
500
100
11 250
3 200
450
2 000
6 000
25
1 200
200
22 175
2 400
75
1 500
750
100
150
150
8 025
400
25
250
750
50
150
25
6 750
400
0
250
0
25
0
25
4 300
8 000
750
5 000
10 000
250
2 000
500
52 500
Basis of apportionment:
1 floor area
2 effective horsepower
3 plant value
4 fixtures and fittings value
Overheads
Forming
$
11 250
1 350
Machines
$
22 175
3 375
Assembly
$
8 025
1 350
995
99
10
1
13 705
2 985
249
30
3
28 817
498
99
5
1
9 978
Maintenance
$
6 750
(6 750)
497
(497)
5
(5)
0
General
$
4 300
675
4 975
(4 975)
50
(50)
Total
$
52 500
52 500
CHAPTER 5
6 The problem with using a single factory overhead absorption rate is that some products will receive
a higher overhead charge than they ought 'fairly' to bear and other products will be undercharged.
7 A
$
Contribution from Mills (unit contribution = $20 $16 = $4 10 000)
Contribution from Streams (unit contribution = $30 $20 = $10 5 000)
Total contribution
Fixed costs for the period
Profit
40 000
50 000
90 000
80 000
10 000
8 (a) C
$
18 000
112 000
130 000
(14 000)
116 000
17 000
133 000
340 000
207 000
(140 000)
67 000
(b) A Absorption costing: fixed production cost per unit in the period $80 000/16 000 = $5.
Therefore value of closing inventory (per unit) = $7 + $5 = $12.
Marginal
costing
Absorption
costing
$
18 000
14 000
$
30 000
24 000
4 000
(3 000 $10)
(2 000 $12)
6 000
The reduction in inventory is an addition to the cost of sales in the period; therefore with
absorption costing the cost of sales in the period would be $2 000 higher, and reported
profit $2 000 lower.
171
CHAPTER 6
OVERHEAD COSTING
ACTIVITY BASED COSTING
Learning objectives
Reference
LO6
LO6.1
Topic list
1
2
3
4
5
6
INTRODUCTION
In this chapter we look at a costing system that has been developed to suit modern practices: activity
based costing.
Basically, activity based costing (ABC) is the modern alternative to traditional absorption costing.
The chapter content is summarised in the diagram below.
Overhead costing
activity based
costing
Reasons for
development
Introducing
ABC
Absorption costing
versus ABC
Outline of
ABC system
Merits and
criticisms
Marginal costing
versus ABC
If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What are the reasons for the development of ABC?
2 Define ABC.
3 Explain the concept of cost drivers.
(Section 1)
(Section 2.1)
(Sections 2.2, 3.2)
(Section 5.1)
(Section 5.2)
(Section 5.2)
(Section 6.1)
(Section 6.1)
(Section 6.2)
CHAPTER 6
The traditional system of absorption costing was developed when cost accounting systems were
used mainly for manufacturing organisations that produced only a narrow range of products and
when overhead costs were only a very small fraction of total costs. Direct labour and direct
material costs accounted for the largest proportion of the costs. Production overhead costs were not
too significant, and were usually considered to be 'driven' by direct labour hours worked. Similarly
selling and distribution costs were relatively small, and were considered to be 'driven' by the volume
of sales activity.
Nowadays, however, with the advent of advanced manufacturing technology (AMT), production
overheads are a much more significant proportion of total production costs. Direct labour costs in
a highly automated production system may account for as little as 5% of a product's cost. There are
now many different ways of delivering products to different types of customer, and selling and
distribution costs depend on factors such as the channel of distribution used and the type of customer,
not just on sales volumes.
It may therefore now be difficult to justify the use of direct labour or direct production cost as the
basis for absorbing production overheads.
Many resources are used in support activities that are not directly related to production (or selling)
volume. The increase in costs of non-volume-related activities is due to AMT: they include costs
relating to setting-up production runs, production scheduling, customer order handling, inspection
and data processing. These support activities assist the efficient manufacture of a wide range of
products (necessary if businesses are to compete effectively) and are not, in general, affected by
changes in production volume. They tend to vary in the long term according to the range and
complexity of the products manufactured rather than the volume of output.
The wider the range and the more complex the products, the more support services will be required.
Consider, for example, factory X which produces 10 000 units of one product, the Alpha, and factory Y
which produces 1 000 units each of ten slightly different versions of the Alpha. Support activity costs in
the factory Y are likely to be a lot higher than in factory X but the factories produce an identical
number of units. For example, factory X will only need to set-up once whereas Factory Y will have to
set-up the production run at least ten times for the ten different products. Factory Y will therefore
incur more set-up costs for the same volume of production.
Activity based costing is a system of costing that analyses overhead costs in a different way. Overhead
costs are allocated initially to activities, and the key factors that 'drive' each of these activities are also
identified. Costs are then attributed to products (or services or customers) on the basis of the use they
make of each of these activities.
Activity based costing (ABC) is an alternative to the traditional method of accounting for
costs - absorption costing. ABC divides production into core activities which drive the
need for resources, assigns costs to those activities based on the resources they use, and
then allocates those costs to products based on their consumption of the activities.
CHAPTER 6
Section overview
An activity cost pool is a grouping of costs relating to a particular activity in an activity based costing
system.
An ABC system operates as follows:
Step 1
Step 2
Identify the factors which determine the size of the costs of an activity/cause the
incurrence of costs of an activity. These are known as cost drivers.
Look at the following examples:
COSTS
Ordering costs
Number of orders
Despatching costs
Number of despatches
For those costs that vary with production levels in the short term, ABC uses volumerelated cost drivers such as labour or machine hours. The cost of oil used as a lubricant
on the machines would therefore be added to products on the basis of the number of
machine hours, since oil would have to be used for each hour the machine ran.
Overheads that vary with some other activity, and not volume of production, should be
traced to products using transaction-based cost drivers such as production runs or
number of orders received.
Step 3
Collect the costs of the resources associated with each activity into what are known as
activity cost pools.
Step 4
Charge the costs of each cost pool to products on the basis of their usage of the
activity, measured by the number of the activity's cost driver a product generates, using
a cost driver rate (total costs in cost pool/number of cost drivers).
An organisation has estimated that the resources incurred in the production set-up activity will cost
$200 000 for a particular period. The machinery for production has to be set-up each time a batch of a
particular product is manufactured and there are expected to be 40 machine set-ups in total. In the
period the company expects to manufacture 150 000 units of Product X (in batches of 5 000 units) and
500 000 units of Product Y (in batches of 50 000 units).
Calculate the production set-up costs to be assigned to a single unit of Product X and Y, using Activity
based costing.
Solution
Step 1
Step 2
Step 3
Step 4
The cost driver rate is therefore $200 000/40 = $5 000 per machine set-up.
The production set-up costs can then be assigned to the products based on the number of machine
set-ups each requires (which because production set-up is a batch level activity is driven by the
number of batches of each product that are made):
a. Number of units produced
b. Units per batch
c. Total number of batches = (a)/(b) (each
batch requires one machine set-up)
d. Total machine set-up costs assigned to
product
= No. of machine set-ups (c)x $5 000
cost per set-up
Production set-up cost per unit of
product = (d)/(a)
Product X
150 000
5 000
30
Product Y
500 000
50 000
10
$150 000
$50 000
$1.00
$0.10
The production set-up costs determined above would then form part of the overhead cost of each
product.
CHAPTER 6
ABC uses multiple cost drivers to absorb costs and by considering each activity separately, attempts
to more closely link the absorption rate to the actual cause of the overhead. When using ABC, for
costs that vary with production levels in the short term, the cost driver will be volume related (labour or
machine hours). Overheads that vary with some other activity, and not volume of production, should
be traced to products using transaction-based cost drivers such as production runs or number of
orders received.
The following example illustrates the point that traditional cost accounting techniques may result in a
misleading and inequitable division of costs between low-volume and high-volume products, and that
ABC can provide a more meaningful allocation of costs.
Worked Example: Absorption costing vs Activity based costing
Suppose that Cooplan manufactures four products, W, X, Y and Z. Output and cost data for the period
just ended are as follows:
Number of
production
runs in the
period
Output units
W
X
Y
Z
10
10
100
100
2
2
5
5
14
$5
Overhead costs
Short run variable costs
Set-up costs
Scheduling costs
Materials handling costs
Material cost
per unit
$
20
80
20
80
Direct labour
hours per unit
Machine
hours per unit
1
3
1
3
1
3
1
3
$
3 080
10 920
9 100
7 700
30 800
Prepare unit costs for each product using conventional absorption costing and ABC.
Solution
Using a conventional absorption costing approach and an absorption rate for overheads based on
either direct labour hours or machine hours, the product costs would be as follows:
Direct material
Direct labour
Overheads *
Units produced
Cost per unit
W
$
200
50
700
950
10
$95
X
$
800
150
2 100
3 050
Y
$
2 000
500
7 000
9 500
Z
$
8 000
1 500
21 000
30 500
10
$305
100
$95
100
$305
Total
$
44 000
* $30 800 440 hours = $70 per direct labour or machine hour.
Using activity based costing and assuming that the number of production runs is the cost driver for
set-up costs, scheduling costs and materials handling costs and that machine hours are the cost driver
for short-run variable costs, unit costs would be as follows:
Units produced
Cost per unit
10
$428
X
$
800
150
210
1 560
1 300
1 100
5 120
Y
$
2 000
500
700
3 900
3 250
2 750
13 100
Z
$
8 000
1 500
2 100
3 900
3 250
2 750
21 500
10
$512
100
$131
100
$215
Total
$
44 000
Workings
1
2
3
4
Summary
Product
W
X
Y
Z
Conventional costing
Unit cost
$
95
305
95
305
ABC
Unit cost
$
428
512
131
215
Difference per
unit
$
+ 333
+ 207
+ 36
90
Difference in
total
$
+3 330
+2 070
+3 600
9 000
The figures suggest that the traditional volume-based absorption costing system is flawed.
a. It under-allocates overhead costs to low-volume products (here, W and X) and over-allocates
overheads to higher-volume products (here Z in particular).
b. It under-allocates overhead costs to smaller-sized products (here W and Y with just one hour of
work needed per unit) and over allocates overheads to larger products (here X and particularly Z).
CHAPTER 6
Direct material
Direct labour
Short-run variable overheads (W1)
Set-up costs (W2)
Scheduling costs (W3)
Materials handling costs (W4)
W
$
200
50
70
1 560
1 300
1 100
4 280
a. Those costs that do vary with production volume, such as power costs, should be traced to
products using production volume-related cost drivers as appropriate, such as direct labour hours
or direct machine hours. Such costs tend to be short-term variable overheads.
Overheads which do not vary with output but with some other activity should be traced to products
using transaction-based cost drivers, such as number of production runs and number of orders
received. Such costs tend to be long-term variable overhead (overhead that traditional accounting
would classify as fixed).
b. Traditional costing systems allow overhead to be related to products in rather more arbitrary ways
producing, it is claimed, less accurate product costs.
Question 2: ABC versus traditional costing
A company manufactures two products, L and M, using the same equipment and similar processes.
An extract of the production data for these products in one period is shown below:
L
5 000
1
3
10
15
M
7 000
2
1
40
60
$
209 000
25 000
51 000
285 000
a. What is the amount of production overhead to be absorbed by one unit of product M using a
traditional absorption costing approach, with a direct labour hour rate to absorb overheads?
A
B
C
D
$15.00
$17.50
$22.00
$30.00
b. What is the amount of production overhead to be absorbed by one unit of product M using an
activity based costing approach, with suitable cost drivers to trace overheads to products?
A
B
C
D
$12.95
$18.19
$32.57
$37.57
(The answers are at the end of the chapter)
The problem with marginal costing is that it analyses cost behaviour patterns according to the volume
of production. However, although certain costs may be fixed in relation to the volume of
production, they may in fact be variable in relation to some other cost driver. A failure to allocate
such costs to individual products could result in incorrect decisions concerning the future
management of the products.
The advantage of ABC is that it spreads costs across products according to a number of different
bases. For example, an ABC analysis may show that one particular activity which is carried out
primarily for one or two products is expensive. A correct allocation of the costs of this activity may
reveal that these particular products are not profitable. If these costs are fixed in relation to the
volume of production then they would be treated as period costs in a marginal costing system and
written off against the marginal costing contribution for the period.
The marginal costing system would therefore make no attempt to allocate these 'fixed' costs to
individual products and a false impression would be given of the long run average cost of the
products.
Therefore, marginal costing may provide incorrect decision making information, particularly in a
situation where 'fixed' costs are vary large compared with 'variable' costs.
CHAPTER 6
One view is that only marginal costing provides suitable information for decision making but this is not
true. Marginal costing provides a crude method of differentiating between different types of cost
behaviour by splitting costs into their variable and fixed elements. However, such an analysis can be
used only for short-term decisions and usually even these have longer-term implications which ought
to be considered.
TYPE OF ACTIVITIES
EXAMPLES
Product level
Volume of production
Machine power
Batch level
Number of batches
Set-up costs
Product-sustaining
Product management
Facility-sustaining
Definitions
Product-sustaining activities are activities undertaken to develop or sustain a product or service.
Product sustaining costs are linked to the number of products or services, not to the number of units
produced.
Facility-sustaining activities are activities undertaken to support the organisation as a whole, and
which cannot be logically linked to individual units of output.
The difference between a unit product cost determined using traditional absorption costing and one
determined using ABC will depend on the proportion of overhead cost which falls into each of the
categories above.
a. If most overheads are related to unit level and facility level activities, the unit product costs
generated by each method will be similar.
b. If the overheads tend to be associated with batch or product level activities the unit product cost
generated by ABC will be significantly different from traditional absorption costing.
Consider the following example.
Worked Example: Batch level activity
XYZ produces a number of products including product D and product E and produces 500 units of
each of products D and E every period at a rate of ten of each every hour. The overhead cost is $500
000 and a total of 40 000 direct labour hours are worked on all products. A traditional overhead
absorption rate would be $12.50 per direct labour hour and the overhead cost per product would be
$1.25.
Production of D requires five production runs per period, while production of E requires 20. An
investigation has revealed that the overhead costs relate mainly to 'batch-level' activities associated
with setting-up machinery and handling materials for production runs.
There are 1,000 production runs per period and so overheads could be attributed to XYZ's products at
a rate of $500 per run.
Overhead cost per D = ($500 5 runs)/500 = $5
Overhead cost per E = ($500 20 runs)/500 = $20
These overhead costs are activity based and recognise that overhead costs are incurred due to batch
level activities. The fact that E has to be made in frequent small batches, perhaps because it is
perishable, means that it uses more resources than D. This is recognised by the ABC overhead costs,
not the traditional absorption costing overhead costs.
In the modern manufacturing environment, production often takes place in short, discontinuous
production runs and a high proportion of product costs are incurred at the design stage. An
increasing proportion of overhead costs are therefore incurred at batch or product level.
Such an analysis of costs gives management an indication of the decision level at which costs can
be influenced. For example, a decision to reduce production costs will not simply depend on making
a general reduction in output volumes: production may need to be organised to reduce batch
volumes; a process may need to be modified or eliminated; product lines may need to be merged or
cut out; facility capacity may need to be altered.
ACTIVITIES
EXAMPLES
Unit level
Accept cash
Processing of cash by bank
Number of transactions
Number of transactions
Batch level
Product level
Number of accounts
Number of accounts
An important aspect of ABC in non-manufacturing operations is to identify the items for which the
costing system is intended to provide cost information. In the case of cash processing above, ABCrelated costs can be established for customer accounts and also for cash processing transactions.
Costs can also be established for 'close outs' and fund transfers.
Having identified the items for which unit costs are needed, at a unit, batch or product level, activity
costs should be assigned to each cost item on the basis of their 'use' of each activity.
Question 3: ABC and retail organisations
List five activities that might be identified in a department store and state one possible cost driver for
each of the activities you have identified.
(The answer is at the end of the chapter)
CHAPTER 6
ABC was first introduced in manufacturing organisations but it can equally well be used in other types
of organisation. For example, the management of the Post Office in the US introduced ABC. They
analysed the activities associated with cash processing as follows:
e. The costs of activities not included in the costs of the products an organisation makes or the
services it provides can be considered to be not contributing to the value of the
product/service. The following questions can then be asked:
What is the purpose of this activity?
How does the organisation benefit from this activity?
Could the number of staff involved in the activity be reduced?
f. ABC can help with cost management. For example, suppose there is a fall in the number of orders
placed by a purchasing department. This fall would not impact on the amount of overhead
absorbed in a traditional absorption costing system as the cost of ordering would be part of the
general overhead absorption rate. The reduction in the workload of the purchasing department
might therefore go unnoticed and the same level of resources would continue to be provided,
despite the drop in number of orders. In an ABC system, however, this drop would be immediately
apparent because the cost driver rate would be applied to fewer orders.
g. Many costs are driven by customers, delivery costs, discounts, after-sales service and so on, but
traditional absorption costing systems do not account for this. Organisations may be trading with
certain customers at a loss but may not realise it because costs are not analysed in a way that
reveals the true situation. ABC can be used in conjunction with customer profitability analysis to
determine more accurately the profit earned by servicing particular customers.
Definition
Customer profitability analysis is the analysis of the revenue streams and service costs associated
with specific customers or customer groups.
h. Many service businesses have characteristics similar to those required for the successful
application of ABC:
A highly competitive market.
Diversity of products, processes and customers.
Significant overhead costs not easily assigned to individual 'products'.
Demands placed on overhead resources by individual 'products' and customers, which are not
proportional to volume.
If ABC were to be used in a hotel, for example, attempts could be made to identify the activities
required to support each guest by category and the cost drivers of these activities. The cost of a onenight stay midweek by a businessman could then be distinguished from the cost of a one-night stay by
a teenager at the weekend. Such information could prove invaluable for Customer profitability
analysis.
Before an ABC system can be implemented, management must analyse the organisation's activities,
determine the extent of their occurrence and establish the relationships between activities,
products/services and their cost.
The information database produced from such an exercise can then be used as a basis for forward
planning and budgeting. For example, once an organisation has set its budgeted production level,
the database can be used to determine the number of times that activities will need to be carried out,
thereby establishing necessary departmental staffing and machine levels. Financial budgets can then
be drawn up by multiplying the budgeted activity levels by cost per activity.
This activity based approach may not produce the final budget figures but it can provide the basis for
different possible planning scenarios.
6.3.2 CONTROL
The information database also provides an insight into the way in which costs are structured and
incurred in service and support departments. Traditionally it has been difficult to control the costs of
such departments because of the lack of relationship between departmental output levels and
departmental cost. With ABC, however, it is possible to control or manage the costs by managing
the activities which underlie them by monitoring cost driver usage.
CHAPTER 6
Set-up costs
Product development costs
Short-run variable overhead costs
Materials handling and despatch costs
3 Which of the following is most likely to be the cost driver for production scheduling costs?
A
B
C
D
Volume of output
Number of orders
Number of production runs
Volume of materials handled
CHAPTER 6
2 (a) D
Traditional absorption costing approach
Direct
labour
hours
5 000
14 000
19 000
$285 000
= $15 per hour
19 000
2 hours $15
(b) B
ABC approach
Product L
Machine
hours
15 000
Product M
7 000
22 000
Using ABC the overhead costs are absorbed according to the cost drivers.
Machine-hour driven costs
Set-up driven costs
Order driven costs
$
= $9.50 per m/c hour
= $500 per set-up
= $680 per order
Machine-driven costs
Set-up costs
(40 $500)
20 000
(60 $680)
40 800
127 300
Units produced
Overhead cost per unit of Product M
7 000
$18.19
These figures suggest that product M absorbs an excessive amount of overhead using a direct
labour hour basis. Overhead absorption should be based on the activities which drive the costs,
in this case machine hours, the number of production run set-ups and the number of orders
handled for each product. Most overhead costs are driven by machine activity, but Product M
requires much less machine time than Product L.
CHAPTER 6
1 D A cost driver is best described as any factor which causes a change in the cost of an activity.
3
ACTIVITIES
Number of orders
Returned goods
Number of returns
Operating a department
Check-out activity
Number of customers/check-outs
Home deliveries
191
CHAPTER 7
PROCESS AND JOB
COSTING
Learning objectives
Reference
LO7
LO7.1
LO7.2
Topic list
1
2
3
4
5
6
7
8
INTRODUCTION
This chapter looks at costing systems. Costing systems are used to cost goods or services. The
method used depends on the way in which the goods or services are produced.
The chapter begins by considering process costing. Process costing is applied when output consists of
a continuous stream of identical units. We will begin with the basics and look at how to account for the
most simple of processes. We will then move on to how to account for any losses which might occur,
as well as what to do with any scrapped units which are sold. Next we will consider how to deal with
closing work in process before examining situations involving closing work in process and losses. We
will then go on to have a look at situations involving opening work in process and how to deal with
situations where we have both opening and closing work in process and losses. This is followed with
an outline discussion of joint products and by-products.
This chapter will conclude by covering job costing.
The chapter content is summarised in the diagram below.
Process and
job costing
Process
costing
Basics
Accounting
for scrap
Work in
process
Joint products
and by-products
Job
costing
(Section 1)
(Section 1)
(Section 2.1)
(Section 2.1)
(Section 2.2)
(Section 3.1)
(Section 3.1)
(Sections 5, 6)
(Section 7.1)
(Section 7.2)
(Section 8)
CHAPTER 7
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
Process costing is used where there is a continuous flow of identical units and it is common to
identify it with continuous production such as the following:
Oil refining
The manufacture of soap
Paint manufacture
Food and drink manufacture
Concrete/cement production
Magazine printing
Definition
Process costing is a cost accounting system used where products or services are mass produced in a
continuous flow of production. Process costs are attributed to the number of units produced. This may
involve estimating the number of equivalent units in stock at the start and end of the period under
consideration.
LO
7.2
Section overview
Costs incurred in processes are recorded in what are known as process accounts. A process
account has two sides, and on each side there are two columns, one for quantities (of raw
materials, work-in-process and finished goods) and one for costs.
There is a four step approach for dealing with process costing questions.
The quantity columns on each side of the account should total to the same amount. Why? For
instance if we put 100 kgs of material in to a process, which we record on the left hand side of the
account, we should know what has happened to those 100 kgs. Some would be losses maybe, some
would be WIP, some would be finished units, but the total should be 100 kgs.
Likewise the cost of the inputs to the process during a period (i.e. the total of the costs recorded on
the left hand side of the account) is the cost of the outputs of the process. If we have recorded
material, labour and overhead costs totalling $1 000 and at the end of the process we have 100
finished units (and no losses or WIP), then that output cost $1 000.
Here's a simple example of a process account:
PROCESS ACCOUNT
Material
Labour
Units
1 000
Overhead
1 000
$
11 000
4 000
Closing WIP
Finished goods
inventory
3 000
18 000
Units
200
800
$
2 000
16 000
1 000
18 000
As you can see, the quantity columns on each side balance (i.e. they are the same), as do the
monetary columns. Don't worry at this stage about how the costs are split between WIP and finished
units.
Worked Example: Basics of process costing
Suppose that Purr and Miaow Co make squeaky toys for cats. Production of the toys involves two
processes, shaping and colouring. During the year to 31 March 20X3, 1 000 000 units of material worth
$500 000 were input to the first process, shaping. Direct labour costs of $200 000 and production
overhead costs of $200 000 were also incurred in connection with the shaping process. There were no
opening or closing inventories in the shaping department. The process account for shaping for the
year ended 31 March 20X3 is as follows:
PROCESS 1 (SHAPING) ACCOUNT
Direct materials
Direct labour
Production overheads
Units
1 000 000
1 000 000
$
500 000
200 000
200 000
900 000
Output to Process 2
Units
1 000 000
$
900 000
1 000 000
900 000
When preparing process accounts, balance off the quantity columns (i.e. ensure they total to the same
amount on both sides) before attempting to complete the monetary value columns since they will
help you to check that you have not missed something. This becomes increasingly important as more
complications are introduced into questions.
CHAPTER 7
iii. At the end of a period, some units of input might be in the process of being turned into finished
units so would be work in process (WIP). We record the units of WIP and the cost of these units.
When using process costing, if a series of separate processes is needed to manufacture the finished
product, the output of one process becomes the input to the next until the final output is made in
the final process. In our example, all output from shaping was transferred to the second process,
colouring, during the year to 31 March 20X3. An additional 500 000 units of material, costing $300 000,
were input to the colouring process. Direct labour costs of $150 000 and production overhead costs of
$150 000 were also incurred. There were no opening or closing inventories in the colouring
department.
The process account for colouring for the year ended 31 March 20X3 is as follows:
PROCESS 2 (COLOURING) ACCOUNT
Materials from process 1
Added materials
Direct labour
Production overhead
Units
1 000 000
500 000
1 500 000
$
900 000 Output to finished
300 000 goods
150 000
150 000
1 500 000
Units
1 500 000
1 500 000
1 500 000
1 500 000
In some cases, the figures for direct labour and production overhead may not be given separately in
an assessment question, but instead grouped together as one figure and called 'conversion cost'.
Added materials, labour and overhead in process 2 are usually added gradually throughout the
process. Materials from process 1, in contrast, will often be introduced in full at the start of the second
process.
Step 1
Step 2
Step 3
Step 4
Complete accounts.
Complete the process account and any other accounts required.
LO
7.2
Section overview
Losses may occur in a process. If a certain level of loss is expected, this is known as normal
loss. If losses are greater than expected, the extra loss is abnormal loss. If losses are less
than expected, the difference is known as abnormal gain.
3.1 LOSSES
During a production process, a loss may occur.
Definitions
The normal loss is expected loss, allowed for in the budget, and normally calculated as a percentage
of the good output, from a process during a period of time. Normal losses are generally either valued
at zero or at their disposal values.
Abnormal loss is any loss in excess of the normal loss budgeted.
Abnormal gain is the outcome from improvements associated with production activity.
Units associated with abnormal loss and gain are valued at the same unit rate as 'good' units.
Abnormal events do not therefore affect the cost of good production. Their costs are analysed
separately in an abnormal loss or abnormal gain account.
Step 1
Units
140
100
40
CHAPTER 7
Since normal loss is not given a cost, the cost of producing these units is borne by the 'good' units of
output.
Step 2
Costs incurred
$4 500
=
= $5 per unit
Expected output
900 units
Step 3
Step 4
Complete accounts.
PROCESS ACCOUNT
Cost incurred
Units
1 000
1 000
$
4 500
Normal loss
Output (finished
goods a/c)
Abnormal loss
4 500
Units
100
860
40
1 000
Units
40
$
200
Statement of
comprehensive
income
Units
40
$
0
( $5)
( $5)
4 300
200
4 500
$
200
Step 1
Step 2
Units
80
100
20
Step 3
$
4 600
0
(100)
4 500
Step 4
Complete accounts.
PROCESS ACCOUNT
Cost incurred
Abnormal gain a/c
( $5)
Units
1 000
20
$
4 500
100
1 020
4 600
Normal loss
Output
(Finished goods a/c)
( $5)
Units
100
920
$
0
4 600
1 020
4 600
ABNORMAL GAIN
Statement of
comprehensive
income
Units
20
$
100
Process a/c
Units
20
$
100
During a four-week period, period 3, costs of input to a process were $29 070. Input was 1 000 units,
output was 850 units and normal loss is 10%.
During the next period, period 4, costs of input were again $29 070. Input was again 1 000 units, but
output was 950 units.
There were no units of opening or closing inventory.
Prepare the process account and abnormal loss or gain account for each period.
Solution
Step 1
Units
850
100
50
1 000
Period 4
Actual output
Normal loss (10% 1 000)
Abnormal gain
Input
Step 2
Units
950
100
(50)
1 000
CHAPTER 7
Step 3
Step 4
$
27 455
0
1 615
29 070
Period 4
Cost of output (950 $32.30)
Normal loss
Abnormal gain (50 $32.30)
$
30 685
0
(1 615)
29 070
Complete accounts.
PROCESS ACCOUNT
Units
Period 3
Cost of input
Period 4
Cost of input
Abnormal gain a/c
( $32.30)
1 000
$
29 070
1 000
29 070
1 000
50
29 070
1 615
1 050
30 685
Normal loss
Finished goods a/c
( $32.30)
Abnormal loss a/c
( $32.30)
Normal loss
Finished goods a/c
( $32.30)
Units
100
850
0
27 455
50
1 615
1 000
29 070
100
950
0
30 685
1 050
30 685
1 615
$
Period 4
Abnormal gain in process a/c
1 615
Charlton Co manufactures a product in a single process operation. Normal loss is 10% of input. Loss
occurs at the end of the process. Data for June are as follows:
Opening and closing inventories of work in process
Cost of input materials (3 300 units)
Direct labour and production overhead
Output to finished goods
The full cost of finished output in June was
A $74 250.
B $81 000.
C $82 500.
D $89 100.
(The answer is at the end of the chapter)
Nil
$59 100
$30 000
2 750 units
Zed Co makes product Emm which goes through several processes. The following information is
available for the month of June:
Opening WIP
Closing WIP
Input
Normal loss
Transferred to finished goods
kg
5 200
3 500
58 300
400
59 900
Section overview
The valuation of normal loss is either at scrap value or nil. It is conventional for the scrap
value of normal loss to be deducted from the cost of materials before a cost per equivalent
unit is calculated.
Definition
Scrap account
Process account
Abnormal losses and gains never affect the cost of good units of production. The scrap value of
abnormal losses is not credited to the process account, and the abnormal loss and gain units
carry the same full cost as a good unit of production.
c. The scrap value of abnormal loss is used to reduce the cost of abnormal loss with the scrap
value of abnormal loss, which therefore reduces the write-off of cost to the statement of
comprehensive income.
DEBIT
CREDIT
Scrap account
Abnormal loss account
CHAPTER 7
A 260 kgs
B 300 kgs
C 400 kgs
D 560 kgs
(The answer is at the end of the chapter)
d. The scrap value of abnormal gain arises because the actual units sold as scrap will be less than
the scrap value of normal loss. Because there are fewer units of scrap than expected, there will be
less revenue from scrap as a direct consequence of the abnormal gain. The abnormal gain account
should therefore be debited with the scrap value of the abnormal gain.
DEBIT
CREDIT
e. The scrap account is completed by recording the actual cash received from the sale of scrap with
the amount received from the sale of the actual scrap.
DEBIT
CREDIT
Cash at bank/Receivables
Scrap account
The same basic principle therefore applies that only normal losses should affect the cost of the good
output. The scrap value of normal loss only is credited to the process account. The scrap values of
abnormal losses and gains are analysed separately in the abnormal loss or gain account.
Worked Example: Scrap and abnormal loss or gain
A factory has two production processes. Normal loss in each process is 10% and scrapped units sell for
$0.50 each from process 1 and $3 each from process 2. Relevant information for costing purposes
relating to period 5 is as follows:
Direct materials added:
Units
Cost
Direct labour
Production overhead
Output to process 2/finished goods
Actual production overhead
Process 1
2 000
$8 100
$4 000
150% of direct labour cost
1 750 units
$17 800
Process 2
1 250
$1 900
$10 000
120% of direct labour cost
2 800 units
Prepare the accounts for process 1, process 2, scrap and abnormal loss or gain.
Solution
Step 1
Output
Normal loss (10% of input)
Abnormal loss
Abnormal gain
Process 1
Units
1 750
200
50
2 000
Process 2
Units
2 800
300
(100)
3 000*
Step 2
(150% $4 000)
(200 $0.50)
Expected output
90% of 2 000
90% of 3 000
Cost per unit
$18 000 1 800
$40 500 2 700
Process 2
$
8 100
4 000
6 000
18 100
(1 750 $10)
(100)
18 000
(300 $3)
1 900
17 500
10 000
12 000
41 400
(900)
40 500
1 800
2 700
$10
$15
Note. Calculate the cost per unit of output for process 1 prior to attempting to calculate the cost of
process 2.
Step 3
18 100
Process 2
$
42 000
900
42 900
(1 500)
41 400
(2 800 $15)
(300 $3)*
(100 $15)
Units
2 000
$
8 100
4 000
6 000
18 100
2 000
Units
200
1 750
50
$
100
17 500
500
2 000
18 100
PROCESS 2 ACCOUNT
Units
Direct materials
From process 1
Added materials
Direct labour
Production overhead
1 750
1 250
17 500
1 900
10 000
12 000
41 400
1 500
42 900
3 000
100
3 100
Abnormal gain
Units
Scrap a/c (normal loss)
Finished goods a/c
300
2 800
900
42 000
3 100
42 900
$
Scrap a/c: sale of scrap of
extra loss (50 units)
Statement of comprehensive
income
500
25
475
500
$
Process 2 abnormal gain
(100 units)
1 500
300
1 200
1 500
1 500
SCRAP ACCOUNT
$
Scrap value of normal loss
Process 1 (200 units)
Process 2 (300 units)
Abnormal loss a/c (process 1)
100
900
25
1 025
$
Cash at bank/Receivables
Loss in process 1 (250 units)
Loss in process 2 (200 units)
Abnormal gain a/c (process 2)
125
600
300
1 025
CHAPTER 7
Step 4
Parks Co operates a processing operation involving two stages, the output of process 1 being passed
to process 2. The process costs for period 3 were as follows:
Process 1
Material
Labour
Process 2
Material
Labour
General overhead for period 3 amounted to $357 and is absorbed into process costs at a rate of 375%
of direct labour costs in process 1 and 496% of direct labour costs in process 2.
The normal output of process 1 is 80% of input and of process 2, 90% of input. Waste from process 1 is
sold for $0.20 per kg and that from process 2 for $0.30 per kg.
The output for period 3 was as follows:
Process 1
Process 2
2 300 kgs
4 000 kgs
There was no inventory of work in process at either the beginning or the end of the period and it may
be assumed that all available waste had been sold at the prices indicated.
Show how the above would be recorded in process, scrap and abnormal loss/gain accounts by
completing the proformas below. (Hint. Not all boxes require entries.)
PROCESS 1 ACCOUNT
Kg
kg
Material
Labour
Production transferred to
process 2
General overhead
PROCESS 2 ACCOUNT
Kg
Material added
Production transferred to
Labour
finished inventory
General overhead
Abnormal loss
kg
kg
Abnormal gain
SCRAP ACCOUNT
kg
Cash
kg
Process 1 (loss)
Process 2 (loss)
loss
Process 1 (gain)
Statement of comprehensive
income
Process 2 (gain)
In the examples we have looked at so far we have assumed that opening and closing inventories of
work in process have been nil. We must now look at more realistic examples and consider how to
allocate the costs incurred in a period between completed output, i.e. finished units, and partly
completed closing inventory.
Some examples will help to illustrate the problem, and the techniques used to share out (apportion)
costs between finished output and closing work in process.
Worked Example: Valuation of closing inventory
Trotter Co is a manufacturer of processed goods. In March 20X3, in one process, there was no
opening inventory, but 5,000 units of input were introduced to the process during the month, at the
following cost:
Direct materials
Direct labour
Production overhead
$
16 560
7 360
5 520
29 440
Of the 5 000 units introduced, 4 000 were completely finished during the month and transferred to the
next process. Closing inventory of 1 000 units was only 60% complete with respect to materials and
conversion costs.
Solution
a. The problem in this example is to divide the costs of production ($29 440) between the finished
output of 4 000 units and the closing inventory of 1 000 units. It is argued, with good reason, that a
division of costs in proportion to the number of units of each (4 000:1 000) would not be 'fair'
because closing inventory has not been completed, and has not yet 'received' its full amount of
materials and conversion costs, but only 60% of the full amount. The 1 000 units of closing
inventory, being only 60% complete, are the equivalent of 600 fully worked units.
b. To apportion costs fairly and proportionately, units of production must be converted into the
equivalent of completed units, i.e. into equivalent units of production.
CHAPTER 7
LO
7.2
Definition
Equivalent units are the notional number of whole units that could have been fully produced in the
period. They represent the sum of the proportion of incomplete units that have been completed.
Equivalent units are used to apportion costs between work in process and completed output.
Step 1
Determine output.
For this step in our framework we need to prepare a statement of equivalent units.
STATEMENT OF EQUIVALENT UNITS
Total
units
4 000
1 000
5 000
Step 2
Completion
100%
60%
Equivalent
units
4 000
600
4 600
Step 3
Item
Fully worked units
Closing inventory
Step 4
4 000
600
4 600
Valuation
$
25 600
3 840
29 440
$6.40
$6.40
Complete accounts.
The process account would be shown as follows:
PROCESS ACCOUNT
Direct materials
Direct labour
Production o'hd
Units
5 000
5 000
$
16 560
7 360
5 520
29 440
Units
4 000
1 000
$
25 600
3 840
5 000
29 440
Suppose that Shaker Co is a manufacturer of processed goods, and that results in process 2 for April
20X3 were as follows:
Opening inventory
Material input from process 1
Costs of input:
nil
4 000 units
$
6 000
1 080
1 720
Process 1 material
Added materials
Conversion costs
Required
Step 1
Input
Units
4 000
4 000
Output
Completed
production
Closing inventory
Total
Units
3 200
800
4 000
100
400*
3 600
50
240**
3 440
30
CHAPTER 7
Step 2
Cost
$
6 000
1 080
1 720
8 800
Process 1 material
Added materials
Conversion costs
Step 3
Equivalent production
in units
Cost per
unit
$
1.50
0.30
0.50
2.30
4 000
3 600
3 440
Production
Completed production
Closing inventory:
Cost element
process 1 material
added material
Conversion cots
Number of
equivalent
units
3 200
800
400
240
Cost per
equivalent
unit
$
2.30
1.50
0.30
0.50
Total
$
Cost
$
7 360
1 200
120
120
1 440
8 800
Step 4
Complete accounts.
PROCESS ACCOUNT
Process 1 material
Added material
Conversion costs
Units
4 000
4 000
$
6 000
1 080
1 720
8 800
Process 3 a/c
(finished output)
Closing inventory c/f
Units
3 200
$
7 360
800
4 000
1 440
8 800
none
2 800 units
$16 695
10%; nil scrap value
Step 1
Total units
2 000
( 100%)
Equivalent units
of work
done this
period
2 000
Closing inventory
450
( 70%)
315
280
70
( 100%)
0
70
2 800
Step 2
2 385
Step 3
Step 4
$
14 000
2 205
490
16 ,695
Complete accounts.
PROCESS ACCOUNT
Units
Opening inventory
Input costs
2 800
16 695
2 800
16 695
Normal loss
Finished goods a/c
Abnormal loss a/c
Closing inventory c/f
Units
280
2 000
70
450
2 800
$
0
14 000
490
2 205
16 695
CHAPTER 7
Complete the process account below from the following information. (Hint. Not all boxes require
entries.)
Opening inventory
Nil
Input units
10 000
Input costs
Material
Labour
$5 150
$2 700
Normal loss
5% of input
Total loss
1 000 units
$1 per unit
8 000 units
Closing inventory
1 000 units
Units
Units
Material
Completed production
Labour
Closing inventory
Abnormal gain
Normal loss
Abnormal loss
Section overview
The weighted average cost method of valuing opening WIP makes no distinction between
units of opening WIP and new units introduced to the process during the current period.
%
100
40
30
$
4 700
600
1 000
6 300
During September 20X3, 3,000 units were transferred from process 1 at a valuation of $18 100. Added
materials cost $9,600 and conversion costs were $11 800.
Closing inventory at 30 September 20X3 amounted to 1,000 units which were 100% complete with
respect to process 1 materials and 60% complete with respect to added materials. Conversion cost
work was 40% complete.
CHAPTER 7
Magpie Co uses a weighted average cost system for the valuation of output and closing inventory.
Prepare the process 2 account for September 20X3.
Solution
Step 1
Process 1
units
2 800
1 000
3 800
(100%)
(100%)
material
2 800
1 000
3 800
(60%)
Equivalent units
Added
Conversio
n
material
costs
2 800
2 800
600 (40%)
400
3 400
3 200
* 3 000 units from process 1 minus closing inventory of 1 000 units plus opening inventory
of 800 units.
Step 2
Opening inventory
Added in September 20X3
Total cost
Process 1
material
$
4 700
18 100
22 800
Equivalent units
Cost per equivalent unit
Step 3
Added
materials
$
600
9 600
10 200
3 800 units
$6
3 400 units
$3
Conversion
costs
$
1 000
11 800
12 800
3 200 units
$4
16 800
6 000
Added
materials
$
8 400
1 800
Conversion
costs
$
Total
cost
$
11 200
1 600
36 400
9 400
45 800
Step 4
Complete accounts
PROCESS 2 ACCOUNT
Opening inventory b/f
Process 1 a/c
Added materials
Conversion costs
Units
800
3 000
3 800
$
6 300
18 100
9 600
11 800
45 800
Units
2 800
$
36 400
1 000
3 800
9 400
45 800
Take some time to work through this question carefully and to check your workings against the answer
given below. This question should help consolidate all of the process costing knowledge that you
have acquired while studying this chapter.
Question 5: Watkins Ltd
Watkins Ltd has a financial year which ends on 30 April 20X0. It operates in a processing industry in
which a single product is produced by passing inputs through two sequential processes. A normal loss
of 10% of input is expected in each process. Total loss for process 1 was 1 200 units.
The following account balances have been extracted from its ledger at 31 March 20X0:
Debit
$
8 144
9 681
1 400
Credit
$
300
250
585 000
442 500
65 000
Watkins Ltd uses the weighted average method of accounting for work in process.
During April 20X0 the following transactions occurred:
Process 1
Process 2
4 000 kg
$22 000
$12 000
2 400 kg
2 400 kg
$15 000
2 500 kg
$54 000
$52 000
Overhead costs are absorbed into process costs on the basis of 150% of labour cost.
The losses which arise in process 1 have no scrap value: those arising in process 2 can be sold for $2 per
kg.
Details of opening and closing work in process for the month of April 20X0 are as follows:
Process 1
Process 2
Opening
3 000 kg
2 250 kg
Closing
3 400 kg
2 600 kg
In both processes closing work in process is fully complete as to material cost and 40% complete as to
conversion cost.
Inventories of finished goods at 30 April 20X0 were valued at cost of $60 000.
You are required to fill in the blank boxes.
a. In an account for process 1, the monetary and quantity values for:
kgs at $
kgs at $
kgs at $
kgs at $
kgs at $
kgs at $
kgs at $
kgs at $
kgs at $
LO
7.2
Section overview
Joint products are two or more products produced by the same process and separated in
processing, each having a sufficiently high saleable value to merit recognition as a main
product.
A by-product is an incidental product from a process which has an insignificant value
compared to the main product(s).
For example, in the oil refining industry the following joint products all arise from the same process:
Diesel fuel
Petrol
Paraffin
Lubricants
CHAPTER 7
7.2 BY-PRODUCTS
A by-product is an incidental product from a process which has an insignificant value compared to
the main product(s).
Definition
A by-product is output of some insignificant value produced incidentally while manufacturing the
main product. By products are not separately identifiable as individual products until separation point.
A by-product is a product which is similarly produced at the same time and from the same common
process as the 'main product' or joint products. The distinguishing feature of a by-product is its
relatively low sales value in comparison to the main product. In the timber industry, for example, byproducts include sawdust, small off cuts and bark.
Input
raw materials
A
roduct
Joint p
Joint p
roduc
tB
Process 1
roduct
Process 2
Joint p
Joint
By-product X
produ
ct D
By-product Y
a. How to spread the common costs of oil refining between the joint products made petrol,
naphtha, kerosene and so on.
b. How to spread the common costs of running the telephone network between telephone calls in peak
rate times and cheap rate times, or between local calls and long-distance calls.
Despite the fact that the by-product has a small value relative to that of the main product, it does have
some commercial value and its accounting treatment usually consists of one of the following:
a. Income (minus any post-separation further processing or selling costs) from the sale of the byproduct may be added to sales of the main product, thereby increasing sales revenue for the
period.
b. The sales of the by-product may be treated as a separate, incidental source of income against
which are offset only post-separation costs (if any) of the by-product. The revenue would be
recorded in the statement of comprehensive income as 'other income'.
c. The sales income of the by-product may be deducted from the cost of production or cost of sales
of the main product.
d. The net realisable value of the by-product may be deducted from the cost of production of the
main product. The net realisable value is the final saleable value of the by-product minus any
post-separation costs.
The choice of method will be influenced by the circumstances of production and ease of calculation,
as much as by conceptual correctness. The most common method is method (d). Notice that this
method is the same as the accounting treatment of a normal loss which is sold for scrap.
Question 6: Split off point
Butter
Milk
Cream
Yoghurt
8 JOB COSTING
Section overview
Job costing is the costing method used where work is undertaken to customers' special
requirements and each order is of comparatively short duration.
The usual method of fixing prices within a company involved in contracting is cost plus
pricing.
CHAPTER 7
LO
7.2
7.2
The work relating to a job is usually carried out within a factory or workshop and moves through
processes and operations as a continuously identifiable unit.
Definitions
A job is a customer order or task of relatively short duration. It can be an individual product, a small
unique batch of products, a project, a case or even a client project.
Job costing is a form of specific order costing where costs are attributed to individual jobs.
Twist and Tern Co is a company that carries out contracting work. One of the jobs carried out in
February was job 1357, to which the following information relates:
Direct material Y: 400 kilos were issued from stores at a cost of $5 per kilo.
Direct material Z: 800 kilos were issued from stores at a cost of $6 per kilo.
60 kilos were returned.
Department P:
320 labour hours were worked, of which 100 hours were done as overtime.
Department Q:
200 labour hours were worked, of which 100 hours were done as overtime.
Overtime work is not normal in department P, where basic pay is $8 per hour plus an overtime
premium of $2 per hour. Overtime work was done in department Q in February because of a request
by the customer of another job to complete that job quickly. Basic pay in department Q is $10 per
hour and the overtime premium is $3 per hour.
Overhead is absorbed at the rate of $3 per direct labour hour in both departments.
a. The direct materials cost of job 1357 is $
.
.
CHAPTER 7
b. When profit is calculated as 25 per cent of cost, the correct selling price for the job is $
$
630
840
240
1 710
During June, three new jobs were started in the factory, and costs of production were as follows:
Direct materials
Issued to:
Job 6832
Job 6833
Job 6834
Job 6835
$
2 390
1 680
3 950
4 420
Material transfers
Job 6832 to Job 6834
Job 6834 to Job 6833
$
620
250
$
870
170
Hours
430
650
280
410
The cost of labour hours during June 20X2 was $8 per hour, and production overhead is absorbed at
the rate of $2 per direct labour hour. Completed jobs were delivered to customers as soon as they
were completed, and the invoiced amounts were as follows:
Job 6832
Job 6834
Job 6835
$8 500
$9 000
$9 500
Administration and marketing overheads are added to the cost of sales at the rate of 20% of factory
cost.
Required
a. Prepare the job accounts for each individual job during June 20X2. (Remember inputs to the job go
on the left-hand side of the account, outputs on the right-hand side.)
b. Prepare the summarised job cost cards for each job, and calculate the profit on each completed
job.
Solution
a. Job accounts
JOB 6832
Balance b/f
Materials (stores a/c)
Labour (wages a/c)
Production overhead (o'hd a/c)
$
1 710
2 390
3 440
860
8 400
$
620
870
6 910
8 400
JOB 6833
$
1 680
5 200
1 300
250
8 430
$
8 430
Balance c/f
8 430
JOB 6834
Materials (stores a/c)
Labour (wages a/c)
Production overhead (o'hd a/c)
Job 6832 a/c (materials transfer)
$
3 950
2 240
560
620
7 370
$
250
7 120
7 370
JOB 6835
Materials (stores a/c)
Labour (wages a/c)
Production overhead (o'hd a/c)
$
4 420
3 280
820
8 520
$
170
8 350
8 520
Note that the accounts to which the double entry is made are shown in brackets.
b. Job cards, summarised
Materials
Labour
Production overhead
Factory cost
Admin & marketing o'hd (20%)
Cost of sale
Invoice value
Profit/(loss) on job
Job 6832
$
1 530*
4 280
1 100
6 910
1 382
8 292
8 500
208
Job 6833
$
1 930
5 200
1 300
(c/f) 8 430
Job 6834
$
4 320**
2 240
560
7 120
1 424
8 544
9 000
456
Job 6835
$
4 250
3 280
820
8 350
1 670
10 020
9 500
(520)
CHAPTER 7
Step 1
Step 2
Step 3
Step 4
Losses may occur in a process. If a certain level of loss is expected, this is known as normal loss. If
losses are greater than expected, the extra loss is abnormal loss. If losses are less than expected,
the difference is known as abnormal gain.
The valuation of normal loss is either at scrap value or nil. It is conventional for the scrap value of
normal loss to be deducted from the cost of materials before a cost per equivalent unit is
calculated.
Abnormal losses and gains never affect the cost of good units of production. The scrap value of
abnormal losses is not credited to the process account, and the abnormal loss and gain units carry
the same full cost as a good unit of production.
When units are partly completed at the end of a period, i.e. when there is closing work in process,
it is necessary to calculate the equivalent units of production in order to determine the cost of a
completed unit.
The weighted average cost method of valuing opening WIP makes no distinction between units of
opening WIP and new units introduced to the process during the current period.
Joint products are two or more products separated in a process, each of which has a significant
value.
A by-product is an incidental product from a process which has an insignificant value compared to
the main products(s).
Job costing is the costing method used where work is undertaken to customers' special
requirements and each order is of comparatively short duration.
The usual method of fixing prices within a company involved in contract work is cost plus pricing.
A company manufactures chemical X in a single process. At the start of the month there was no workin-process. During the month 300 litres of raw material were input into the process at a total cost of
$6 000. Conversion costs during the month amounted to $4 500. At the end of the month 250 litres of
chemical X were transferred to finished goods inventory. The remaining work-in-process was 100%
complete with respect to materials and 50% complete with respect to conversion costs. There were no
losses in the process.
A
B
C
D
Material
25 litres
25 litres
50 litres
50 litres
Conversion costs
25 litres
50 litres
25 litres
50 litres
2 If there had been a normal process loss of 10% of input during the month the value of this loss
would have been
A nil.
B $450.
C $600.
D $1 050.
357 litres
374 litres
391 litres
400 litres
CHAPTER 7
1 The equivalent units for closing work-in-process at the end of the month would have been
A company produces a certain food item in a manufacturing process. On 1 November, there was no
opening inventory of work in process. During November, 500 units of material were input to the
process, with a cost of $9 000. Direct labour costs in November were $3 840. Production overhead is
absorbed at the rate of 200% of direct labour costs. Closing inventory on 30 November consisted of
100 units which were 100% complete as to materials and 80% complete as to labour and overhead.
There was no loss in process.
5 The full production cost of completed units during November was
A $10 400.
B $16 416.
C $16 800.
D $20 520.
6 The value of the closing work in process on 30 November is
A $2 440.
B $3 720.
C $4 104.
D $20 520.
A company makes a product in two processes. The following data is available for the latest period, for
process 1.
Opening work in process of 200 units was valued as follows:
Material
Labour
Overhead
$2 400
$1 200
$400
Closing work in process of 100 units had reached the following degrees of completion:
Material
Labour
Overhead
100%
50%
30%
9 A company manufactures two joint products, P and R, in a common process. Data for June are as
follows:
$
1 000
10 000
12 000
3 000
Opening inventory
Direct materials added
Conversion costs
Closing inventory
Production
Units
4 000
6 000
P
R
Sales
Units
5 000
5 000
Sales price
$ per unit
5
10
A
B
C
D
$1.25
$2.22
$2.50
$2.75
CHAPTER 7
If costs are apportioned between joint products on a sales value basis, what was the cost per unit
of product R in June?
Conversion costs
%
Equiv.
litres
50
25
50 litres in progress
Option A is incorrect because it assumes that the units in progress are only 50 per cent
complete with respect to materials.
Option B has transposed the information concerning the two cost elements.
If you selected option D you calculated the correct number of litres in progress but you did not
take account of their degree of completion.
2 A There is no mention of a scrap value available for any losses therefore the normal loss would
have a zero value. The normal loss does not carry any of the process costs therefore options B,
C and D are all incorrect.
3 D Abnormal losses are valued at the same unit rate as good production, so that their occurrence
does not affect the cost of good production. They are not valued at zero, so option A is
incorrect.
The scrap value of the abnormal loss (option B) is credited to a separate abnormal loss account;
it does not appear in the process account.
Option C is incorrect because abnormal losses also absorb some conversion costs.
4 D The total loss was 15% of the material input. The 340 litres of good output therefore represents
85% of the total material input.
Therefore, material input =
340
= 400 litres
0.85
Options A and B are incorrect because they represent a further five per cent and ten per cent
respectively, added to the units of good production.
If you selected option C you simply added 15 per cent to the 340 litres of good production.
However, the losses are stated as a percentage of input, not as a percentage of output.
5 C
Step 1
Step 2
Output
Finished units (balance)
Closing inventory
Total
Units
400
100
500
Equivalent units
Materials
Labour and overhead
Units
%
Units
%
400
100
400
100
100
100
80
80
500
480
Input
Materials
Labour and overhead
Cost
$
9 000
11 520
Equivalent
production
in units
500
480
Cost per
unit
$
18
24
42
Step 3
6 B Using the data from answer 5 above, extend step 3 to calculate the value of the work in
progress.
Work in progress:
Number of
equivalent units
Materials
Labour & overhead
100
80
Cost per
equivalent unit
$
18
24
Total
$
1 800
1 920
3 720
If you selected option A you omitted the absorption of overhead into the process costs. If you
selected option C you did not allow for the fact that the work in progress was incomplete.
Option D is the total process cost for the period, some of which must be allocated to the
completed output.
7 C STATEMENT OF EQUIVALENT UNITS
Output to process 2*
Closing WIP
Total
Units
600
100
700
Equivalent units
Labour
Materials
(100%)
600
100
700
(50%)
600
50
650
Overheads
600
30
630
(30%)
*500 units input + opening WIP 200 units closing WIP 100 units.
Option A is incorrect because it is the number of units input to the process, taking no account
of opening and closing work in progress.
Option B is the completed output, taking no account of the work done on the closing
inventory. Option D is the total number of units worked on during the period, but they are not
all complete in respect of overhead cost.
8 B STATEMENT OF COSTS PER EQUIVALENT UNIT
Opening stock
Added during period
Total cost
Equivalent units
Cost per equivalent unit
Materials
$
2 400
6 000
8 400
700
$12
Labour
$
1 200
3 350
4 550
650
$7
Overheads
$
400
1 490
1 890
630
$3
Total
$22
CHAPTER 7
Cost
element
Opening inventory
Direct materials added
Conversion costs
Less closing inventory
Total production cost
P
R
Production
Units
4 000
6 000
( $5)
( $10)
Sales value
$
20 000
60 000
80 000
Apportioned
cost
$
5 000
15 000
20 000
Product R cost per unit = $15 000/6 000 = $2.50 per unit.
Option A is the cost per unit for product P, and if you selected option B you apportioned the
production costs on the basis of units sold. If you selected option D you made no adjustment
for inventories when calculating the total costs.
10 C Revenue from scrap is treated as a reduction in costs of processing.
Step 1
Actual output
Normal loss (10% 3 300)
Abnormal loss
Step 2
Step 3
PROCESS ACCOUNT
CR
5 200
Output
58 300
Normal loss
59 900
400
Closing WIP
3 500
Abnormal gain
63 800
63 800
The abnormal gain is the balancing figure: 63 800 5 200 58 300 = 300
3
Step 1
Output
Normal loss (20% of 3 000 kgs)
Abnormal loss
Abnormal gain
Process 1
kgs
2 300
600
100
3 000
(10% of 4 300)
Process 2
kgs
4 000
430
(130)
4 300*
CHAPTER 7
Cost of input
$89 100
=
= $30 per unit
Expected units of output
3 300 330
Step 2
120
450
Step 3
(2 000 $0.40)
(2 300 $0.50)
(496% $84)
(120)
1 200
(430 $0.3)
(129)
2 322
2 400
$0.50
4 300 90%
3 870
$0.60
$2 451 $129
4 300 430
120
50
1 320
1 320
Abnormal gain
Step 4
Process 2
$
800
1 150
84
417
Process 2
$
2 400
(4 000 $0.60)
(430 $0.30)
129
2 529
(78)
2 451
(130 $0.60)
Complete accounts.
PROCESS 1 ACCOUNT
Material
Labour
General overhead
kg
3 000
3 000
$
750
120
450
kg
Normal loss to scrap a/c
(20%)
Production transferred to
process 2
Abnormal loss a/c
1 320
600
120
2 300
100
3 000
1 150
50
1 320
kg
PROCESS 2 ACCOUNT
kg
Transferred from
process 1
Material added
Labour
General overhead
Abnormal gain
2 300
2 000
4 300
130
4 430
$
1 150
800
84
417
2 451
78
2 529
430
129
4 000
2 400
4 430
2 529
kg
130
1 000
$
39
230
1 130
269
SCRAP ACCOUNT
Normal loss (process 1)
Normal loss (process 2)
Abnormal loss
(process 1)
kg
600
430
$
120
129
100
1 130
20
269
kg
100
50
130
39
9
230
98
Scrap value of
abnormal loss
Process 2 (gain)
kg
100
130
20
78
230
98
(Note. In this answer, a single account has been prepared for abnormal loss/gain. It is also possible
to separate this single account into two separate accounts, one for abnormal gain and one for
abnormal loss.)
Completed production
Closing inventory
Normal loss
Abnormal loss
Equivalent units
Material
Labour
%
Units
%
Units
100
8 000
100
8 000
80
800
50
500
100
500
9 300
100
500
9 000
Cost
$
4 650
2 700
7 350
9 300
9 000
Cost per
equivalent
unit
$
0.50
0.30
0.80
* The scrap value of the normal loss is used to reduce the material costs of the process.
Step 3 Calculate total cost of output, losses and WIP.
STATEMENT OF EVALUATION
Equivalent
units
Completed production
Closing inventory: material
Labour
8 000
800
500
Abnormal loss
500
Cost per
equivalent
unit
$
0.80
0.50
0.30
Total
$
6 400
400
150
550
400
7 350
0.80
Units
10 000
$
5 150
2 700
10 000
7 850
Completed production
Closing inventory
Normal loss
Abnormal loss
Units
8 000
1 000
500
500
10 000
$
6 400
550
500
400
7 850
CHAPTER 7
5 (a) Process 1
STATEMENT OF EQUIVALENT UNITS
Equivalent units
Conversion
Material costs
costs
2 400
2 400
(100%) 3 400
(40%) 1 360
0
0
800
800
6 600
4 560
Total units
2 400
3 400
400
800
7 000
Transfers to process 2
Closing WIP
Normal loss (10% 4 000)
Abnormal loss
$7.40
STATEMENT OF EVALUATION
Materials
$
9 600
3 200
13 600
26 400
Transfers to process 2
Abnormal loss
Closing WIP
Conversion costs
$
17 760
5 920
10 064
33 744
Total
$
27 360
9 120
23 664
60 144
PROCESS 1 ACCOUNT
WIP materials
(opening)
WIP conversion costs
Materials
Labour
Overhead
Kg
3 000
$
4 400
4 000
7 000
3 744
22 000
12 000
18 000
60 144
Process 2
Normal loss
Abnormal loss
WIP materials (closing)
WIP conversion costs
2 400
kgs at $ 27 360
kgs at $
400
800
kgs at $
9 120
kgs at $
3 400
kgs at $ 13 600
0
kgs at $ 10 064
Kg
2 400
$
27 360
400
800
3 400
7 000
9 120
13 600
10 064
60 144
(b) Process 2
STATEMENT OF EQUIVALENT UNITS
Total units
2 500
240 *
(690) *
2 600*
4 650
Finished goods
Normal loss
Abnormal gain
Closing WIP
Process 1
2 500
0
(690)
2 600
4 410
Conversion costs
2 500
0
(690)
1 040**
2 850
CHAPTER 7
Conversion costs =
STATEMENT OF EVALUATION
Process 1
$
17 750
4 899
18 460
41 109
Finished goods
Abnormal gain
Closing WIP
Conversion
costs
$
37 500
10 350
15 600
63 450
Total
$
55 250
15 249
34 060
104 559
PROCESS 2 ACCOUNT
Kg
2 250
2 400
690
5 340
WIP Process 1
WIP conversion costs
Process 1
Labour
Overhead
Abnormal gain
$
4 431
5 250
27 360
15 000
22 500
15 249
89 790
Finished goods
Normal loss
WIP process 1
WIP conversion costs
kgs at $ 55 250
2 500
240
kgs at $
480
2 600
kgs at $ 18 460
kgs at $ 15 600
Kg
2 500
240
2 600
$
55 250
480
18 460
15 600
5 340
89 790
6
Butter
Milk
Cream
Yoghurt
Split off point
6 440
Workings
$
2 000
4 440
6 440
4 560
Workings
$
2 560
2 000
4 560
$
6 440
4 560
1 560
12 560
8 If you have difficulty working out the correct amount, simply jot down the cost and selling price
structures as percentages in each case.
(a) The correct selling price is $ 5 600 .
Workings
Cost
Profit
Selling price
5 250
Workings
%
100
25
125
233
CHAPTER 8
STANDARD COSTING
Learning objectives
Reference
Standard costing
LO8
Explain how standard costing can be used to assist in cost control and efficient resource
allocation
LO8.1
Topic list
INTRODUCTION
Just as there are standards for most things in our daily lives (cleanliness in restaurants, educational
achievement of students, number of trains running on time), there are standards for the costs of
products and services. Also, just as the standards in our daily lives are not always met, the standards
for the costs of products and services are not always met. We will be looking at standards for costs,
what they are used for and how they are set.
In the next chapter we will see how standard costing forms the basis of a process called variance
analysis, a vital management control tool.
The chapter content is summarised in the diagram below.
Standard
costing
What is it?
Setting
standards
(Section 1)
(Section 1.2)
(Section 1.3)
(Section 2.1)
CHAPTER 8
5 Which element of Direct material standards are the purchasing department most likely to estimate
and what knowledge will they use to do this?
(Section 2.3)
LO
8.1
The standard cost of a product provides a detailed breakdown of all the expected costs required to
produce a completed unit of that product
The standard cost of product 1234 is set out below:
STANDARD COST PRODUCT 1234
$
Direct materials
Material X 3 kg at $4 per kg
Material Y 9 litres at $2 per litre
12
18
30
Direct labour
Grade A 6 hours at $1.50 per hour
Grade B 8 hours at $2 per hour
Standard direct cost
Variable production overhead 14 hours at $0.50 per hour
Standard variable cost of production
Fixed production overhead 14 hours at $4.50 per hour
Standard full production cost
Administration and marketing overhead
Standard cost of sale
Standard profit
Standard sales price
9
16
25
55
7
62
63
125
15
140
20
160
Notice how the total standard cost is built up from standards for each cost element: standard
quantities of materials at standard prices, standard quantities of labour time at standard rates and so
on. It is therefore determined by management's estimates of the following:
The expected prices of materials, labour and expenses.
Efficiency levels in the use of materials and labour.
Budgeted overhead costs and budgeted volumes of activity.
We will see how management arrives at these estimates below.
But why should management want to prepare standard costs? Obviously to assist with standard
costing, but what is the point of standard costing?
Direct materials
A 7 kgs $1
B 4 litres $2
C 3 m $3
24
Direct labour
Skilled 8 $10
Semi-skilled 4 $5
80
20
Working
Overhead absorption rate =
$250 000
= $6.25 per skilled labour hour
5 000 8
100
124
20
144
50
194
10
204
51
255
CHAPTER 8
What would a standard cost for product joe show under a marginal system?
Solution
$
24
100
124
20
144
255
111
Although the use of standard costs to simplify the keeping of cost accounting records should not be
overlooked, we will be concentrating on the control and variance analysis aspect of standard costing.
Standard costing is a control technique which compares standard costs with actual results to obtain
variances which are used to improve performance.
Notice that the above definition highlights the control aspects of standard costing.
2 SETTING STANDARDS
Section overview
The standard cost of a product, or service, is made up of a number of different standards,
one for each cost element, each of which has to be set by management.
Performance standards are used to set efficiency targets. There are four types: ideal,
attainable, current and basic. We have divided this section into two: the first part looks at
setting the monetary part of each standard, whereas the second part looks at setting the
resources requirement part of each standard.
LO
8.1
Standard costs may be used in both absorption costing and in marginal costing systems. We shall,
however, confine our description to standard costs in absorption costing systems.
TYPE OF STANDARD
DESCRIPTION
Ideal
Attainable
These are based on the hope that a standard amount of work will be carried out
efficiently, machines properly operated or materials properly used. Some
allowance is made for wastage and inefficiencies. If well set they provide a useful
psychological incentive by giving employees a realistic, but challenging target of
efficiency. The consent and co operation of employees involved in improving the
standard are required. Also sometimes called 'practical standards' or 'target
standards'.
Current
Basic
T These are kept unaltered over a long period of time, and may be out of date
because of changes within the organisation or changes in the environment in
which the organisation operates. They are used as a 'benchmark standard'
against which to measure changes in efficiency or performance over a long
period of time. Basic standards are perhaps the least useful and least common
type of standard in use.
Ideal standards, attainable standards and current standards each have their supporters and it is by no
means clear which of them is preferable.
Question 1: Performance standards
CHAPTER 8
The setting of standards raises the problem of how demanding the standard should be. Should the
standard represent a perfect performance or an easily attainable performance? The type of
performance standard used can have behavioural implications. There are four types of standard.
Similar problems when dealing with inflation to those described for direct material standards can be
encountered when setting labour standards.
To estimate the labour hours required (labour efficiency), technical specifications must be prepared
for each product by production experts in the production department. The 'standard operation
sheet' for labour will specify the expected hours required by each grade of labour in each department
to make one unit of product. These standard times must be carefully set and must be understood by
the labour force. Where necessary, standard procedures or operating methods should be stated.
CHAPTER 8
Standard costs under marginal costing will, of course, not include any element of absorbed
overheads.
A Printing
B Fashion design
C Postal services
D Mobile phone manufacture
CHAPTER 8
4 For which one of the following is standard costing most likely to be appropriate?
CHAPTER 8
247
CHAPTER 9
VARIANCE ANALYSIS
Learning objectives
Reference
Variance analysis
LO9
LO9.1
LO9.2
Calculate a variance
LO9.3
Topic list
1
2
3
4
5
6
7
8
9
Variances
Direct material cost variances
Direct labour cost variances
Variable production overhead variances
Fixed production overhead variances
The reasons for cost variances
The significance of cost variances
Sales variances
Operating statements
INTRODUCTION
The actual results achieved by an organisation during a reporting period (week, month, quarter, year)
will, more than likely, be different from the expected results. The expected results are the standard
costs and revenues which we looked at in the previous chapter. Such differences may occur between
individual items, such as the cost of labour or the volume of sales, and between the total expected
profit and the total actual profit.
Management will have spent considerable time and trouble setting standards. When actual results
differ from the standards, the reasons for the differences need to be considered and the results used
to assist in attempts to attain the standards. The wise manager will use variance analysis as a method
of control.
This chapter examines variance analysis and sets out the method of calculating the variances.
We will then go on to look at the reasons for, and significance of, cost variances.
The chapter concludes by building on the basics set down in this chapter by introducing sales
variances and operating statements.
The chapter content is summarised in the diagram below.
Variance
analysis
Cost
variances
Sales
variances
Direct material
cost variances
Operating
statements
Direct labour
cost variances
Variable production
overhead variances
Fixed production
overhead variances
Reasons for
cost variances
Significance of
cost variances
(Section 1)
(Section 2)
(Section 2.2)
4 The direct labour total variance can be subdivided into which two variances?
(Section 3)
5 The variable production overhead total variance can be subdivided into which two variances?
(Section 4)
6 In an absorption costing system, the fixed production overhead total variance can be subdivided
into which two variances?
(Section 5)
7 State reasons for cost variances arising.
(Section 6)
8 Explain the relevance of materiality and controllability when deciding whether or not a variance
should be investigated.
(Section 7)
9 How is selling price variance calculated?
(Section 8.1)
(Section 8.2)
(Section 9)
CHAPTER 9
11 Draw a proforma operating statement reconciling budgeted profit and actual profit.
1 VARIANCES
Section overview
A variance is the difference between a planned, budgeted, or standard cost and the actual
cost incurred. The same comparisons may be made for revenues. The process by which the
total difference between standard and actual results is analysed is known as variance
analysis.
LO
9.1
When actual results are better than expected results, we have a favourable variance (F). If, on the
other hand, actual results are worse than expected results, we have an unfavourable variance (U).
Variances can be divided into three main groups:
Variable cost variances
Sales variances
Fixed production overhead variances
The direct material total variance The direct material total variance is the difference between what
the output actually cost and what it should have cost, in terms of material. is the difference between
what the output actually cost and what it should have cost, in terms of material.
$
100 000
98 600
1 400 (F)
The variance is favourable because the units cost less than they should have cost.
Now we can break down the direct material total variance into its two constituent parts: the direct
material price variance and the direct material usage variance.
b. The direct material price variance
This is the difference between what 11 700 kgs should have cost and what 11 700 kgs did cost.
11 700 kgs of Y should have cost ( $10)
but did cost
Material Y price variance
$
117 000
98 600
18 400 (F)
The variance is favourable because the material cost less than expected.
c. The direct material usage variance
This is the difference between how many kilograms of Y should have been used to produce 1 000
units of X and how many kilograms were used, valued at the standard cost per kilogram.
1 000 units should have used ( 10 kgs)
but did use
Usage variance in kgs
standard price per kilogram
Usage variance in $
10 000 kgs
11 700 kgs
1 700 kgs (U)
$10
$17 000 (U)
The variance is unfavourable because more material than the standard quantity was used.
Price variance
Usage variance
Total variance
$
18 400 (F)
17 000 (U)
1 400 (F)
CHAPTER 9
d. Summary
b. If they are valued at actual cost (FIFO) (1 000 units at $3.10 per unit) the price variance is calculated
on materials used in production in the period.
A full standard costing system is usually in operation and therefore the price variance is usually
calculated on purchases in the period. The variance on the full 6 000 metres will be written off to the
costing income statement, even though only 5 000 metres are included in the cost of production.
There are two main advantages in extracting the material price variance at the time of receipt.
a. If variances are extracted at the time of receipt they will be brought to the attention of managers
earlier than if they are extracted as the material is used. If it is necessary to correct any variances
then management action can be more timely.
b. Since variances are extracted at the time of receipt, all inventories will be valued at standard
price. This is administratively easier and it means that all issues from inventory can be made at
standard price. If inventories are held at actual cost it is necessary to calculate a separate price
variance on each batch as it is issued. Since issues are usually made in a number of small batches
this can be a time-consuming task, especially with a manual system.
The price variance would be calculated as follows:
6 000 metres of material P purchased should cost ( $3)
but did cost
Price variance
$
18 000
18 600
600 (U)
The direct labour total variance is the difference between what the output should have cost and
what it did cost, in terms of labour.
The direct labour rate variance. This is similar to the direct material price variance. It is the difference
between the standard rate and the actual rate for the actual number of hours paid for.
It is the difference between what the labour did cost and what it should have cost.
The direct labour efficiency variance is similar to the direct material usage variance. It is the
difference between the hours that should have been worked for the number of units actually
produced, and the actual number of hours worked, valued at the standard rate per hour.
It is the difference between how many hours should have been worked and how many hours were
worked, valued at the standard rate per hour.
The calculation of direct labour variances is very similar to the calculation of direct material variances.
$
10 000
8 900
1 100 (F)
The variance is favourable because the units cost less than they should have done.
Again we can analyse this total variance into its two constituent parts.
b. The direct labour rate variance
This is the difference between what 2 300 hours should have cost and what 2 300 hours did cost.
2 300 hours of work should have cost ( $5 per hr)
but did cost
Direct labour rate variance
$
11 500
8 900
2 600 (F)
The variance is favourable because the labour rate was less than the standard rate.
c. The direct labour efficiency variance
1 000 units of X should have taken ( 2 hrs)
but did take
Efficiency variance in hours
standard rate per hour
Efficiency variance in $
2 000 hrs
2 300 hrs
300 hrs (U)
$5
$1 500 (U)
d. Summary
Rate variance
Efficiency variance
Total variance
$
2 600 (F)
1 500 (U)
1 100 (F)
CHAPTER 9
The variance is unfavourable because more hours were worked than should have been worked.
During period 6, 400 units of product X were made. The labour force worked 820 hours, of which
60 hours were recorded as idle time. The variable overhead cost was $1 230.
Calculate the following variances:
a. The variable overhead total variance..
b. The variable production overhead expenditure variance.
c. The variable production overhead efficiency variance.
Solution
Since this example relates to variable production costs, the total variance is based on actual units of
production. (If the overhead had been a variable selling cost, the variance would be based on sales
volumes.)
400 units of product X should cost ( $3)
but did cost
Variable production overhead total variance
$
1 200
1 230
30 (U)
In many variance reporting systems, the variance analysis goes no further, and expenditure and
efficiency variances are not calculated. However, the unfavourable variance of $30 may be explained
as the sum of two factors:
a. The hourly rate of spending on variable production overheads was higher than it should have been,
that is there is an expenditure variance.
b. The labour force worked inefficiently, and took longer to make the output than it should have
done. This means that spending on variable production overhead was higher than it should have
been, in other words there is an efficiency (productivity) variance. The variable production
overhead efficiency variance is exactly the same, in hours, as the direct labour efficiency variance,
and occurs for the same reasons.
It is usually assumed that variable overheads are incurred during active working hours, but are not
incurred during idle time (for example, the machines are not running, therefore power is not being
consumed, and no indirect materials are being used). This means in our example that although the
labour force was paid for 820 hours, they were actively working for only 760 of those hours and so
variable production overhead spending occurred during 760 hours.
The variable production overhead expenditure variance is the difference between the amount of
variable production overhead that should have been incurred in the actual hours actively worked, and
the actual amount of variable production overhead incurred.
a.
760 hours of variable production overhead should cost ( $1.50)
but did cost
Variable production overhead expenditure variance
$
1 140
1 230
90 (U)
The variable production overhead efficiency variance. If you already know the direct labour
efficiency variance, the variable production overhead efficiency variance is exactly the same in
hours, but priced at the variable production
800 hrs
760 hrs
40 hrs (F)
$1.50
$60 (F)
c. Summary
Variable production overhead expenditure variance
Variable production overhead efficiency variance
Variable production overhead total variance
$
90 (U)
60 (F))
30 (U)
LO
9.1
You may have noticed that the method of calculating cost variances for variable cost items is
essentially the same for labour, materials and variable overheads. Fixed production overhead
variances are very different. In an absorption costing system, they are an attempt to explain the
under- or over-absorption of fixed production overheads in production costs.
The fixed production overhead total variance (i.e. the under- or over-absorbed fixed production
overhead) may be broken down into two parts as usual:
An expenditure variance.
A volume variance.
You will find it easier to calculate and understand fixed overhead variances, if you keep in mind the
whole time that you are trying to 'explain' (put a name and value to) any under- or over-absorbed
overhead.
The budgeted fixed overhead is the planned or expected fixed overhead and the budgeted activity
level is the planned or expected activity level.
If either of the following budget estimates are incorrect, then we will have an under- or overabsorption of overhead.
The numerator (number on top) = Budgeted fixed overhead.
The denominator (number on bottom) = Budgeted activity level.
CHAPTER 9
In order to clarify the overhead variances which we have encountered in this section, consider the
following definitions which are expressed in terms of how each overhead variance should be
calculated.
Definition
Fixed overhead total variance is the difference between fixed overhead incurred and fixed overhead
absorbed.
Fixed overhead expenditure variance is the difference between 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.
You should now be ready to work through an example to demonstrate all of the fixed overhead
variances.
Worked Example: Fixed overhead variance
Suppose that a company plans to produce 1 000 units of product E during August 20X3. The expected
time to produce a unit of E is five hours, and the budgeted fixed overhead is $20 000. The standard
fixed overhead cost per unit of product E will therefore be as follows:
5 hours at $4 per hour = $20 per unit
Actual fixed overhead expenditure in August 20X3 turns out to be $20 450. The labour force manages
to produce 1 100 units of product E in the month.
All of the variances help to assess the under- or over absorption of fixed overheads.
a. Fixed overhead total variance
Fixed overhead incurred
Fixed overhead absorbed (1 100 units $20 per unit)
Fixed overhead total variance
(= under-/over-absorbed overhead)
$
20 450
22 000
1 550 (F)
The variance is favourable because more overheads were absorbed than budgeted.
b. Fixed overhead expenditure variance
Budgeted fixed overhead expenditure
Actual fixed overhead expenditure
Fixed overhead expenditure variance
$
20 000
20 450
450 (U)
The variance is unfavourable because actual expenditure was greater than budgeted expenditure.
c. Fixed overhead volume variance
The production volume achieved was greater than expected. The fixed overhead volume variance
measures the difference at the standard rate.
$
Actual production at standard rate (1 100 $20 per unit)
Budgeted production at standard rate (1 000 $20 per unit)
Fixed overhead volume variance
22 000
20 000
2 000 (F)
Expenditure variance
Volume variance
Over-absorbed overhead (total variance)
$
450 (U)
2 000 (F)
$1 550 (F)
In general, a favourable cost variance will arise if actual results are less than expected results. Be
aware, however, of the fixed overhead volume variance which gives rise to favourable and
unfavourable variances in the following situations:
A favourable fixed overhead volume variance occurs when actual production is greater than
budgeted (planned) production.
An unfavourable fixed overhead volume variance occurs when actual production is less than
budgeted (planned) production.
Do not worry if you find fixed production overhead variances more difficult to grasp than the other
variances we have covered. Most students do. Read over this section again and then try the following
practice questions.
CHAPTER 9
4kg @ $10/kg
2 hours @ $4/hour
3 hours @ $2.50
$40.00
$8.00
$7.50
The fixed overheads are based on a budgeted expenditure of $75 000 and budgeted activity of 30 000
hours.
Actual results for the period were recorded as follows:
Production
Materials 33 600 kg
Labour 16 500 hours
Fixed overheads
9 000 units
$336 000
$68 500
$70 000
A
B
C
D
Material price
$
24 000 (F)
24 000 (U)
Material usage
$
24 000 (F)
24 000 (U)
A
B
C
D
Labour rate
$
2 500 (U)
2 500 (F)
6 000 (U)
6 000 (F)
Labour efficiency
$
6 000 (F)
6 000 (U)
2 500 (F)
2 500 (U)
VARIANCE
FAVOURABLE
UNFAVOURABLE
Material price
Price increase
Careless purchasing
Defective material
Theft
Material usage
Excessive waste
Idle time
Labour efficiency
Overhead expenditure
This is not an exhaustive list and in a question you should review the information given in order to
analyse possible reasons for variances.
CHAPTER 9
LO
9.2
Once variances have been calculated, management have to decide whether or not to investigate their
causes. It would be extremely time consuming and expensive to investigate every variance, therefore
managers have to decide which variances are worthy of investigation.
There are a number of factors which can be taken into account when deciding whether or not a
variance should be investigated.
a. Materiality. A standard cost is an average expected cost and is not a rigid specification. Small
variations either side of this average are therefore bound to occur. The problem is to decide
whether a variation from standard should be considered significant and worthy of investigation.
Tolerance limits can be set and only variances which exceed such limits would require
investigating.
b. Controllability. Some types of variance may not be controllable even once their cause is
discovered. For example, if there is a general worldwide increase in the price of a raw material
there are limited actions that can be taken to mitigate the impact on costs. If a central decision is
made to award all employees a 10% increase in salary, staff costs in division A will increase by this
amount and the variance is not controllable by division A's manager. Uncontrollable variances call
for a change in the plan, not an investigation into the past.
c. The type of standard being used.
i. The efficiency variance reported in any control period, whether for materials or labour, will
depend on the efficiency level set. If, for example, an ideal standard is used, variances will
always be unfavourable.
ii. A similar problem arises if average price levels are used as standards. If inflation exists,
favourable price variances are likely to be reported at the beginning of a period, to be offset by
unfavourable price variances later in the period as inflation pushes prices up.
d. Interdependence between variances. Individual variances should not be looked at in isolation.
One variance might be inter-related with another, and much of it might have occurred only
because the other, inter-related, variance occurred too. We will investigate this issue further in a
moment.
e. Costs of investigation. The costs of an investigation should be weighed against the benefits of
correcting the cause of a variance.
The investigation of variances and the need for control action is discussed further in Chapter 12.
A large unfavourable direct labour efficiency variance has been reported. Which TWO of the following
might be causes of the variance?
I
List the factors which should be taken into account when deciding whether or not a variance should be
investigated.
(The answer is at the end of the chapter)
8 SALES VARIANCES
Section overview
The selling price variance is a measure of the effect on expected profit of a different selling
price to standard selling price. The sales volume profit variance is the difference between
the actual units sold and the budgeted (planned) quantity, valued at the standard profit per
unit.
LOs
9.1
9.3
The selling price variance is a measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have
been for the actual quantity sold, and what it was.
Suppose that the standard selling price of product X is $15. Actual sales in 20X3 were 2 000 units at
$15.30 per unit.
The selling price variance is calculated as follows:
Sales revenue from 2 000 units should have been ( $15)
but was ( $15.30)
Selling price variance
$
30 000
30 600
The variance calculated is favourable because the price was higher than expected.
600 (F)
CHAPTER 9
Definition
LOs
9.1
9.3
The sales volume profit variance is the difference between the actual units sold and the budgeted
(planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or
decrease in standard profit as a result of the sales volume being higher or lower than budgeted
(planned).
Suppose that a company budgets to sell 8,000 units of product J for $12 per unit. The standard full
cost per unit is $7. Actual sales were 7,700 units, at $12.50 per unit.
The sales volume profit variance is calculated as follows:
8 000 units
7 700 units
300 units (U)
$5
$1 500 (U)
The variance calculated above is unfavourable because actual sales were less than budgeted
(planned).
Question 6: Selling price variance
Jasper Co has the following budget and actual figures for 20X4:
Budget
600
$30
Sales units
Selling price per unit
Actual
620
$29
A
B
C
D
Sales price
$
600 (U)
600 (U)
620 (U)
620 (U)
Sales volume
$
20 (F)
40 (F)
20 (F)
40 (F)
FAVOURABLE
UNFAVOURABLE
Sales price
The possible interdependence between sales price and sales volume variances should be obvious to
you. A reduction in the sales price might stimulate bigger sales demand, so that an unfavourable sales
price variance might be counterbalanced by a favourable sales volume variance. Similarly, a price rise
would give a favourable price variance, but possibly at the cost of a fall in demand and an
unfavourable sales volume variance.
It is important in analysing an unfavourable sales variance that the overall consequence should be
considered, for example, has there been a counterbalancing favourable variance as a direct result of
the unfavourable one?
9 OPERATING STATEMENTS
Section overview
Operating statements show how the combination of variances reconcile budgeted profit
and actual profit.
So far, we have considered how variances are calculated without considering how they combine to
reconcile the difference between budgeted profit and actual profit during a period. This reconciliation
is usually presented as a report to senior management at the end of each control period. The report is
called an operating statement or statement of variances.
Definition
An operating statement is a regular report for management of actual costs and revenues, usually
showing variances from budget.
An extensive example will now be introduced, both to revise the variance calculations already
described, and also to show how to combine them into an operating statement.
Worked Example: Example name
Sydney manufactures one product, and the entire product is sold as soon as it is produced. There are
no opening or closing inventories and work in progress is negligible. The company operates a
standard costing system and analysis of variances is made every month. The standard cost card for the
product, a boomerang, is as follows:
Direct materials
Direct wages
Variable overheads
Fixed overhead
Standard cost
Standard profit
Standing selling price
$
2.00
4.00
0.60
7.40
14.00
6.00
20.00
Selling and administration expenses are not included in the standard cost, and are deducted from
profit as a period charge.
CHAPTER 9
Budgeted (planned) output for the month of June 20X7 was 5 100 units. Actual results for June 20X7
were as follows:
Production of 4 850 units was sold for $95 600.
Materials consumed in production amounted to 2 300 kgs at a total cost of $9 800.
Labour hours paid for amounted to 8 500 hours at a cost of $16 800.
Actual operating hours amounted to 8 000 hours.
Variable overheads amounted to $2 600.
Fixed overheads amounted to $42 300.
Selling and administration expenses amounted to $18 000.
Calculate all variances and prepare an operating statement for the month ended 30 June 20X7.
Solution
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
$
9 200
9 800
600 (U)
2 425 kgs
2 300 kgs
125 kg (F)
$4
$ 500 (F)
$
17 000
16 800
200 (F)
$
9 700 hrs
8 000 hrs
1 700 hrs (F)
$2
$3 400 (F)
$1 000 (U)
$
2 400
2 600
200 (U)
$ 510 (F)
$
37 740
42 300
4 560 (U)
$
35 890
37 740
1 850 (U)
$
97 000
95 600
1 400 (U)
5 100 units
4 850 units
250 units
$6 (U)
$1 500 (U)
There are several ways in which an operating statement may be presented. Perhaps the most
common format is one which reconciles budgeted profit to actual profit. In this example, sales and
administration costs will be introduced at the end of the statement, so that we shall begin with
'budgeted profit before sales and administration costs'.
Sales variances are reported first, and the total of the budgeted profit and the two sales variances
results in a figure for 'actual sales minus the standard cost of sales'. The cost variances are then
reported, and an actual profit before sales and administration costs calculated. Sales and
administration costs are then deducted to reach the actual profit for June 20X7.
SYDNEY OPERATING STATEMENT JUNE 20X7
$
Budgeted (planned) profit before sales and administration costs
Sales variances:
price
volume
1 400 (U)
1 500 (U)
2 900 (U)
27 700
(U)
$
600
500
200
3 400
1 000
200
510
4 610
Actual profit before sales and
administration costs
Sales and administration costs
Actual profit, June 20X7
Check:
Sales
Materials
Labour
Variable overheads
Fixed overhead
Sales and administration
Actual profit
4 560
1 850
8 210
3 600 (U)
24 100
18 000
6 100
95 600
9 800
16 800
2 600
42 300
18 000
89 500
6 100
CHAPTER 9
Cost variances
Material price
Material usage
Labour rate
Labour efficiency
Labour idle time
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Fixed overhead volume
$
30 600
A company expected to produce 200 units of its product, the Bone, in 20X3. The actual number
produced was 260 units. The standard labour cost per unit was $70 (10 hours at a rate of $7 per hour).
The actual labour cost was $18 600 and the number of hours worked was 2 200 hours although 2 300
hours were paid.
1 What is the direct labour rate variance for the company in 20X3?
A $400 (U)
B $2 500 (F)
C $2 500 (U)
D $3 200 (U)
2 What is the direct labour efficiency variance for the company in 20X3?
A $400 (U)
B $2 100 (F)
C $2 800 (U)
D $2 800 (F)
3 What is the idle time variance?
A $700 (F)
B $700 (U)
C $809 (U)
D $809 (F)
4 A company has budgeted to make and sell 4 200 units of product X during a period.
The standard fixed overhead cost per unit is $4.
During the period covered by the budget, the actual results were as follows:
Production and sales
Fixed overhead incurred
5 000 units
$17 500
A
B
C
D
Fixed overhead
expenditure variance
$700 (F)
$700 (F)
$700 (U)
$700 (U)
Fixed overhead
volume variance
$3 200 (F)
$3 200 (U)
$3 200 (F)
$3 200 (U)
5 A company has a budgeted material cost of $125 000 for the production of 25 000 units per month.
Each unit is budgeted to use 2 kgs of material. The standard cost of material is $2.50 per kg.
Actual materials in the month cost $136 000 for 27 000 units and 53 000 kgs were purchased and
used.
What was the favourable material usage variance?
A $2 500
B $4 000
C $7 500
D $10 000
CHAPTER 9
A company operating a standard costing system has the following direct labour standards per unit for
one of its products:
4 hours at $12.50 per hour
Last month when 2 195 units of the product were manufactured, the actual direct labour cost for the 9
200 hours worked was $110 750.
6 What was the direct labour rate variance for last month?
A $4 250 favourable
B $4 250 unfavourable
C $5 250 favourable
D $5 250 unfavourable
7 What was the direct labour efficiency variance for last month?
A $4 250 favourable
B $4 250 unfavourable
C $5 250 favourable
D $5 250 unfavourable
8 PQ Limited currently uses a standard absorption costing system. The fixed overhead variances
extracted from the operating statement for November are:
Fixed production overhead expenditure variance
Fixed production overhead volume variance
$
5 800 unfavourable
2 800 favourable
PQ Limited is considering using standard marginal costing as the basis for variance reporting in
future. What variance for fixed production overhead would be shown in a marginal costing
operating statement for November?
A No variance
B Volume variance: $2 800 favourable
C Total variance: $3 000 unfavourable
D Expenditure variance: $5 800 unfavourable
Option A is the total direct labour cost variance. If you selected option B you based your
calculations on the 2,300 hours paid for; but efficiency measures should be based on the active
hours only, i.e. 2 200 hours.
If you selected option C you calculated the correct dollar value of the variance but you
misinterpreted its direction.
3 B Idle time hours (2 300 2 200) standard rate per hour
= 100 hrs $7
= $700 (U)
If you selected option A you calculated the correct dollar value of the variance but you
misinterpreted its direction. The idle time variance is always unfavourable.
If you selected options C or D you evaluated the idle time at the actual hourly rate instead of
the standard hourly rate.
4 C Fixed overhead expenditure variance
$
16 800
17 500
700 (U)
The variance is unfavourable because the actual expenditure was higher than the amount
budgeted.
Fixed overhead volume variance
Actual production at standard rate (5 000 $4 per unit)
Budgeted production at standard rate (4 200 $4 per unit)
Fixed overhead volume variance
$
20 000
16 800
3 200 (F)
The variance is favourable because the actual volume of output was greater than the budgeted
volume of output.
If you selected an incorrect option you misinterpreted the direction of one or both of the
variances.
CHAPTER 9
5 A
27 000 units should use ( 2 kg)
but did use
standard price per kg
Material usage variance
$
54 000 kg
53 000 kg
1 000 kg (F)
2.5
2 500 (F)
6 A
9 200 hours should have cost ( $12.50)
but did cost
Direct labour rate variance
$
115 000
110 750
4 250 (F)
7 D
2 195 units should have taken ( 4 hours)
but did take
Direct labour efficiency variance (in hours)
standard rate pre hour
8 780 hours
9 200 hours
420 hours (U)
12.50
5 250 (U)
8 D The only fixed overhead variance in a marginal costing statement is the fixed overhead
expenditure variance. This is the difference between budgeted and actual overhead
expenditure, calculated in the same way as for an absorption costing system.
There is no volume variance with marginal costing, because under or over absorption due to
volume changes cannot arise.
$
336 000
336 000
36 000 kg
33 600 kg
2 400 kg (F)
$10
24 000 (F)
2 A
Direct labour rate variance
16 500 hrs should have cost ( $4)
but did cost
$
66 000
68 500
2 500 (U)
18 000 hrs
16 500 hrs
1 500 (F)
$4
6 000 (F)
3 A
Fixed production overhead absorbed ($7.50 9 000)
Fixed production overhead incurred
$
67 500
70 000
2 500 (U)
6 D
Sales revenue for 620 units should have been ( $30)
but was ( $29)
Selling price variance
Budgeted sales volume
Actual sales volume
Sales volume variance in units
standard profit per unit ($(30 28))
Sales volume profit variance
$18 600
$17 980
$620 (U)
600 units
620 units
20 units (F)
$2
$40 (F)
CHAPTER 9
4 C If a target standard rather than a current standard is used, unfavourable variances will occur until
the target is achieved. Poor quality materials may slow down work, and possibly increase
wastage/rejection rates. This will cause labour inefficiency. Using expensive skilled labour
should be expected to result in favourable efficiency variances. There should be no connection
between labour efficiency and whether work is done in normal time or overtime.
273
CHAPTER 10
CAPITAL EXPENDITURE
Learning objectives
Reference
Capital expenditure
LO10
LO10.1
LO10.2
Decision making
LO2
LO2.3
LO2.4
Explain the impact of cash flows and risks on project decision making
LO2.5
Topic list
1
2
3
4
5
INTRODUCTION
This chapter is an introduction to the appraisal of projects which involve the outlay of capital.
Capital expenditure differs from day-to-day revenue expenditure for two reasons:
Capital expenditure often involves a bigger outlay of money.
The benefits from capital expenditure are likely to accrue over a long period of time, usually well
over one year and often much longer. In such circumstances the benefits cannot all be set against
costs in the current year's income statement.
For these reasons any proposed capital expenditure project should be properly appraised, and found
to be worthwhile, before the decision is taken to go ahead with the expenditure.
We begin the chapter with an overview of the investment decision-making process, before moving on
to examine two capital investment appraisal techniques, the straightforward payback method and the
slightly more involved accounting rate of return method.
We conclude by looking at uncertainty and risk. Decision making involves making decisions now about
what will happen in the future. Ideally, the decision maker would know with certainty what the future
consequences would be for each choice faced. But, in reality, decisions must be made in the
knowledge that their consequences, although perhaps probable, are rarely totally certain.
The chapter content is summarised in the diagram below.
Capital
expenditure
The process
Payback
method
Post audit
ARR method
Risk and
uncertainty
(Section 1.2)
(Section 1.5)
(Section 2)
(Section 2.1)
(Section 2.2)
(Section 2.4)
(Section 3)
(Section 3.2)
(Section 3.3)
(Section 4)
11 What are the drawbacks and advantages to the ARR method of project appraisal?
(Section 4.2)
(Section 5.1)
CHAPTER 10
2 What are steps involved in the analysis stage of investment decision making?
The capital budget will normally be prepared to cover a longer period than sales, production and
resource budgets, from three to five years, although it should be broken down into periods matching
those of other budgets. It should indicate the expenditure required to cover capital projects already
underway and those it is anticipated will start in the three to five year period of the capital budget.
The budget should therefore be based on the current production budget, future expected levels of
production and the long-term development of the organisation, and industry, as a whole.
Budget limits or constraints might be imposed internally (soft capital rationing) or externally (hard
capital rationing).
Projects can be classified in the budget into those that generally arise from top management policy
decisions or from sources such as mandatory government regulations (health, safety and welfare
capital expenditure) and those that tend to be appraised using the techniques covered in this chapter.
a. Cost reduction and replacement expenditure.
b. Expenditure on the expansion of existing product lines.
c. New product expenditure.
The administration of the capital budget is usually separate from that of the other budgets. Overall
responsibility for authorisation and monitoring of capital expenditure is, in most large organisations,
the responsibility of a committee.
Capital expenditure often involves the outlay of large sums of money, and expected benefits may
take a number of years to accrue. For these reasons it is vital that capital expenditure is subject to a
rigorous process of appraisal and control.
A typical model for investment decision making has a number of distinct stages:
Origination of proposals
Project screening
Analysis and acceptance
Monitoring and review
Step 2
Classify the project by type to separate projects into those that require more or less
rigorous financial appraisal, and those that must achieve a greater or lesser rate of return
in order to be deemed acceptable.
Step 3
Carry out financial analysis of the project. We look at this in more detail below.
Step 4
Step 5
Consider the project in the light of the capital budget for the current and future
operating periods.
Step 6
Step 7
The approval hierarchy for an investment will be dependent on the level of investment i.e. its
cost/value and complexity (see section 1.5.3).
Steps 1 to 6 above can be seen in the context of the decision-making process that was described in
chapter 1, section 3.7. After all, investing in capital projects involves a decision about whether to
spend, and how much to spend. Using the approach from chapter 1:
CHAPTER 10
Step 1
Define the problem. The problem that leads to capital expenditure decisions may be
that existing assets are getting old and less reliable, and management want to decide
how to improve reliability and efficiency in production. The problem may be that the
organisation wants to expand the scale of its operations or diversify into a new line of
business, and to do this it needs to invest in new assets.
Step 2
Identify the decision-making criteria. There are several different ways of evaluating
investment options. As we shall see later, the decision-making criteria may be that any
new investment should earn a minimum return on capital invested, or should add value to
the business, or that any amount invested should be recovered within a given number of
years.
Step 3
Step 4
Analyse the alternatives. Each of the alternatives should be analysed and evaluated,
using the chosen decision-making criterion. If the alternatives are simply either to invest
or not to invest, the analysis is carried out by evaluating the decision to invest.
Step 5
A difficulty with control measurements of capital projects is that most projects are 'unique' with no
standard or yardstick to judge them against other than their own appraisal data. Therefore if actual
costs were to exceed the estimated costs, it might be impossible to tell just how much of the variance
is due to bad estimating and how much is due to inefficiencies and poor cost control.
CHAPTER 10
Further control can be exercised over capital projects by ensuring that the anticipated benefits do
actually materialise, the benefits are as big as anticipated and running costs do not exceed
expectation.
In the same way, if benefits are below expectation, is this because the original estimates were
optimistic, or because management has been inefficient and failed to get the benefits they should
have done?
Many capital projects such as the purchase of replacement assets and marketing investment decisions
do not have clearly identifiable costs and benefits. The incremental benefits and costs of such
schemes can be estimated, but it would need a very sophisticated management accounting system to
be able to identify and measure the actual benefits and many of the costs. Even so, some degree of
monitoring and control can still be exercised by means of a post-completion appraisal or audit
review.
2 POST-COMPLETION AUDIT
Section overview
A post-completion audit cannot reverse the decision to incur the capital expenditure,
because the expenditure has already taken place but it can assist with the implementation
and control of future investments.
Definition
A post-completion audit (PCA) is an objective independent assessment of the success of a capital
project in relation to plan. It covers the whole life of the project and provides feedback to managers to
aid the implementation and control of future projects. A post-completion audit is often referred to as
post-implementation audit in some countries.
A 1999 Management Accounting article looked at post completion auditing at Heineken (the Dutch
beer producer) and how it was applied to a project to replace a 20-year old bottling line. The
following table shows the planned objectives of the investment and the actual situation at the time a
PCA was carried out on the investment. (Guilders were the Dutch currency prior to the euro.) This
should give you an idea of the type of objectives that can be monitored with a PCA.
CHAPTER 10
Case study
OBJECTIVES
PLAN
ACTUAL
Efficiency
No increase yet
Staff savings
Achieved
Forklift savings
1 vehicle less
Savings on overhaul of
old bottling line
Savings on
maintenance
Quality
Achieved
Working conditions
Level of noise
Accessibility
Safety
Attainability
Now that we have discussed all the stages involved in the capital budgeting process, we will return to
study in detail the stage that many managers consider to be the most important: the financial
appraisal. A decision about whether to invest is often made on financial considerations, and the
decision criterion is related to financial return. We will begin with what is probably the most
straightforward appraisal technique: the payback method.
Payback is often used as a 'first screening method' because it helps focus attention on liquidity. By
this, we mean that when a capital investment project is being subjected to financial appraisal, the first
question to ask is: 'How long will it take to pay back its cost?' The organisation might have a target
payback, and so it would reject a capital project unless its payback period were less than a target
maximum number of years.
When deciding between two or more competing projects, management may prefer the one with the
shortest payback.
If payback were the only method of evaluation used, the decision criterion would be to recover the
initial capital outlay as quickly as possible.
However, a project should not be evaluated on the basis of payback alone. If a project gets through
the payback test, it ought then to be evaluated with a more sophisticated project appraisal technique.
Payback is a cash based measure. Ideally it is based on the project's cash inflows versus its cash
outflows. It does not consider profit. In the absence of cash flow information however, profits before
depreciation can be used as a very rough approximation of annual cash flows.
With some methods of capital expenditure appraisal, it is commonly assumed that cash flows in each
period occur on the last day of the period. However with the payback method, either of two different
assumptions may be used:
a. that the cash flows in each period do occur at the end of the period: this means that capital
expenditure at the beginning of the first year are assumed to occur in 'Year 0', which is the year
that has just ended. When this assumption is used, payback will occur at the end of a particular
year.
b. that the cash flows occur at an even rate throughout each time period. When this assumption is
used, payback will normally occur at some time during a particular year, not at the end of a year.
When it is assumed that cash flows occur at an even rate throughout the year (with the exception of
any cash from the disposal of a capital asset, which happens at the very end of the project), the
payback period is calculated as follows.
a. Calculate the cumulative cash flows at the end of each year. The initial capital outlay is a cash
outflow, so the cumulate cash flow will remain negative until payback is achieved.
b. Payback is achieved during the year that the cumulative cash flows change from negative to
positive.
c. The time in the payback year that payback occurs is found by calculating the proportion:
(Extra cash inflow needed for payback at the start of the year/Cash flow during the year)
d. Multiply this proportion by 12 months to get the payback month in the year.
For example, suppose that the cumulative cash flow for a project at the end of Year 3 is - $15 000 and
the cash flow in Year 4 is $36 000. The payback period will be 3 years + [(15 000/36 000) 12 months]
= 3 years 5 months.
Project P
$60 000
$20 000
$30 000
$40 000
$50 000
$60 000
Project Q
$60 000
$50 000
$20 000
$5 000
$5 000
$5 000
Project P pays back in year 3. If we assume that cash flows occur at the end of the year, payback occurs
at the end of year 3. If we assume that cash flows occur at an even rate throughout each year, Project P
will pay back one quarter of the way through year 3 (after 2 years 3 months).
Using payback alone to judge projects, project Q would be preferred. But the returns from project P
over its life are much higher than the returns from project Q. Project P will earn total profits before
depreciation of $200 000 on an investment of $60 000, whereas project Q will earn total profits before
depreciation of only $85 000 on an investment of $60 000. Making the choice between the projects on
payback alone would be inappropriate: total return must also be considered.
CHAPTER 10
Project Q pays back in year 2. If we assume that cash flows occur at the end of the year, payback
occurs at the end of year 2. If we assume that cash flows occur at an even rate throughout each year,
Project Q will pay back half way through year 2 (after 1 year 6 months).
Question 1: Payback
An asset costing $120 000 is to be depreciated over ten years to a nil residual value. Profits after
depreciation for the first five years are as follows:
Year
1
2
3
4
5
$
12 000
17 000
28 000
37 000
8 000
How long is the payback period to the nearest month, assuming that cash flows occur at an even rate
during each year?
A 3 years
B 3 years 6 months
C 3 years 7 months
D The project does not payback in five years
(The answer is at the end of the chapter)
ARR =
Or ARR =
The measurement of ARR is different according to whether 'average annual profit' or 'total profits over
the asset life' is the figure above the line. Similarly, ARR differs according to whether 'average
investment' or 'initial investment' is used below the line.
Note: Average investment = [(Initial cost + Estimated residual value)/2].
Whichever method of measuring ARR is selected (assuming that the ARR method is used as a decision
criterion) the method selected should be used consistently. For examination purposes we
recommend the first definition (average profit as a percentage of average investment) unless the
question clearly indicates that some other one is to be used.
Note that this is the only appraisal method that we will be studying that uses profit instead of cash
flow. If you are not provided with a figure for profit, assume that net cash inflow minus depreciation
equals profit.
Worked Example: Target accounting rate of return
A company has a target accounting rate of return of 20%, using the first definition above, and is now
considering the following project.
$80 000
4 years
$20 000
$25 000
$35 000
$25 000
The capital asset would be depreciated by 25% of its cost each year, and will have no residual value.
Assess whether the project should be undertaken.
CHAPTER 10
Solution
The annual profits after depreciation, and the mid-year net book value of the asset, would be as
follows.
Year
1
2
3
4
Profit after
depreciation
$
0
5 000
15 000
5 000
Mid-year net
book value
$
70 000
50 000
30 000
10 000
ARR in the
year
%
0
10
50
50
As the table shows, the ARR is low in the early stages of the project, partly because of low profits in
Year 1 but mainly because the NBV of the asset is much higher early on in its life. The project does not
achieve the target ARR of 20% in its first two years, but exceeds it in years 3 and 4. Should it be
undertaken?
When the ARR from a project varies from year to year, it makes sense to take an overall or 'average'
view of the project's return. In this case, we should look at the return over the four-year period.
$
105 000
25 000
6 250
80 000
40 000
The project would not be undertaken because its ARR is (6 250/40 000) 100% = 15.625% and so it
would fail to yield the target return of 20%.
Arrow wants to buy a new item of equipment. Three models of equipment are available, differing
according to cost, size, reliability and supplier. The expected costs and profits of each item are as
follows:
Equipment item
Capital cost
Life
Profits before depreciation
Year 1
Year 2
Year 3
Year 4
Year 5
Disposal value
X
$80 000
5 years
$
50 000
50 000
30 000
20 000
10 000
0
Y
$150 000
5 years
$
50 000
50 000
60 000
60 000
60 000
0
Z
$200 000
5 years
$
60 000
70 000
90 000
70 000
60 000
50 000
ARR is measured as the average annual profit after depreciation, divided by the average net book
value of the asset. The investment with the highest ARR will be selected, provided that its expected
ARR is more than 30%.
Depreciation is charged on the straight line basis. Profits and cash flows are assumed to occur at an
even rate within each year. The maximum acceptable payback period is 3 years and the minimum
acceptable ARR is 23%.
a. What is the payback period for each investment?
A Proposal A 2 years 6 months, Proposal B 2 years 11 months
B Proposal A 2 years 6 months, Proposal B 3 years 1 month
C Proposal A 2 years 8 months, Proposal B 2 years 11 months
D Proposal A 2 years 8 months, Proposal B 3 years 1 month
CHAPTER 10
Initial investment
Year 1
Year 2
Year 3
Year 4
Estimated scrap value at the end of year 4
b. What is the ARR for each investment, using average profit and average investment to measure
ARR?
A Proposal A 22%, Proposal B 26%
B Proposal A 22%, Proposal B 28.3%
C Proposal A 23.5%, Proposal B 26%
D Proposal A 23.5%, Proposal B 28.3%
c. On the basis of these two performance criteria (payback and ARR) which project or projects should
be undertaken?
A Proposal A only
B Proposal B only
C Both Proposal A and Proposal B
D Neither proposal
(The answer is at the end of the chapter)
LOs
2.5
10.2
Risk involves situations or events which may or may not occur, but whose probability of occurrence
can be calculated statistically and the frequency of their occurrence predicted from past records.
Therefore insurance deals with risk.
Uncertain events are those whose outcome cannot be predicted with statistical confidence.
In everyday usage the terms risk and uncertainty are not clearly distinguished. In the context of capital
investment however the difference relates to whether sufficient information is available to allow the
lack of certainty surrounding costs or revenues to be quantified.
A risk averse investor requires compensation for risk and will avoid risk unless the expected return
adequately compensates for it. If two investments have the same expected return, they would choose
the one with the lowest risk. However, a risk averse decision maker may be prepared to invest in a
more risky project, provided that the expected return is higher.
LO
2.5
An investor is risk neutral if they are indifferent to the level of risk involved in an investment and only
concerned about the expected return. A risk neutral decision maker would be indifferent between
investments that offered the same expected return, regardless of the risk with each investment.
A risk seeker is an investor who is attracted to risk. They would choose an investment that offers the
possibility of a higher level of return, even when there is a high probability of a much lower return. For
example a risk seeker might choose to invest in something that offers a 10% chance of a return of $20
000 and a 90% chance of $0 in preference to an investment that is 100% certain to provide a return of
$5 000.
This has clear implications for managers and organisations. A risk seeking manager working for
an organisation that is characteristically risk averse is likely to make decisions that are not
congruent with the goals of the organisation. There may be a role for the management
accountant here, who could be instructed to present decision-making information in such a way
as to ensure that the manager considers all the possibilities, including the worst.
Case study
What constitutes an acceptable amount of risk will vary from organisation to organisation. For large
public companies it is largely a question of what is acceptable to the shareholders. A 'safe' investment
will attract investors who are to some extent risk averse, and the company will therefore be obliged to
follow relatively 'safe' policies. A company that is recognised as being an innovator or a 'growth'
company in a relatively new market, like Yahoo!, will attract investors who are looking for high
performance and are prepared to accept some risk in return. Such companies will be expected to
make 'bolder' decisions.
The risk of an individual strategy should also be considered in the context of the overall 'portfolio' of
investment strategies adopted by the company.
a. If a strategy is risky, but its outcome is not related to the outcome of other strategies, then
adopting that strategy will help the company to spread its risks.
b. If a strategy is risky, but is inversely related to other adopted strategies, so that if strategy A does
well, other adopted strategies will do badly and vice versa, then adopting strategy A would actually
reduce the overall risk of the company's investment portfolio.
CHAPTER 10
LO
2.4
Scenario planning, involves asking 'what if?' and 'what is the effect of?' questions about the future.
Project screening.
Analysis and acceptance.
Monitoring and review.
During the project's progress, project controls should be applied to ensure the following:
Capital spending does not exceed the amount authorised.
$100 000. If no information can be provided on the returns from the project, we are faced with
uncertainty.
People may be risk seekers, risk neutral or risk averse.
CHAPTER 10
Scenario planning, involves asking 'what if?' and 'what is the effect of?' questions about the future.
4 Which of the following can be used to calculate the return on capital employed?
I
II
III
A I, II and III
B I and II only
C I and III only
D II and III only
5 The ARR method of investment appraisal is primarily criticised because
A there are different ways of calculating ARR.
B investment is about cash returns on cash investments.
C depreciation rates are arbitrary when calculating profit.
D it does not consider the full expected life of the project.
6 Which one of the following statements is correct?
A Earlier payback improves profitability.
B Investment risk is lower if payback is longer.
C A risk averse investor wants to avoid risk entirely.
D Shorter term forecasts are likely to be more reliable.
CHAPTER 10
D The ARR method of investment appraisal uses accounting profits before depreciation charges.
Year
1
2
3
4
5
Depreciation
$ 000
12
12
12
12
12
Profit before
depreciation
$ 000
24
29
40
49
20
Cumulative
profit
$ 000
24
53
93
142
(120 - 93)
= 3 years 7 months
2 A
Item X
$
Item Y
$
Item Z
$
160 000
80 000
16 000
40 000
40%
280 000
130 000
26 000
75 000
34.7%
350 000
200 000
40 000
125 000
32%
All three projects would earn a return in excess of 30%, but since item X would earn the biggest
ARR, it would be preferred to item Y and item Z, even though the profits from Y would be
higher by an average of $10 000 a year and the annual profit from Z would be $24 000 higher.
3 Workings:
Depreciation must first be added back to the annual profit figures, to arrive at the annual cash
flows.
Depreciation
= $10 500 pa
Adding $10 500 per annum to the profit figures produces the cash flows for each proposal.
0
1
2
3
4
4
Proposal A
Cumulative
cash flow
$
(46 000)
(29 000)
(15 000)
9 000
18 000
22 000
Annual
cash flow
$
(46 000)
15 000
13 000
15 000
25 000
4 000
Proposal B
Cumulative
cash flow
$
(46 000)
(31 000)
(18 000)
(3 000)
22 000
26 000
15 000
a. D Proposal A payback = 2 +
12 months = 2 years 8 months
24 000
3 000
Proposal B payback = 3 +
12 months = 3 years 1 month
25 000
CHAPTER 10
Year
Annual
cash flow
$
(46 000)
17 000
14 000
24 000
9 000
4 000
b. A The return on capital employed (ROCE) is calculated using the accounting profits given in
the question.
Proposal A
Proposal B
Average profit
Average investment
ARR
$5 500
100% = 22%
$25 000
Average profit
$6 500
100% = 26%
$25 000
ARR
c. D Project Y takes just over 3 years to pay back. Project X earns less than 23% return, measured
as ARR. Applying the decision criteria strictly, neither proposal is acceptable.
297
CHAPTER 11
INVENTORY AND PRICING
DECISIONS
Learning objectives
Reference
LO11.1
Apply the economic order quantity formula to determine order quantities for inventory
management
LO11.2
Establish and apply the appropriate approach for long-term pricing decisions
LO11.3
Topic list
INTRODUCTION
This chapter examines two separate topics inventory and pricing.
Within the area of inventory two areas will be examined Just-in-time systems and inventory
management.
In recent years there have been significant changes in the business environment in which both
manufacturing and service organisations operate. Organisations have therefore adopted new
management approaches and have changed their manufacturing systems. One such type of system is
just-in-time (JIT) systems.
The investment in inventory is a very important one for most businesses, both in terms of monetary
value and relationships with customers. It is therefore vital that management establish and maintain an
effective inventory control system.
This chapter will concentrate on a inventory control system for materials, but similar problems and
considerations apply to all forms of inventory.
The chapter concludes by looking at pricing. Finding the cost of a product or service means, among
other things, that you have a basis for setting a selling price that will earn the business the profit it
wants. Recently, however, some businesses have approached the problem from the opposite side:
they have decided what the selling price should be in order for the product to sell, and then they
deduct the profit they want, which leaves the target cost. In this chapter we look at methods of pricing
that are based on cost, as well as target costing. Finally, there is a brief discussion on transfer pricing
this is where internal transfers of goods or services are made between different units of the same
business and management must decide on the appropriate price at which such transfers should be
charged.
The chapter content is summarised in the diagram below.
Inventory and
pricing decisions
Inventory
JIT systems
Value added
Inventory
control levels
Economic
order quantity
Full cost
pricing
Pricing
Market-based
approaches
Target
costing
Transfer
pricing
If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What is JIT?
(Section 1)
(Section 1.3)
(Section 1.4)
(Section 2.1.1)
(Section 2.3)
(Section 2.3.1)
(Section 2.4)
(Section 3.1.1)
(Section 3.2.1)
10 What is PED?
(Section 3.2.8)
(Section 3.3)
(Section 3.3.3)
CHAPTER 11
'Just-in-time' systems (which were introduced in chapter 1, section 8) are systems of purchasing,
inventory management and production planning and control that differ from so-called 'traditional'
systems.
In a traditional system, production quantities are planned to meet expected sales demand.
Management try to avoid running out of inventories of raw materials and finished goods, so that the
entity can meet demand for production and sales out of inventories. Inventory management therefore
involves deciding what levels of inventories should be held, and in what locations. Inventory managers
may try to maintain inventory levels at a number of weeks' supply.
'Efficient' management in a traditional system involves trying to minimise production costs through
long production runs (reducing set-up time and costs). 'Efficient' purchasing and inventory
management might involve buying materials and parts from suppliers in economic order quantities, in
order to minimise the combined costs of purchase orders and holding inventory.
Purchasing managers or buyers deal with immediate suppliers, but not suppliers at earlier stages in
the supply chain. The general view about suppliers is that they cannot be trusted to supply the correct
quantities of supplies or to supply items to the quality standards required and specified. Consequently
it is necessary to check all deliveries from suppliers for quantity and quality.
'Traditional' responses to the problems of improving manufacturing capacity and reducing unit costs
of production might therefore be described as follows:
Longer production runs
Economic batch quantities for purchasing and production runs
Fewer products in the product range
Reduced time on preventive maintenance, to keep production flowing
In general terms, longer production runs and large batch sizes should mean less disruption, better
capacity utilisation and lower unit costs.
Just-in-time management involves trying to eliminate non-value adding activities, where costs are
incurred for little or no benefit. One aspect of this is the elimination of waste, and 'getting things right
first time'. Another is the elimination of (or reduction in) inventory levels, because items held in
inventory have a cost but are not earning anything.
Although often described as a technique, JIT is more of a philosophy or approach to management
since it encompasses a commitment to continuous improvement and the search for excellence in
the design and operation of the production management system.
JIT has the following essential elements:
JIT purchasing
Parts and raw materials should be purchased as near as possible to the time they are
needed, using small frequent deliveries against bulk contracts.
Close relationship
with suppliers
In a JIT environment, the responsibility for the quality of goods lies with the supplier, who
must operate within the 'right first time' environment that JIT operations demand. In a
traditional system, deliveries from suppliers are verified for quality and quantity when they
are received. With JIT there is minimal checking of deliveries, which means that there must
be trust between the entity and the supplier. To achieve this, the relationship between
them cannot be seen as short-term. A long-term commitment between supplier and
customer should be established: as a key supplier, the supplier is guaranteed demand and
is able to plan to meet the customer's production schedules. If an organisation has
confidence that suppliers will deliver material of 100% quality, on time, so that there will be
no rejects or returns and hence no consequent production delays, usage of materials can
be matched with delivery of materials and inventories can be kept at near zero levels.
Suppliers are also chosen because of their close proximity to an organisation's plant.
Uniform loading
All parts of the productive process should be operated at a speed which matches the rate
at which the final product is demanded by the customer. Production runs will therefore be
shorter and there will be smaller inventories of finished goods because output is being
matched more closely to demand, and so storage costs will be reduced.
Set-up time
reduction
Machinery set-ups are non-value-added activities (see below) which should be reduced or
even eliminated.
Machine cells
Quality
Production management should seek to eliminate scrap and defective units during
production, and to avoid the need for reworking of units since this stops the flow of
production and leads to late deliveries to customers. Product quality and production
quality are important 'drivers' in a JIT system.
Pull system (Kanban) A Kanban, or signal, is used to ensure that products / components are only produced
when needed by the next process. Nothing is produced in anticipation of need, to then
remain in inventory, consuming resources. It is important to monitor usage, so that new
production or supply can be arranged to meet demand. In supermarkets, for example, the
sale of stores items is monitored 'just in time' through the use of bar codes and automatic
scanners at the check-out points.
Preventative
maintenance
Production systems must be reliable and prompt, without unforeseen delays and
breakdowns. Machinery must be kept fully maintained, and so preventative maintenance is
an important aspect of production.
Employee
involvement
Workers within each machine cell should be trained to operate each machine within that
cell and to be able to perform routine preventative maintenance on the cell machines, i.e.
to be multiskilled and flexible.
Because it is important that suppliers should be able to deliver materials and parts when
they are needed, it is often necessary to monitor the supply chain along its entire length,
and not just to establish a close relationship with immediate suppliers. Inventory
management may therefore involve monitoring supplies throughout the supply chain, and
there are software systems that can help companies to do this.
CHAPTER 11
Just-in-time purchasing is a purchasing system in which material purchases are contracted so that the
receipt and usage of material, to the maximum extent possible, coincide.
More frequent revision of inventory control levels and of the economic order quantity
Increase in the number of raw material suppliers in order to guarantee supply
Selection of suppliers close to the company's manufacturing facility
Increased focus on the accurate forecasting of customer demand
Increased quality control activity
A I and II only
B III, IV and V only
C II, III, IV and V only
D I, II, III, IV and V
(The answer is at the end of the chapter)
'The costs of those activities that can be eliminated without the customer's perceiving deterioration in
the performance, function, or other quality of a product are non-value-added. The costs of handling
the materials of a television set through successive stages of an assembly line may be non-valueadded. Improvements in plant layout that reduce handling costs may be achieved without affecting
the performance, function, or other quality of the television set.'
(Horngren)
Question 2: Value-added activity
Which of the following is a value-added activity?
A
B
C
D
Storing materials
Repairing faulty production work
Painting a car, if the organisation manufactures cars
Setting up a machine so that it drills holes of a certain size
Case study
The following extract from an article in the UK's Financial Times illustrates how 'just-in-time' some
manufacturing processes can be.
'Just-in-time manufacturing is down to a fine art at Nissan Motor Manufacturing (UK). Stockholding of
some components is just ten minutes - and the holding of all parts bought in Europe is less than a day.
These manufacturers do not even receive an order to make a component until the car for which it is
intended has started along the final assembly line. Seat manufacturer Ikeda Hoover, for example, has
about 45 minutes to build seats to specification and deliver them to the assembly line a mile away. It
delivers 12 sets of seats every 20 minutes and they are mounted in the right order on an overhead
conveyor ready for fitting to the right car.
Nissan has close relationships with a dozen or so suppliers and deals exclusively with them in their
component areas. It involves them and even their own suppliers in discussions about future needs and
other issues. These companies have generally established their own manufacturing units close to the
Nissan plant.
Other parts from further afield are collected from manufacturers by Nissan several times at fixed times.
This is more efficient than having each supplier making individual haulage arrangements.'
CHAPTER 11
Nissan has moved beyond just-in-time to synchronous supply for some components, which means
manufacturers deliver these components directly to the production line minutes before they are
needed.
II Opportunity cost of lost production capacity as machinery and the workforce reorganise for a
different product
III Additional materials handling costs
IV Increased administrative costs
A I only
B II and III only
C I, II, III and IV
D none of the above
(The answer is at the end of the chapter)
b. Interest charges. Holding inventories involves the tying up of capital (cash) on which interest must
be paid.
c. Insurance costs. The larger the value of inventories held, the greater insurance premiums are likely
to be.
e. Deterioration. When materials in store deteriorate to the extent that they are unusable, they must
be thrown away with the likelihood that disposal costs would be incurred.
CHAPTER 11
d. Risk of obsolescence. The longer a inventory item is held, the greater is the risk of obsolescence.
Formula to learn
Reorder level = maximum usage maximum lead time
Formula to learn
Average inventory = safety inventory + reorder quantity
A component has a safety inventory of 500, a re-order quantity of 3 000 and a rate of demand which
varies between 200 and 700 per week. The average inventory is approximately
A
B
C
D
2 000.
2 300.
2 500.
3 500.
Economic order theory assumes that the average inventory held is equal to one half of the reorder
quantity. Although, as we saw in the last section, if an organisation maintains some sort of buffer or
safety inventory then average inventory = buffer inventory + half of the reorder quantity. We have
seen that there are certain costs associated with holding inventory. These costs tend to increase with
the level of inventories, and so could be reduced by ordering smaller amounts from suppliers each
time.
On the other hand, as we have seen, there are costs associated with ordering from suppliers:
documentation, telephone calls, payment of invoices, receiving goods into stores and so on. These
costs tend to increase if small orders are placed, because a larger number of orders would then be
needed for a given annual demand.
The EOQ can be calculated using a table, or a graph, or a formula. This is illustrated in the three
worked examples below:
Worked Example: Method 1 Economic order quantity table
Suppose a company purchases raw material at a cost of $16 per unit. The annual demand for the raw
material is 25 000 units. The holding cost per unit is $6.40 and the cost of placing an order is $32.
We can tabulate the annual relevant costs for various order quantities as follows:
Order quantity (units)
Average inventory (units) (a)
Number of orders
(b)
Annual holding cost
Annual order cost
Total relevant cost
(c)
(d)
100
50
250
$
320
8 000
8 320
200
100
125
$
640
4 000
4 640
300
150
83
$
960
2 656
3 616
400
200
63
$
1 280
2 016
3 296
500
250
50
$
1 600
1 600
3 200
600
300
42
$
1 920
1 344
3 264
Notes
a. Average inventory = order quantity 2 (i.e. assuming no safety inventory)
b. Number of orders = annual demand order quantity
c. Annual holding cost = average inventory $6.40
800
400
31
$
2 560
992
3 552
1 000
500
25
$
3 200
800
4 000
CHAPTER 11
Annual costs
($)
9 000
8 000
7 000
6 000
5 000
Total costs
4 000
Holding costs
3 000
2 000
1 000
Ordering costs
Order quantity (units)
0
100
200 300
200
300
400
500
Note that the total cost line is at a minimum for an order quantity of 500 units and occurs at the point
where the ordering cost curve and holding cost curve intersect. The EOQ is therefore found at the
point where holding costs equal ordering costs.
where CH
CO
D
2C D
0
C
H
=
=
=
The formula calculates the order quantity that minimises the total annual holding and ordering costs
(the lowest point of the total cost curve).
CH
CO
D
EOQ
=
=
=
2 $32 25 000
$6.40
250 000
500 units
A manufacturing company uses 25 000 components at an even rate during a year. Each order placed
with the supplier of the components is for 2 000 components, which is the economic order quantity.
The company holds a buffer inventory of 500 components. The annual cost of holding one
component in inventory is $2.
What is the total annual cost of holding inventory of the component?
A $2 000
B $2 500
C $3 000
D $4 000
(The answer is at the end of the chapter)
CHAPTER 11
Instead of using a table or graph we can calculate the EOQ using the formula based on the
information in Paragraph 2.3
This selective approach to stores control is sometimes called the ABC method whereby materials are
classified A, B or C according to their expense-group: A being the expensive, group B the mediumcost and group C the inexpensive materials.
3 PRICING
3.1 COST-BASED APPROACHES TO PRICING
Section overview
Many firms base price on simple cost-plus rules.
Full cost-plus pricing is a method of determining the sales price by calculating the full cost of the
product and adding a percentage mark-up for profit.
In practice cost is one of the most important influences on price. Many firms base price on simple
cost-plus rules (costs are estimated and then a mark-up is added in order to set the price). A
traditional approach to pricing is full cost-plus pricing.
The 'full cost' may be a fully absorbed production cost only, or it may include some absorbed
administration, selling and distribution overhead.
A business might have an idea of the percentage profit margin it would like to earn, and so might
decide on an average profit mark-up as a general guideline for pricing decisions. This would be
particularly useful for businesses that carry out a large amount of contract work or jobbing work, for
which individual job or contract prices must be quoted regularly to prospective customers. However,
the percentage profit mark-up does not have to be rigid and fixed, but can be varied to suit the
circumstances. In particular, the percentage mark-up can be varied to suit demand conditions in the
market.
Question 7: Full cost
A product's full cost is $4.70 and is sold at full cost plus 70%.
What is the selling price?
(The answer is at the end of the chapter)
Markup has begun to produce a new product, Product X, for which the following cost estimates have
been made:
Direct materials
Direct labour: 4 hrs at $5 per hour
Variable production overheads: machining, hr at $6 per hour
$
27
20
3
50
Fixed production overheads are budgeted at $300 000 per month and, because of the shortage of
available machining capacity, the company will be restricted to 10 000 hours of machine time per
month. The absorption rate will be a direct labour rate, however, and budgeted direct labour hours
are 25 000 per month.
What is the full cost-plus based price?
Solution
$
27.00
20.00
Direct materials
Direct labour (4 hours)
Variable production overheads
3.00
48.00
98.00
19.60
117.60
There are several serious problems with relying on a full cost approach to pricing:
a. It fails to recognise that demand may be determining price. For many products, the price set will
determine the quantity sold. The price we set using this method may not lead to selling the
quantity that gives us the biggest profit. In other words, the price we set might not be competitive.
b. There may be a need to adjust prices to market and demand conditions.
c. Budgeted output volume needs to be established. Output volume is a key factor in the overhead
absorption rate.
d. A suitable basis for overhead absorption must be selected, especially where a business produces
more than one product.
However, it is a quick, simple and cheap method of pricing which can be delegated to junior
managers, which is particularly important with jobbing work where many prices must be decided and
quoted each day and, since the size of the profit margin can be varied, a decision based on a price in
excess of full cost should ensure that a company working at normal capacity will cover all of its fixed
costs and make a profit.
Marginal cost-plus pricing/Mark-up pricing is a method of determining the sales price by adding a
profit margin on to either marginal cost of production or marginal cost of sales.
Whereas a full cost-plus approach to pricing draws attention to net profit and the net profit margin, a
variable cost-plus approach to pricing draws attention to gross profit and the gross profit margin, or
contribution.
Question 8: Mark up on cost
$
5
3
7
2
Fixed overheads are $10 000 per month. Budgeted sales per month are 400 units.
CHAPTER 11
The company wishes to make a profit of 20% on full production cost from product X.
15%
17.6%
25%
33.3%
The product life concept is relevant to pricing policy. The concept states that a typical product moves
through four stages:
a. Introduction
The product is introduced to the market. Heavy capital expenditure will be incurred on product
development and perhaps also on the purchase of new non-current assets and building up stocks
for sale.
On its introduction to the market, the product will begin to earn some revenue, but initially
demand is likely to be small. Potential customers will be unaware of the product or service, and the
organisation may have to spend further on advertising to bring the product or service to the
attention of the market.
b. Growth
c. Maturity
Eventually, the growth in demand for the product will slow down and it will enter a period of
relative maturity. It will continue to be profitable. The product may be modified or improved, as a
means of sustaining its demand.
d. Saturation and decline
At some stage, the market may reach 'saturation point'. Demand will start to fall. For a while, the
product will still be profitable in spite of declining sales, but eventually it will become a loss-maker
and this is the time when the organisation should decide to stop selling the product or service, and
so the product's life cycle should reach its end.
Remember, however, that some mature products may never decline: staple food products such as
milk or bread are the best example.
Not all products follow this cycle, but it remains a useful tool when considering decisions such as
pricing. The life cycle concept is relevant when considering what pricing policy will be adopted.
3.2.2 MARKETS
The price that an organisation can charge for its products will also be influenced by the market in
which it operates.
Definitions
Perfect competition: many buyers and many sellers all dealing in an identical product. No individual
or group of sellers or buyers can influence the market price.
Monopoly: one seller who dominates many buyers. The monopolist can use this market power to set
a profit-maximising price.
Oligopoly: relatively few competitive companies dominate the market. While each large firm has the
ability to influence market prices, the unpredictable reaction from the other giants makes the final
industry price indeterminate.
3.2.3 COMPETITION
In established industries dominated by a few major firms, a price initiative by one firm will usually be
countered by a price reaction by competitors. In these circumstances, prices tend to be stable.
If a rival cuts its prices in the expectation of increasing its market share, a firm has several options:
a. It will maintain its existing prices if the expectation is that only a small market share would be lost,
so that it is more profitable to keep prices at their existing level. Eventually, the rival firm may drop
out of the market or be forced to raise its prices.
b. It may maintain its prices but respond with a non-price counter-attack. This is a more positive
response, because the firm will be securing or justifying its current prices with a product change,
advertising, or better back-up services.
c. It may reduce its prices. This should protect the firm's market share so that the main beneficiary
from the price reduction will be the consumer.
d. It may raise its prices and respond with a non-price counter-attack. The extra revenue from the higher
prices might be used to finance an advertising campaign or product design changes. A price increase
would be based on a campaign to emphasise the quality difference between the firm's own product
and the rival's product.
CHAPTER 11
The product gains a bigger market as demand builds up. Sales revenues increase and the product
begins to make a profit. The initial costs of the investment in the new product are gradually
recovered. However competitors enter the market, increasing competition, which can cause prices
to drop. Also additional investment in manufacturing capacity may be required to meet demand.
EXAMPLE
By market segment
A cross-Tasman airline would market its services at different prices in Australia and New
Zealand, for example. Services such as cinemas and hairdressers are often available at
lower prices to senior citizens and/or juveniles.
By product version
Many car models have 'add on' extras which enable one brand to appeal to a wider
cross-section of customers. The final price need not reflect the cost price of the add on
extras directly: usually the top of the range model would carry a price much in excess of
the cost of provision of the extras, as a prestige appeal.
By place
Theatre seats are usually sold according to their location so that patrons pay different
prices for the same performance according to the seat type they occupy.
By time
This is perhaps the most popular type of price discrimination. Railway companies, for
example, are successful price discriminators, charging more to rush hour rail
commuters whose demand remains the same whatever the price charged at certain
times of the day.
The price elasticity of demand () measures the extent of change in demand for a good following a
change to its price.
Formula to learn
Demand is said to be elastic when a small change in the price produces a large change in the quantity
demanded. The PED is then greater than 1. Demand is said to be inelastic when a small change in the
price produces only a small change in the quantity demanded. The PED is then less than 1.
There are two special values of price elasticity of demand:
Demand is perfectly inelastic ( = 0). There is no change in quantity demanded, regardless of the
change in price.
Demand is perfectly elastic ( = ). Consumers will want to buy an infinite amount, but only up to
a particular price level. Any price increase above this level will reduce demand to zero.
An awareness of the concept of elasticity can assist management with pricing decisions.
In circumstances of inelastic demand, prices should be increased because revenues will increase
and total costs will reduce (because quantities sold will reduce).
In circumstances of elastic demand, increases in prices will bring decreases in revenue and
decreases in price will bring increases in revenue. Management therefore have to decide whether
the increase/decrease in costs will be less than/greater than the increases/decreases in
revenue.
In situations of very elastic demand, overpricing can lead to a massive drop in quantity sold and
hence a massive drop in profits, whereas underpricing can lead to costly stock outs and, again, a
significant drop in profits. Elasticity must therefore be reduced by creating a customer
preference which is unrelated to price (through advertising and promotional activities).
In situations of very inelastic demand, customers are not sensitive to price. Quality, service,
product mix and location are therefore more important to a firm's pricing strategy.
CHAPTER 11
Economists argue that the higher the price of a good, the lower will be the quantity demanded. We
have already seen that in practice it is by no means as straightforward as this (some goods are bought
because they are expensive, for example), but you know from your personal experience as a consumer
that the theory is essentially true.
For example, a large transport authority might be considering an increase in bus fares or underground
fares. The effect on total revenues and profit of the increase in fares could be estimated from a
knowledge of the demand for transport services at different price levels. If an increase in the price per
ticket caused a large fall in demand, because demand was price elastic, total revenues and profits
would fall whereas a fares increase when demand is price inelastic would boost total revenue, and
since a transport authority's costs are largely fixed, this would probably boost total profits too.
Many businesses enjoy something akin to a monopoly position, even in a competitive market. This is
because they develop a unique marketing mix, for example, a unique combination of price and
quality. The significance of a monopoly situation is:
a. The business does not have to 'follow the market' on price. In other words it is not a 'price-taker',
but has more choice and flexibility in the prices it sets.
(i) At higher prices, demand for its products or services will be less.
(ii) At lower prices, demand for its products or services will be higher.
b. There will be a selling price at which the business can maximise its profits.
Where internal transfers of goods or services are made between different units of the same
business, management must decide on the appropriate price at which such transfers should be
charged.
Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the
divisional performance measurement or discouraging overall profit maximisation.
Definition
A transfer price is the price at which goods or services are transferred between different units of the
same company. The extent to which the transfer price covers costs and contributes to (internal) profit
is a matter of policy.
When there are transfers of goods or services between divisions, the transfers could be made free to
the division receiving the benefits. For example, if a garage and car showroom has two divisions, one
for car repairs and servicing and the other for car sales, the servicing division will be required to
service cars before they are sold. The servicing division could do the work without making any record
of the work done. However, unless the cost or value of such work is recorded, management cannot
keep a check on the amount of resources, such as time, that has been required for new car servicing.
For planning and control purposes, it is necessary that some record of inter-divisional services or
transfers of goods should be kept.
Inter-divisional work can be given a cost or charge, and this is its transfer price. The transfer price is
revenue to the division providing the goods or service, and a cost to the division receiving the benefit.
CHAPTER 11
Section overview
Suppose that profit centre A supplies goods to profit centre B, and the cost to profit centre A is, say,
$10 000. Any price in excess of $10 000 will result in a profit for profit centre A. Now suppose that
profit centre B then re-sells the goods for $18 000 without doing any further work on them.
a. The total profit to the company is $8 000 ($18 000 $10 000).
b. If the price charged by profit centre A to profit centre B is $12,000, profit centre A will make a profit
of $2 000 ($12 000 $10 000) and profit centre B will make a profit of $6 000
($18 000 $12 000).
c. If the price charged by profit centre A to profit centre B is $17 000, profit centre A will make a profit
of $7 000 ($17 000 $10 000) and profit centre B will make a profit of $1 000 ($18 000 $17 000).
The overall profit is the same, whatever price profit centre A charges to profit centre B, but the price
charged affects the share of the total profit enjoyed by each profit centre.
The purpose of having a profit centre organisation is to provide an incentive for improving profitability
within each part of the organisation. However, setting prices for work done by one profit centre for
another is a potential source of disagreement, since one profit centre can improve its profits at the
expense of another, by charging higher prices.
In theory since the transfer price represents a cost to one party and income to the other, overall
corporate profits should be the same regardless of the transfer price. In practice however, the transfer
pricing policy has behavioural implications, which may cause managers to take decisions in the
interests of their profit centre but which reduce the profits of the organisation as a whole. For
example, if profit centre A charges $18 000 or more, B will not be encouraged to take the transfer
despite it being worthwhile for the company as a whole. This will lead to unused capacity.
JIT aims for zero inventory and perfect quality and operates by demand-pull. It consists of JIT
purchasing and JIT production and results in lower investment requirements, space savings,
greater customer satisfaction and increased flexibility.
JIT aims to eliminate all non-value-added costs.
Inventory costs include purchase costs, holding costs, ordering costs and costs of running out
inventory.
Inventory control levels can be calculated in order to maintain inventories at the optimum level.
The three critical control levels are reorder level, minimum level and maximum level.
The economic order quantity (EOQ) is the order quantity which minimises inventory costs.
The EOQ can be calculated using a table, graph or formula.
There are a number of other systems of stores control and reordering, such as order cycling, twobin, classification and Pareto distribution.
Under the order cycling method, quantities on hand of each stores item are reviewed
periodically.
The two-bin system of stores control, or visual method of control, is one whereby each stores
item is kept in two storage bins.
Materials items may be classified as expensive, inexpensive or in a middle-cost range.
Pareto (80/20) distribution which is based on the finding that in many stores, 80% of the value of
stores is accounted for by only 20% of the stores items.
Many firms base price on simple cost-plus rules.
Full cost-plus pricing is a method of determining the sales price by calculating the full cost of
the product and adding a percentage mark-up for profit.
Marginal cost-plus pricing/mark-up pricing is a method of determining the sales price by
adding a profit margin on to either marginal cost of production or marginal cost of sales.
Many firms base price on what consumers demand rather than simple cost-plus rules.
Target costing requires managers to change the way they think about the relationship between
cost, price and profit. The traditional approach is to develop a product, determine the expected
standard production cost of that product and then set a selling price (probably based on cost), with
a resulting profit or loss.
The target costing approach is to develop a product concept and then to determine the price
customers would be willing to pay for that concept. The desired profit margin is deducted from the
price, leaving a figure that represents total cost. This is the target cost.
Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the
divisional performance measurement or discouraging overall corporate profit maximisation.
Transfer prices may be based on market price where there is an external market.
CHAPTER 11
I, II and III
I and II only
I and III only
II and III only
3 A company determines its order quantity for a raw material by using the Economic Order Quantity
(EOQ) model.
What would be the effects on the EOQ and the total annual holding cost of a decrease in the cost
of ordering a batch of raw material?
A
B
C
D
EOQ
Higher
Higher
Lower
Lower
Introduction
Growth
Saturation and decline
It could be any of these
I only
II only
I and II
Neither I nor II
1 C Features of JIT production systems are shorter production runs, more preventive maintenance
work (to prevent production hold-ups) and less movement of materials within the production
area (with production based around work cells). The organisation produces only to meet known
customer demand.
2 A To take advantage of bulk purchase discounts, it may be necessary to buy larger quantities, but
the cost of holding more inventory is justified by the saving in purchase costs. When sales
demand is seasonal, a manufacturer may schedule even production flows through the year (to
reduce overtime costs, avoid excessive production capacity, etc) and this means building up
inventories during the low sales seasons. When the production process is long, for example in
wine-making, it is necessary to hold large quantities of work-in-progress.
3 C If there is a decrease in the cost of ordering a batch of raw material, then the EOQ will also be
lower (as the numerator in the EOQ equation will be lower). If the EOQ is lower, then average
inventory held (EOQ/2) with also be lower and therefore the total annual holding costs will also
be lower.
4 C Market skimming pricing is appropriate when customers will pay high prices to own a new
product. Cost plus pricing cannot ensure maximum profits, because profitability depends on
sales demand. Marginal cost plus pricing is more appropriate when marginal costs are a large
proportion of total costs, for example in retailing. For differential pricing to succeed, it must be
possible to keep the different price markets segregated: for example separate prices for
children and people over 70. Unless the markets can be kept segregated, customers will buy in
the lower-priced market and re-sell in the higher-priced market, or will move to the lower-priced
market to buy the product or service.
5 D Net profits are revenues minus costs. In the introductory stage, high prices can be charged, but
fixed costs may be high and development costs may be charged against profits. In the growth
phase, sales volume is rising, but prices are falling and additional capital investment may add to
total costs. In the saturation and decline phase, sales volumes and probably also prices are
falling, and losses may be incurred. So for a given product, any of these phases of the life cycle
could be the least profitable.
6 D Negotiated transfer prices may result in maximum profit and market-based transfer prices may
encourage internal transfers, but not 'always'.
CHAPTER 11
= minimum level
= reorder level (average usage average lead time)
= 6 300 (350 13) = 1 750
Option A could again be easily eliminated. With minimum usage of 180 per day, a buffer
inventory of only 200 would not be much of a buffer!
5 A Average inventory = safety inventory + reorder quantity
= 500 + (0.5 3 000)
= 2 000
6 C [Buffer inventory + (EOQ/2)] Annual holding cost per component
= [500 + (2 000/2)] $2
= $3 000
$7.99 ($4.70 170%)
7
8 B
Selling price
Marginal (variable) cost (5 + 3 + 7 + 2)
Mark up =
Profit
100%
Marginal cost
3
100%
17
= 17.6%
=
Note that the fixed overheads are not included in marginal cost.
$
20
17
323
CHAPTER 12
PERFORMANCE
MEASUREMENT AND
EVALUATION
Learning objectives
Reference
LO12
LO12.1
Analyse the different types of financial performance measures and their limitations
LO12.2
Describe the key characteristics of the Balanced Scorecard and its advantages over
traditional performance measurement systems
LO12.3
Outline the characteristics of reward systems and the circumstances in which they can
be tied to performance measures
LO12.4
LO1
Identify and explain appropriate internal controls for management and accounting
systems in a range of situations
LO1.8
Topic list
1
2
3
4
5
6
Responsibility centres
Investigating variances
Control action
Performance measures
The balanced scorecard
Reward systems
INTRODUCTION
In Chapter 9 we learnt the mechanics of calculating variances and preparing operating statements.
But, for the purposes of operating a budgetary control system, this is not the end of the matter. The
information must be given to the people responsible for the parts of the organisation that are
experiencing variances, so that they can take action to bring the situation under control. A system
which gives this responsibility to managers is known as responsibility accounting.
Variances provide one way of highlighting a possible problem area to managers, and are therefore a
type of performance indicator. We will have a look at other performance indicators, which can be used
to monitor the performance of individual departments in the organisation and the organisation as a
whole.
The chapter then moves on to a discussion about the key characteristics of the balanced scorecard
and its advantages over traditional performance measurement systems.
Finally, we consider reward systems.
The chapter content is summarised in the diagram below.
Performance
measurement
and evaluation
Responsibility
centres
Investigating
variances
Performance
measures
Control action
Balanced
scorecard
Reward
systems
(Section 1)
3 Explain the concept of interdependence between variances and why this is relevant when
considering control action.
(Section 3)
4 Give examples of performance measures.
(Section 4.1)
(Section 4.4.3)
(Section 4.10)
(Section 5.1)
(Section 5.2)
(Section 6)
CHAPTER 12
2 What factors should be considered when deciding whether or not to investigate the reasons for the
occurrence of a particular variance?
(Section 2)
1 RESPONSIBILITY CENTRES
Section overview
Responsibility accounting is a system of accounting that segregates revenue and costs into
areas of personal responsibility to monitor and assess the performance of each part of an
organisation.
A responsibility centre is a function or department of an organisation that is headed by a
manager who has direct responsibility for its performance.
There are a number of different bases for control:
A cost centre is any unit of an organisation to which costs can be separately attributed.
A profit centre is any unit of an organisation to which both revenues and costs are
assigned, so that the profitability of the unit may be measured.
An investment centre is a profit centre whose performance is measured by its return on
capital employed.
Definitions
Responsibility accounting is a system of accounting that makes revenues, costs and assets the
responsibility of particular managers so that the performance of each part of the organisation can be
monitored and assessed. It is the accounting system that measures the performance of managers
against their budgets.
A responsibility centre is a section of an organisation that is headed by a manager who has direct
responsibility for its performance.
LO
12.1
A budget will be prepared for each responsibility centre, and its manager will be responsible for
achieving the budget targets of that centre. The performance of the centre will be monitored, and the
manger will be expected to take appropriate action if there are significant variances or other targets
are not met.
Responsibility centres are usually divided into different categories. Here we shall describe cost
(expense), revenue, profit and investment centres.
Cost centres can be quite small, sometimes one person or one machine or one expenditure item.
They can also be quite big, for example, an entire department. An organisation might establish a
hierarchy of cost centres. For example, within a transport department, individual vehicles might each
be made a cost centre, the repairs and maintenance section might be a cost centre, there might be
cost centres for expenditure items such as rent or building depreciation on the vehicle depots, vehicle
insurance and road tax. The transport department as a whole might be a cost centre at the top of this
hierarchy of sub-cost centres.
To charge actual costs to a cost centre, each cost centre will have a cost code, and items of
expenditure will be recorded with the appropriate cost code. When costs are eventually analysed,
there may be some apportionment of the costs of one cost centre to other cost centres.
Information about cost centres might be collected in terms of total actual costs, total budgeted
costs and total cost variances. In addition, the information might be analysed in terms of ratios, such
as cost per unit produced (budget and actual), hours per unit produced (budget and actual) and
transport costs per tonne/ kilometre (budget and actual).
Profit centres differ from cost centres in that they account for both costs and revenues. The key
performance measure of a profit centre is therefore profit. The manager of the profit centre must be
able to influence both revenues and costs, in other words, have a say in both sales and production
policies.
A profit centre manager is likely to be a fairly senior person within an organisation, and a profit centre
is likely to cover quite a large area of operations. A profit centre might be an entire division within the
organisation, or there might be a separate profit centre for each product, brand or service or each
geographical selling area. Information requirements need to be similarly focused.
In the hierarchy of responsibility centres within an organisation, there are likely to be several cost
centres within a profit centre.
Several profit centres might share the same capital items, for example, the same buildings, stores or
transport fleet, and so investment centres are likely to include several profit centres, and provide a
basis for control at a very senior management level, like that of a subsidiary company within a group.
The performance of an investment centre is measured by the return on capital employed. It shows
how well the investment centre manager has used the resources under their control to generate profit.
CHAPTER 12
The term 'revenue centre' is often used in non-profit-making organisations. Revenue centres are
similar to cost centres, except that whereas cost centres are for costs only, revenue centres are for
recording revenues only. Information collection and reporting could be based on a comparison of
budgeted and actual revenues earned by that centre.
2 INVESTIGATING VARIANCES
Section overview
Materiality, controllability and variance trend should be considered before a decision about
whether to investigate a variance is taken.
One way of deciding whether to investigate a variance is to only investigate those variances
which exceed pre-set tolerance limits.
2.1 MATERIALITY
Small variations in a single period between actual and standard are bound to occur and are unlikely to
be significant. Obtaining an 'explanation' of the reasons why they occurred is likely to be timeconsuming and irritating for the manager concerned. For such variations further investigation is not
worthwhile.
Management will only want to spend time investigating meaningful or material variances. A variance is
material or significant if it is likely to influence the actions and decisions of management. An
assessment of materiality may be linked to the size, relative amount and nature of the variance. e.g. a
50% saving in sundry costs which total less than $500 (a favourable variance of $250) may not be
material for a large company, but the cause of a 10% increase in capital expenditure compared to the
budget of $10million (an unfavourable variance of $1 million) would need to be investigated. One
approach is to set tolerance limits and investigate the cause of variances which fall outside these
limits.
2.2 CONTROLLABILITY
Managers of responsibility centres should only be held responsible for costs over which they have
some control. These are known as controllable costs - items of expenditure which can be directly
influenced by a given manager within a given time span.
If there is a general worldwide price increase in the price of an important raw material there is nothing
that can be done internally to control the effect of this. If a central decision is made to award all
employees a 10% increase in salary, staff costs in division A will increase by this amount and the
variance is not controllable by division A's manager. Uncontrollable variances call for a change in the
standard, not an investigation into the past.
a. If a labour efficiency variance is $1 000 unfavourable in month 1, this could indicate that the
production process is out of control and that corrective action must be taken to improve
productivity. This may be correct, but what if the same variance is $1 000 unfavourable every
month? The trend may indicate that the process is in control but that the standard has been
wrongly set. The unfavourable labour efficiency variance may reflect an ongoing operational
decision to use lower skilled labour which might otherwise have been idle. Alternatively it could
reflect the purchasing department's decision to acquire cheaper but lower quality material which is
proving more time-consuming to work with.
b. Suppose, though, that the same labour efficiency variance is consistently $1 000 unfavourable for
each of the first six months of the year but that production has steadily fallen from 100 units in
month 1 to 65 units by month 6. The variance trend in absolute terms is constant, but relative to the
number of units produced, labour efficiency has got steadily worse. Hence an investigation into the
cause of the inefficiency and the decline in production is almost certainly required, in order for
corrective action to be taken.
Individual variances should therefore not be looked at in isolation; variances should be scrutinised
for a number of successive periods if their full significance is to be appreciated.
Variances also need to be considered in the light of the type of standards being used, cost drivers for
the relevant expenditure, any known operational decisions and the interdependence between
variances. The possible causes of variances were examined in more detail in Chapter 9.
Question 2: Variance trend information
Which of the following trends in variances might indicate a learning curve effect?
A
B
C
D
CHAPTER 12
Although small variations in a single period are unlikely to be significant, small variations that occur
consistently may need more attention. Variance trend is more important than a single set of variances
for one accounting period. The trend provides an indication of whether the variance is fluctuating
within acceptable control limits or becoming out of control.
Control limit
Adverse
*Notify as an exception
There are several ways of establishing control limits:
Management might establish a rule that any variance should be deemed significant if it exceeds a
certain percentage of standard, for example, if it exceeds 10% of standard in any one period based
on judgment or experience.
Management can use statistics, and estimate not only the standard cost, but the expected
standard deviation, a measure of the spread or dispersion, of actual costs around the standard.
Variances would then be deemed significant if actual costs were significantly different from
standard.
Not all variances which are outside the control limits require detailed investigation. Often the cause is
already known. A variance will only be investigated if the expected value of benefits from investigation
and any control action exceed the costs of investigation.
For example, it may be known from past experience that the cost of investigating a particular variance
is $150 and that cost savings amounting to $1 200 can be made if the variance is corrected
successfully. However it is also known that there is only a 30% possibility of the variance being
corrected once the cause is found.
Expected value of an investigation = ($1 200 0.3) $150 = $210
In this particular case it is worth investigating the variance.
Question 3: Jefferson Ltd
Every month for the past eight months, the operating statement of Jefferson Ltd has shown an
unfavourable direct material efficiency variance of between $1 500 and $2 500 relating to a product
that is only to be produced for a further six months. The company management accountant believes
that if the variance is investigated, there is a 70% chance that its cause can be eliminated. The cost of
the investigation to find out the cause of the variance would be $2 000 and the expected cost of
corrective action, if the cause is found to be controllable, would be an additional $5 000.
What is the best estimate of the net benefit from investigating the cause of this variance?
A
$1 400
B
$2 000
C
$2 500
D
$2 900
(The answer is at the end of the chapter)
The variance in each period is added to the total of the variances that have occurred over a longer
period of time. If the variances are not significant, the total will simply fluctuate in a random way above
and below the average (favourable and unfavourable variances), to give an insignificant total or
cumulative sum. If the cumulative sum develops a positive or negative drift, it may exceed a set
tolerance limit. Then the situation must be investigated, and control action will probably be required.
The cumulative sum of variances over a period of time can be shown on a cusum chart.
The advantage of the multiple period approach is that trends are detectable earlier, and control
action can be introduced sooner than might have been the case if only current-period variances were
investigated.
3 CONTROL ACTION
Section overview
If a variance is assessed as significant then the responsible manager may need to take
control action.
If the cause of a variance is controllable, action can be taken to bring the system back
under control in future. If the variance is uncontrollable, but not simply due to chance, it will
be necessary to review forecasts of expected results, and perhaps to revise the budget.
LO
1.8
Since a variance compares historical actual costs with standard costs, it is a statement of what has
gone wrong (or right) in the past. By taking control action, managers can do nothing about the past,
but they can use their analysis of past results to identify where the 'system' is out of control. If the
cause of the variance is controllable, action can be taken to bring the system back under control in
future. If the variance is uncontrollable, on the other hand, but not simply due to chance, it will be
necessary to revise forecasts of expected results, and perhaps to revise the budget.
It may be possible for control action to restore actual results back on course to achieve the original
budget. For example, if there is an unfavourable labour efficiency variance in month 1 of 1 100 hours,
control action by the production department might succeed in increasing efficiency above standard
by 100 hours per month for the next 11 months.
CHAPTER 12
Another approach is to look at the variances over a number of accounting periods, instead of just
looking at variances in a single period.
It is also possible that control action might succeed in restoring better order to a situation, but the
improvements might not be sufficient to enable the company to achieve its original budget. For
example, if for three months there has been an unfavourable labour efficiency in a production
department, so that the cost per unit of output was $8 instead of a standard cost of $5, then control
action might succeed in improving efficiency, so that unit costs are reduced to $7, $6 or even $5, but
the earlier excess spending means that the profit in the master budget will not be achieved.
Depending on the situation and the control action taken, the action may take immediate effect, or it
may take several weeks or months to implement. The effect of control action might be short-lived,
lasting for only one control period; but it is more likely to be implemented with the aim of long-term
improvement.
b. Similarly, if employees used to do some work are highly experienced, they may be paid a higher
rate than the standard wage per hour, but they should do the work more efficiently than
employees of 'average' skill. In other words, an unfavourable rate variance may be compensated by
a favourable efficiency variance.
c. An unfavourable efficiency variance may be reported following the purchase of cheaper material
(favourable material price variance) because operatives find difficulty in processing the cheaper
material.
d. A rise in selling price very often leads to a fall in the volume of goods sold, so sales price and
volume variances can be interdependent.
Question 4: Variance report
VARIANCE REPORT: SEPTEMBER 20X5
Material
Usage
Price
Labour
Efficiency
Rate
Fixed production overhead
Expenditure
Volume
Variance
(Favourable)
$
Total
variance
$
2 000
5 500
3 500
1 500
3 000
1 500
500
4 500
5 000
$
100 000
80 000
75 000
255 000
The fixed overhead expenditure variance could be caused by some expenditures being
deferred to a later month.
The total unfavourable variance of $4 000 is just 1.57% of total costs; therefore the variances do
not justify investigation.
The fixed overhead volume variance indicates that the production operation worked at above
budgeted capacity during the period.
The materials usage variance and materials price variance are interdependent; and the two
components of the materials variance therefore do not justify separate investigation.
4 PERFORMANCE MEASURES
Section overview
Performance measurement aims to establish how well something or somebody is doing in
relation to a planned activity.
Ratio and percentages are useful performance measurement techniques.
CHAPTER 12
Variance
(Unfavourable)
$
LO
12.1
The process of performance measurement is carried out using a variety of performance indicators,
which are individual measurements. We look at performance indicators in general below before
moving on to look at performance indicators derived from the statements of income and financial
position. As well as being of use to management, parties external to the organisation can use these as
a guide to how well the organisation is performing.
The direct labour efficiency variance, which could identify problems with labour productivity.
Distribution costs as a percentage of turnover, which could help with the control of costs.
Number of hours during which labour are idle, which could indicate how well resources are being
used.
Profit as a percentage of turnover, which could highlight how well the organisation is being
managed.
Number of units returned by customers, which could help with planning production and finished
inventory levels.
Given this wide range of uses, you should be able to appreciate the importance of performance
indictors and their value to managers in allowing them to see where improvements in organisational
performance can be made.
A performance indicator is only useful if it is given meaning in relation to something else. Here is a list
of yardsticks against which indicators can be compared so as to become useful.
The results of other parts of the organisation. Large manufacturing companies may compare the
results of their various production departments, supermarket chains will compare the results of
their individual stores, while a college may compare pass rates in different departments.
The results of other organisations. For example, trade associations or the government may
provide details of key indicators based on averages for the industry.
As with all comparisons, it is vital that the performance measurement process compares 'like with
like'. There is little to be gained in comparing the results of a small supermarket in a high street with a
huge one in an out-of-town shopping complex. We return to the importance of consistency in
comparisons later in this chapter.
Consider the statement 'Seven out of ten customers think our beds are very comfortable'. This is a
quantitative measure of customer satisfaction as well as a qualitative measure of the perceived
performance of the beds. (But it does not mean that only 70% of the total beds produced are
comfortable, nor that each bed is 70% comfortable and 30% uncomfortable: 'very' is the measure of
comfort.)
May
$128 600
12 000
June
$143 200
13 500
$128 600
$143 200
12 000
= $10.72
13 500
$10.61
CHAPTER 12
Qualitative measures are by nature subjective and judgmental but this does not mean that they are
not valuable. They are especially valuable when they are derived from several different sources.
4.4.3 INDICES
Indices can be used in order to measure activity.
Indices show how a particular variable has changed relative to a base value. The base value is
usually the level of the variable at an earlier date. The 'variable' may be just one particular item, such
as material X, or several items may be incorporated, such as 'raw materials' generally.
In its simplest form an index is calculated as (current value base value) 100%.
Therefore if materials cost $15 per kg in 20X0 and now (20X3) cost $27 per kg the 20X0 value would be
expressed in index form as 100 (15/15 100) and the 20X3 value as 180 (27/15 100). If you find it
easier to think of this as a percentage, then do so. The current cost is 180% of the base cost.
Worked Example: Work standards and indices
Standards for work done in a service department could be expressed as an index. The budget forms
the base value. For example, suppose that in a sales department, there is a standard target for sales
representatives to make 25 customer visits per month each. The budget for May might be for ten sales
representatives to make 250 customer visits in total. Actual results in May might be that nine sales
representatives made 234 visits in total. Performance could then be measured as:
Budget
Actual
100
104
This shows that 'productivity' per sales representative was actually 4% over budget.
The profit margin provides a simple measure of performance for profit centres. Investigation of
unsatisfactory profit margins enables control action to be taken, either by reducing excessive costs or
by raising selling prices.
Profit
Year 1
$
120 000
40 000
40 000
22 000
42 000
144 000
20 000
30 000
20 000
35 000
105 000
16 000
15 000
16 000
100%
160 000
15 000
100%
120 000
10%
12%
The above information shows that there is a decline in profitability in spite of the $1 000 increase in
profit, because the profit margin is less in year 2 than year 1.
16 000 42 000
Year 1:
100% = 36.25%
160 000
15 000 35 000
Year 2:
100% = 41.67%
120 000
CHAPTER 12
Sales revenue
Cost of sales
Direct materials
Direct labour
Production overhead
Marketing overhead
Year 2
$
160 000
Look back to the previous example. A more detailed analysis would show that higher direct materials
are the probable cause of the decline in profitability.
Year 2
40 000
100%
160 000
Year 1
25%
20 000
100%
120 000
16.7%
Question 5: Margin
Use the following summary income statement to answer the questions below.
Sales revenue
Cost of sales
Selling and distribution expenses
Administrative expenses
Operating profit
$
3 000
1 800
1 200
300
200
700
Calculate
(a) the profit margin.
(b) the gross profit margin.
(The answer is at the end of the chapter)
4.7 RESOURCES
Traditional measures for materials compare actual costs with expected costs, looking at differences
(or variances) in price and usage. Many traditional systems also analyse wastage. Measures used in
modern manufacturing environments include the number of rejects in materials supplied, and the
timing and reliability of deliveries of materials.
Labour costs are traditionally measured in terms of standard performance (such as ideal or attainable)
and rate and efficiency variances.
Qualitative measures of labour performance concentrate on matters such as ability to communicate,
interpersonal relationships with colleagues, customers' impressions and levels of skills attained.
Managers can expect to be judged to some extent by the performance of their staff. High profitability
or tight cost control are not the only indicators of managerial performance!
For variable overheads, differences between actual and budgeted costs, i.e. variances, are traditional
measures. Various time based measures are also available, such as:
a. Machine down time: total machine hours. This ratio provides a measure of machine usage and
efficiency.
b. Value added time: production cycle time. Value added time is the direct production time during
which the product is being made. The production cycle time includes non-value-added times such
as set-up time, downtime, idle time and so on. The 'perfect' ratio is 100%, but in practice this
optimum will not be achieved. A high ratio means non-value-added activities are being kept to a
minimum.
Plates
Mugs
Eggcups
Quarter 2
800
1 500
900
The fact that 3 000 products were produced in quarter 1 and 3 200 in quarter 2 does not tell us
anything about Sam Ltd's performance over the two periods because plates, mugs and eggcups are
so different. The fact that the production mix has changed is not revealed by considering the total
number of units produced. The problem of how to measure output when a number of dissimilar
products are manufactured can be overcome, however, by the use of the standard hour.
The standard hour (or standard minute) is the quantity of work achievable at standard
performance, expressed in terms of a standard unit of work done in a standard period of time.
Standard time
1
/2 hour
1
/3 hour
1
/2 hour
Plate
Mug
Eggcup
By measuring the standard hours of output in each quarter, a more useful output measure is obtained:
Product
Plate
Mug
Eggcup
Standard hours
per unit
1/2
1/3
1/4 hour
Quarter 1
Standard
Production
hours
1 000
500
1 200
400
200
800
1 100
Quarter 2
Standard
Production
Hours
800
400
1 500
500
225
900
1 125
The output level in the two quarters was therefore very similar.
Given the following information about Sam Ltd for quarter 1 of 20X5, calculate a capacity ratio, an
activity ratio and an efficiency ratio and explain their meaning.
Budgeted hours
Standard hours produced
Actual hours worked
CHAPTER 12
The standard time allowed to produce one unit of each of Sam Ltd's products is as follows:
Solution
Capacity ratio =
Activity ratio =
The overall activity or production volume for the quarter was 2% greater than forecast. This was
achieved by a 9% increase in capacity.
Efficiency ratio =
If
what is
Z
?
Y
A Capacity ratio
B Activity ratio
C Efficiency ratio
D Standard hours produced ratio
(The answer is at the end of the chapter)
Return on investment (ROI), also called Return on capital employed (ROCE), is calculated as (profit
before interest and tax/capital employed) 100% and shows how much profit has been made in
relation to the amount of resources invested.
ROI is generally used for measuring the performance of investment centres; profits alone do not
show whether the return is sufficient when different values of assets are used. Therefore if company A
and company B have the following results, company B would have the better performance.
Profit
Sales revenue
Capital employed
ROI
A
$
5 000
100 000
50 000
10%
B
$
5 000
100 000
25,000
20%
The profit of each company is the same but company B only invested $25 000 to achieve that profit
whereas company A invested $50 000.
ROI may be calculated in a number of ways, but profit before interest and tax is usually used.
Similarly all assets of a non-operational nature, for example, trade investments and intangible assets
such as goodwill, should be excluded from capital employed.
Profits should be related to average capital employed. In practice, many companies calculate the ratio
using year-end assets. This can be misleading. If a new investment is undertaken near to the year end,
the capital employed will rise but profits will only have a month or two of the new investment's
contribution.
What does the ROI tell us? What should we be looking for? There are two principal comparisons that
can be made:
Residual income (RI)is 'Pre-tax profits less a notional interest charge for invested capital'.
A division with average capital employed of $400 000 currently earns a ROI of 22%. It expects this
average investment and ROI to continue next year for its current operations. It has decided to make
an additional investment of $50 000 at the beginning of the year in a new operation generating an
annual net profit of $12 000 after depreciation of $4 000 on the capital equipment. A notional interest
charge amounting to 15% of the average capital invested is to be charged to the division each year.
What is the expected residual income of the division in the first year of the new investment?
A
B
C
D
28 500
28 800
32 500
32 800
5.1 INTRODUCTION
LO
12.3
So far in our discussion we have focused on performance measurement and control from a financial
point of view. Another approach, originally developed by Kaplan and Norton, is the use of what is
called a 'balanced scorecard' consisting of a variety of indicators, both financial and non-financial.
CHAPTER 12
Definition
Definition
QUESTION
EXPLANATION
Financial
Customer
Internal
Learning and
growth
Performance targets are set once the key areas for improvement have been identified, and the
balanced scorecard is the main monthly report.
The scorecard is 'balanced' in the sense that managers are required to think in terms of all four
perspectives, to prevent improvements being made in one area at the expense of another.
The types of measure which may be monitored under each of the four perspectives include the
following. The list is not exhaustive but it will give you an idea of the possible scope of a balanced
scorecard approach. The measures selected, particularly within the internal perspective, will vary
considerably with the type of organisation and its objectives.
PERSPECTIVE
MEASURES
Financial
Revenue growth
Earnings per share
Customer
On-time deliveries
Returns
Internal
Speed of producing
management information
Broadbent and Cullen (in Berry, Broadbent and Otley, eds, Management Control, 1995) identify the
following important features of this approach:
The balanced scorecard approach may be particularly useful for performance measurement in
organisations which are unable to use simple profit as a performance measure. For example, the
public sector has long been forced to use a wide range of performance indicators, which can be
formalised with a balanced scorecard approach.
5.2 PROBLEMS
PROBLEM
EXPLANATION
Conflicting measures
Selecting measures
Interpretation
6 REWARD SYSTEMS
Section overview
Employment is an economic relationship: labour is exchanged for reward. Extrinsic rewards
derive from job context and include remuneration and benefits. Intrinsic rewards derive
from job content and satisfy higher level needs. reward interacts with many other aspects of
the organisation. Reward policy must recognise these interactions, the economic
relationship and the psychological contract.
LO
12.4
Reward is 'all of the monetary, non-monetary and psychological payments that an organisation
provides for its employees in exchange for the work they perform'.
(Bratton)
CHAPTER 12
CHAPTER 12
Performance-related remuneration takes many forms, including commission, merit remuneration and
piecework remuneration. In addition to bonus plans tied to short-term performance measures, a
company may also offer executive incentive plans linked to longer term financial performance and
shareholder returns. These will often consist of shares and/or share options.
Controllable costs are items of expenditure which can be directly influenced by a given manager
within a given time span.
Materiality, controllability and variance trend should be considered before a decision about
whether to investigate a variance is taken.
One way of deciding whether to investigate a variance is to only investigate those variances which
exceed pre-set tolerance limits.
Control limits may be illustrated on a control chart.
If the cause of a variance is controllable, action can be taken to bring the system back under
control in future. If the variance is uncontrollable, but not simply due to chance, it will be necessary
to review forecasts of expected results, and perhaps to revise the budget.
Performance measurement aims to establish how well something or somebody is doing in relation
to a planned activity.
Ratios and percentages are useful performance measurement techniques.
The profit margin (profit to sales ratio) is calculated as (profit sales revenue) 100%.
The gross profit margin is calculated as gross profit sales revenue 100%.
Return on investment (ROI) or return on capital employed (ROCE) shows how much profit has
been made in relation to the amount of resources invested.
Residual income (RI) is an alternative way of measuring the performance of an investment
centre. It is a measure of the centre's profits after deducting a notional or imputed interest cost.
a cost centre.
a profit centre.
a revenue centre.
an investment centre.
A
B
C
D
I only
II only
I and II
Neither statement
Theft of materials
Change in type of services used
Unexpected slump in sales demand
Direct labour inefficiency, taking longer than the standard time to do work
5 Which one of the following is the least appropriate performance measure for a revenue centre?
A
B
C
D
Profitability
Customer satisfaction
Speed of customer service
% of customer deliveries on time
efficiency ratio.
standard hours.
value added time.
cost/sales revenue ratio.
CHAPTER 12
5 200
5 600
5 800
96.6%
103.6%
107.7%
111.5%
8 In calculating the ROI for an investment centre, the most commonly-used measure of return is
A
B
C
D
9 The four perspectives of performance using the balanced scorecard are financial, customer,
internal and
A
B
C
D
external.
value chain.
competitive.
learning and growth.
4 B A change in the type of services used will change spending patterns, and this could mean
unfavourable spending variances. Labour inefficiency will cause efficiency variances. Material
theft will result in a usage variance when a shortfall in materials is discovered. An unexpected
slump in sales demand will cause a sales volume variance.
5 A Profitability is an inappropriate performance measure for a revenue centre since it is only able
to control revenue.
6 B A common basis for measuring the volume of output of different products is standard hours.
7 C
Standard hours
produced
Budgeted hours
5 600
100%
= 107.7%
5 200
8 C In calculating the ROI for an investment centre, the most commonly-used measure of return is
profit before interest and tax
9 D The four perspectives of performance using the balanced scorecard are financial, customer,
internal and learning and growth
CHAPTER 12
3 B The significance of a variance can be assessed initially by means of its size relative to the actual
costs incurred. A large variance in one month should be investigated, even when there have
been no significant variances in the past, because it is important to find out what the reasons for
the variance are and to try to ensure that it does not happen again. A cusum chart shows
cumulative variances over time, not the variances each month.
$
2 000
3 500
5 500
8 400
2 900
A more cautious estimate would be to assume minimum monthly savings of $1 500 rather than
$2 000 if the cause is controllable, This would reduce the expected value of benefit by (70% 6
months $500) $2 100 to just $800. However this was not one of the answer options.
4 A Note that the cause of the favourable expenditure variance, which represents 6% of the total
overhead costs for the month, should be encouraged if it is a genuine reduction in costs.
However some fixed overhead costs may simply slip from one month to the next, so
expenditure variances cannot be judged on the basis of one month's figures alone.
Option B: The purpose of analysing variances into sub-variances is to enable each separate
sub-variance to be investigated if its seems significantly large. The total variance may only be
1.57% of total costs but this total disguises a number of significant unfavourable and favourable
variances which need investigating.
Option C: The unfavourable fixed overhead volume variance is more likely to indicate that the
production operation worked at below budgeted capacity during the period, because the
unfavourable variance indicates under-absorption of fixed overheads.
Option D: Similarly, the materials price and usage variance should be considered separately,
even though the fact that there is a favourable price variance and an unfavourable usage
variance could indicate interdependence between them. The purchasing department may have
bought cheap materials but these cheaper materials may have been more difficult to work with
so that more material was required per unit produced. The possibility of such an
interdependence should be investigated. Whether or not there is an interdependence, both
variances do require investigation since they represent 5.5% (usage) and 3.5% (price) of the
actual material cost for the month.
5 (a)
700
100% = 23%
3 000
The profit margin usually refers to operating profit/sales revenue.
(b)
1200
100% = 40%
3 000
The gross profit margin is the gross profit/sales revenue ratio.
verage capital
Original investment: assume no change
New investment: 50% of (50 000 + 46 000)
Average capital employed
Notional interest (448 000 0.15)
Residual income
$
100 000
400 000
48 000
448 000
67 200
32 800
Note: Depreciation on the new investment will be $4 000 therefore the average investment for
the year is half-way between the initial investment of $50 000 and the year-end net book value
of $46 000.
CHAPTER 12
353
REVISION QUESTIONS
CHAPTER 1
1 Possum Ltd is now engaged solely in a service industry having previously been involved in
manufacturing. Its chief accountant is considering which of the following management accounting
processes the company needs to retain:
I Capacity planning
II Inventory valuation
III Production planning
IV Workforce planning
A
B
C
D
IV only
I and III only
II and III only
II and IV only
I only
III only
I and II only
II and III only
4 Which of the following statements about cost and management accounting are true?
I
II
III
IV
A
B
C
D
I and II only
I and IV only
II and III only
III and IV only
7 Wateraid is a charity providing relief for victims of drought in Africa. A fund-raising brochure
produced by the charity contains the following statement: 'Wateraid aspires to be the largest
charitable provider of clean water services for Africa.' The statement is an example of the charity's
A vision.
B mission.
C strategy.
D objective.
8 Genzyme Ltd operates its business in four geographical regions. The sales director has decided
that the company needs to increase its market share in the next five years and as a result has
decided to establish a sales quota for next year which is to be achieved by each of the regions. The
setting of a quarterly sales target for each sales representative is an example of
A a tactical plan.
B a strategic plan.
C an operational plan.
D a management control plan.
CHAPTER 2
1 A machine which originally cost $12 000 has an estimated life of ten years and is depreciated at the
rate of $1 200 a year. It has been unused for some time, as expected production orders did not
materialise.
A special order has now been received which would require the use of the machine for two
months.
The current net realisable value of the machine is $8 000. If it is used for the special order, its value
is expected to fall to $7 500. The net book value of the machine is $8 400.
Routine maintenance of the machine currently costs $40 a month. With use, the cost of
maintenance and repairs would increase to $60 a month for the months that the machine is being
used.
Ignore the time value of money.
What is the relevant cost of using the machine for the special order?
A
B
C
D
$240
$520
$540
$620
2 The total relevant cost of a scarce resource is equal to the sum of the variable cost of the scarce
resource and
A the fixed cost absorbed by a unit of the scarce resource.
B the price that the resource would sell for in the open market.
C the price that would have to be paid to replace the scarce resource.
D the contribution forgone from the next-best opportunity for using the scarce resource.
3 Which of the following is not an assumption typically made in relevant costing?
A Decisions should be based on future incremental cash flows.
B Absorbed overheads should be included for decision making purposes.
C Sunk costs are irrelevant to decision making because the expenditure has already been
incurred.
D Opportunity costs need to be considered when one course of action is chosen in preference to
an alternative.
4 Keyboards Pty Ltd is in the process of deciding whether or not to accept a special order. The order
will require 100 litres of liquid X. Keyboards Pty Ltd has 85 litres of liquid X in inventory but no
longer produces the product which required liquid X. It could therefore sell the 85 litres and
receive net proceeds of only $2 per litre, if it rejected the special order. The low net proceeds are
because of high selling costs. The liquid was purchased three years ago at a price of $8 per litre
but its replacement cost is $10 per litre. What is the relevant cost of liquid X to include in the
decision-making process?
A $200
B $320
C $800
D $1 000
5 A company is considering accepting a one-year contract which will require four skilled employees.
The four skilled employees could be recruited on a one-year contract at a cost of $40 000 per
employee. The employees would be supervised by an existing manager who earns $60 000 per
annum. It is expected that supervision of the contract would take 10% of the manager's time.
Instead of recruiting new employees the company could retrain some existing employees who
currently earn $30 000 per year. The training would cost $15 000 in total. If these employees were
used they would need to be replaced at a total cost of $100 000.
The relevant labour cost of the contract is:
A
B
C
D
$115 000
$135 000
$166 000
$275 000
6 A company is considering its options with regard to a machine which cost $120 000 four years ago.
If sold, the machine would generate scrap proceeds of $150 000. If kept, this machine would
generate net income of $180 000.
The current replacement cost for this machine is $210 000.
The relevant cost of the machine is:
A
B
C
D
$120 000
$150 000
$180 000
$210 000
CHAPTER 3
1 Which one of the following is the budget committee not responsible for?
A Preparing functional budgets
B Monitoring the budgeting process
C Timetabling the budgeting operation
D Allocating responsibility for the budget preparation
2 Which of the following may be considered to be objectives of budgeting?
I Expansion
II Co-ordination
III Communication
IV Resource allocation
A
B
C
D
I and II only
I, II, III and IV
I, III and IV only
II, III and IV only
3 What does the statement 'For company XYZ Ltd, sales is the principal budget factor' mean?
A If the company gets its sales level correct then nothing else matters.
B The company's activities are limited by the level of sales it can achieve.
C The level of sales will determine the level of cash at the end of the period.
D The level of sales will determine the level of profit at the end of the period.
4 A production process uses Material M to make Product P. At the beginning of a budget period, it
is expected that the opening inventory of Material M will be 16 000 kg, but the plan will be to
reduce the inventory level to 14 000 kg by the end of the year. During the year, the budgeted
production of Product P is 36 000 kg. The loss or wastage in production is 10% of the quantities of
material input.
What should be the materials purchases budget for Material M?
A 34 000 kg
B 37 600 kg
C 38 000 kg
D 42 000 kg
5 Budgeted sales for a company in three months of the year are as follows:
March
April
May
$
500 000
600 000
700 000
All sales are invoiced and invoices are sent out on the last day of each month. An early settlement
discount of 2% is offered to customers who pay within 7 days. 20% of customers are expected to
take the discount, another 30% are expected to pay within one month after the invoice date and all
other payments are expected in the following month. Irrecoverable debts are expected to be 1% of
the total sales invoiced.
What will be the budgeted cash receipts from customers in May?
A $542 600
B $547 600
C $562 200
D $641 200
6 The following information is available about the costs of producing a single item of product in a
manufacturing operation:
Production
units
36 000
29 000
Cost
$
370 200
291 800
It is known that fixed costs increase by $49 000 when output volume exceeds 30 000 units.
Using this data and the high/low method, what should be the budgeted cost of producing 31
000 units?
A
B
C
D
$300 200
$314 200
$347 200
$349 200
CHAPTER 4
1 The following information for advertising expenditure and sales revenue has been established over
the past six months:
Month
Sales revenue
$ 000
155
125
200
175
150
225
1
2
3
4
5
6
Advertising expenditure
$ 000
3.0
2.5
6.0
5.5
4.5
6.5
Using the high-low method which of the following is the correct equation for linking advertising
expenditure and sales revenue from the above data?
A
B
C
D
Activity level
units
5 000
7 500
10 000
Using the high-low method what is the variable cost per unit?
A
B
C
D
$25
$30
$35
$40
Level 1
3 000
6 750
Level 2
5 000
9 250
The variable production cost per unit and the total fixed production cost both remain constant in
the range of activity shown.
What is the level of fixed costs?
A
B
C
D
$2 000
$2 500
$3 000
$3 500
4 A company generates a 12 per cent contribution on its weekly sales of $280 000. A new product, Z,
is to be introduced at a special offer price in order to stimulate interest in all the company's
products, resulting in a 5 per cent increase in weekly sales of the company's other products.
Product Z will incur a variable unit cost of $2.20 to make and $0.15 to distribute. Weekly sales of Z,
at a special offer price of $1.90 per unit, are expected to be 3 000 units.
The effect of the special offer will be to increase the company's weekly profit by
A
B
C
D
$330.
$780.
$12 650.
$19 700.
5 A company manufactures one product which it sells for $40 per unit. The product has a
contribution to sales ratio of 40%. Monthly total fixed costs are $60 000. At the planned level of
activity for next month, the company has a profit target of $25 600.
What is the planned activity level (in units) for next month?
A
B
C
D
3 100
4 100
5 350
7 750
25%.
50%.
55%.
60%.
$ per unit
20
4
3
2
1
5
5
CHAPTER 5
1 Which of the following items would be treated as an indirect cost?
A Wood used to make a chair
B Metal used for the legs of a chair
C Fabric to cover the seat of a chair
D Staples to fix the fabric to the seat of a chair
2 Spaced Out Ltd has two production departments (F and G) and two service departments (Cafeteria
and Maintenance). Total allocated and apportioned general overheads for each department are as
follows:
F
$125 000
G
$80 000
Cafeteria
$20 000
Maintenance
$40 000
Cafeteria and Maintenance perform services for both production departments and Cafeteria also
provides services for Maintenance in the following proportions:
% of Cafeteria to
% of Maintenance
F
60
65
G
25
35
Cafeteria
Maintenance
15
What would be the total overheads for production department G once the service department's
costs have been apportioned?
A
B
C
D
$90 763
$99 000
$100 050
$100 500
25 000
21 875
Budgeted overheads
$350 000
Actual overheads
$350 000
Based on the data above, what is the machine hour absorption rate as conventionally calculated?
A
B
C
D
$12
$14
$16
$18
$ per unit
6.00
7.50
2.50
5.00
21.00
9.00
30.00
Budgeted production for the month was 5 000 units although the company managed to produce 5
800 units, selling 5 200 of them and incurring fixed overhead costs of $27 400.
4 The profit under the marginal costing method for the month is
A $45 400.
B $46 800.
C $53 800.
D $72 800.
5 The profit under the absorption costing method for the month is
A $45 200.
B $45 400.
C $46 800.
D $48 400.
6 Which of the following are acceptable bases for absorbing production overheads?
I Per unit
II Machine hours
III Direct labour hours
IV As a percentage of the prime cost
A I and IV only
B II and III only
C I, II, III and IV
D II, III and IV only
CHAPTER 6
1 Consider the following statements about Activity Based Costing (ABC):
I Introducing ABC will always reduce costs in the short term;
II If the cost of a product or service using both ABC and absorption costing is the same, there will
be no benefit to be gained from adopting ABC.
Which of the statements is/are correct?
A
B
C
D
I only
II only
I and II
neither I nor II
$2 631 200
$1 573 000
$4 204 200
It is estimated that in the next year, 325 000 orders will be processed, and that the delivery vehicles
will travel 1 495 000 km.
A customer has indicated that 138 orders, each of which will require a journey of 122 km for each
order will be placed next year.
To the nearest $, what is the distribution cost for this customer?
A
B
C
D
$1 785
$30 299
$38 891
$47 342
3 The directors of Wiltshire Ltd are considering the introduction of activity based costing (ABC). A
trainee manager has asked which of the following comments about the calculation of overhead
cost using ABC are not correct:
I The volume of activity has no influence on cost
II Each individual cost will have a unique, identifiable, cost driver
III The overhead cost calculated using ABC will always be significantly different from the overhead
cost calculated using absorption costing
A
B
C
D
I, II and III
I and II only
I and III only
II and III only
4 The budgeted overheads of Coleman Ltd for the next year have been analysed as follows:
Machine running costs
Purchase order processing costs
Production run set up costs
$ 000
640
450
180
In the next year, it is anticipated that machines will run for 32 000 hours, 6 000 purchase orders will
be processed and there will be 450 production runs.
One of the company's products is produced in batches of 500. Each batch requires a separate
production run, 30 purchase orders and 750 machine hours.
Using Activity Based Costing, what is the overhead cost per unit of the product?
A
B
C
D
$0.99
$1.59
$35.30
$495.00
CHAPTER 7
1 A chemical process has a normal wastage of 10% of input. In a period, 2 500 kgs of material were
used and there was an abnormal loss of 75 kgs.
What quantity of finished goods output was achieved?
A
B
C
D
2 175 kgs
2 250 kgs
2 325 kgs
2 425 kgs
2 In a particular process, the input for the period was 2 000 units. There were no inventories at the
beginning or end of the process. Normal loss is 5 per cent of input. In which of the following
circumstances is there an abnormal gain?
I Actual output = 1 800 units
II Actual output = 1 950 units
III Actual output = 2 000 units
A
B
C
D
I only
II only
I and II only
II and III only
3 A company uses process costing to establish the cost per unit of its output.
The following information was available for the last month:
Input units
10 000
Output units
9 850
Opening inventory
Closing inventory
9 505 units
9 715 units
9 775 units
9 985 units
4 A company uses process costing to value its output. The following was recorded for the period:
Input materials
Conversion costs
Normal loss
Actual loss
$11.8
$11.6
$11.2
$11.0
5 A company manufactures two joint products, P and R, in a common process. Data for June are as
follows:
$
1 000
10 000
12 000
3 000
Opening inventory
Direct materials added
Conversion costs
Closing inventory
Production
Units
4 000
6 000
P
R
Sales
Units
5 000
5 000
Sales price
$ per unit
5
10
If costs are apportioned between joint products on a physical unit basis, what was the total cost of
product P production in June?
A
B
C
D
$8 000
$8 800
$10 000
$12 000
6 Which of the following costing methods is most likely to be used by a company involved in the
manufacture of liquid soap?
A Job costing
B Batch costing
C Service costing
D Process costing
CHAPTER 8
1 Information on standard rates of pay would be provided by
A a newspaper
B a trade union
C a payroll manager
D a production manager
2 For which of the following is an attainable standard (target standard) inappropriate?
I Inventory valuation
II Planning
III Control
A
B
C
D
I only
II only
III only
I and III only
CHAPTER 9
1 A company manufactures a single product L, for which the standard material cost is as follows:
$ per unit
42
Material 14 kg $3
During July, 800 units of L were manufactured, 12 000 kg of material were purchased for $33 600, of
which 11 500 kg were issued to production.
The company values all inventory at standard cost.
The material price and usage variances for July were:
A
B
C
D
Price
Usage
$2 300 (F)
$2 300 (F)
$2 400 (F)
$2 400 (F)
$900 (U)
$300 (U)
$900 (U)
$840 (U)
2 Which of the following would help to explain a favourable direct labour efficiency variance?
I Employees were of a lower skill level than specified in the standard.
II An innovation in production which reduces materials handling requirements.
III Suggestions for improved working methods were implemented during the period.
A
B
C
D
I and II only
I and III only
II and III only
I, II and III
$1 000
$3 500
$7 500
$11 000
5 A company purchased 6 850 kgs of material at a total cost of $21 920. The material price variance
was $1 370 favourable. The standard price per kg was
A $0.20.
B $3.00.
C $3.20.
D $3.40.
6 Which of the following situations is most likely to result in a favourable selling price variance?
A Fewer customers than expected took advantage of the early payment discounts offered.
B Competitors charged lower prices than expected, therefore selling prices had to be reduced in
order to compete effectively.
C The sales director decided to change from the planned policy of market skimming pricing to
one of market penetration pricing.
D Demand for the product was higher than expected and prices could be increased without
unfavourable effects on sales volumes.
CHAPTER 10
1 Which of the following is not an example of soft capital rationing?
A The company is debt-averse.
B The company's credit rating prevents it from borrowing further.
C The company will only use retained earnings to finance new investment.
D Management does not want to issue more shares to raise capital, in order to avoid dilution of
control.
2 The following statements have been made in relation to the advantages of a Post Completion
Audit (PCA).
I It encourages a more realistic approach to new investment project decision making.
II It enables an assessment of project success and may highlight projects that should be
discontinued.
III It encourages (when relevant) project termination.
Which of the statements are true?
A
B
C
D
I and II only
I and III only
II and III only
I, II and III
3 A company has carried out an investigation into a new capital investment project, paying $10 000
for a consultants' report. The consultants have reported that the project would require an outlay of
$90 000 on new equipment. The expected net cash inflows from the project would be:
Year
25 000
35 000
40 000
40 000
60 000
2.25 years
2.5 years
2.75 years
3.0 years
4 James Ltd is considering a capital expenditure project which requires an investment of $46 000 in a
machine that will have a four year life, after which it will be sold for $6 000. Depreciation is charged
in equal instalments over the life of the machine. The expected profits after depreciation to be
generated by the project are as follows:
Year 1
$20 500
Year 2
$23 000
Year 3
$13 500
Year 4
$1 500
What is the payback period and Accounting rate of return (ARR calculated as average annual
profits/initial investment)?
Payback period
A
B
C
D
ARR
1.47 years
1.47 years
2.19 years
2.19 years
31.79%
36.54%
20.65%
36.54%
5 Consider the following two statements concerning investor attitudes towards risk:
I A risk-neutral investor will only be prepared to invest in a project with the prospect of high
returns if there are no risks involved.
II A risk-seeking investor will readily invest in a project with prospects of high returns, even if it
means carrying substantially high risk.
Which one of the following combinations relating to the above statements is correct?
Statement
I
II
A
B
C
D
True
True
False
False
True
False
True
False
II To ensure effective risk management, all investment decisions should be taken at board level
within an organisation.
III Project controls can be applied to monitor the extent of the benefits achieved from an
investment decision.
Which of the statements are true?
A
B
C
D
III only
I and III only
I, II and III
None of them
CHAPTER 11
1 Which of the following is not a feature of Just in Time (JIT)?
A Pull system
B Zero inventory
C Employee involvement
D Increased lead times
2 Which one of the following statements is correct?
A The size of the Economic Order Quantity depends on the supply lead time.
B In a Just-in-Time purchasing system, the maximum inventory is the Economic Order Quantity.
C If a large order discount is offered for purchases above a certain quantity of units, the EOQ may
fall in size.
D When the EOQ formula is used to decide the purchase quantity average total inventory holding
costs will be equal to the average total annual ordering costs.
3 Which one of the following statements is incorrect?
A If the profit margin on a product is 60% of the sales price, the mark-up is 150% on cost.
B An objective of Just-in-Time production is the elimination of bottlenecks and hold-ups in
production.
C For a Just-in-Time purchasing system to be successful there must be complete trust between a
company and its supplier.
D When inventory control involves re-order levels and minimum and maximum inventory levels,
inventory should never fall below the minimum level.
4 When a system of target costing is employed, the product concept is devised first. What should be
decided next?
A
B
C
D
Price
Full cost
Profit margin
Production cost
5 A company may price a new product fairly high initially, in order to recover as much of the
development costs as possible. Prices may then be lowered as demand for the product increases
and may then stabilise, or possibly fall further, when market saturation is reached. This is an
example of the application of which pricing policy?
A
B
C
D
Target pricing
Life cycle pricing
Differential pricing
Market penetration
CHAPTER 12
1 A company uses a range of performance measures, including units produced per tonne of material
and Return on Capital Employed (ROCE). What do these measures assess?
Units produced
per tonne of material
ROCE
A
B
C
D
Efficiency
Efficiency
Effectiveness
Efficiency
Capacity
Efficiency
Effectiveness
Effectiveness
2 When measuring performance, for which of the following costs could the manager of a production
department in a manufacturing company be held responsible?
I Indirect labour employed in the department
II Direct materials consumed in the department
III Indirect materials consumed in the department
IV A share of the costs of the maintenance department
A
B
C
D
II only
I and III only
II and IV only
I, II, III and IV
3 Which one of the following is most likely to be the explanation for an unfavourable material usage
variance?
A Rates of pay have been increased
B Quality standards have been increased
C Unforeseen material price rises have been incurred
D A major supplier of material has reduced the rate of trade discount
4 Tasmin Ltd has many divisions which it evaluates using Return on Investment (ROI) and Residual
Income (RI) measures. The Melbourne division has net assets of $24m at 31 December 20X1. In the
year to 31 December 20X1 it earned profit before interest and tax of $3.6m and paid interest of
$0.6m. Its cost of capital is 12%.
What is the correct combination of ROI and RI for the year to 31 December 20X1?
A
B
C
D
ROI
RI
12.5%
12.5%
15.0%
15.0%
$0.72m
$3.0m
$0.72m
$3.0m
5 Marcham Ltd is a building company. Recently there has been a concern that too many quotations
have been sent to clients either late or containing errors, partly as a result of understaffing in the
responsible department.
Which of the following non-financial performance indicators would not be an appropriate measure
to monitor and improve performance of the quotations department?
A Actual number of quotations issued as a percentage of budget.
B Percentage of quotations found to contain errors when checked.
C Percentage of quotes not issued within company policy of 5 working days.
D Actual number of department staff as a percentage of the department's planned number of
staff.
I, II and III
I and II only
I and III only
II and III only
377
ANSWERS TO REVISION
QUESTIONS
CHAPTER 1
1 A A service company will concentrate on workforce planning and labour allocation. It will neither
engage in production planning (as there is no physical product), nor capacity planning (again, as
there is no physical product) nor in inventory valuation (as there is no inventory of physical
items).
2 B Statement I is not true as the benefit and cost of management information should be
compared. Statement II is not true because many managers require summarised, high level
information rather than very detailed information. Statement III is true. Remember that,
information is data that has been processed so as to be meaningful to the person who receives
it.
3 A Management accounting information is not legally required and therefore I is true. It is used
only by management, therefore II is false. It is information that is communicated concerning
facts or circumstances. It can comprise non-financial (eg employee numbers) as well as financial
information, so III is true. It is concerned with planning and with revenues, ie much more than
just cost control, so IV is false. Thus I and III are true and Option A is correct.
4 C Management accounts are not legally required, so I is false. There is no set format for
management accounts, so II is true. III is the essence of management accounting so is
immediately true. Cost accounting can be used to provide information to value inventory for
internal and external reporting so IV is false. Thus II and III are true, so Option C is correct.
5 D A management control system is a system by which assurance is sought that organisational
goals are being achieved and procedures are being adhered to, or if not, that appropriate
remedial action is taken. Thus Option D is correct.
6 D Data, not information, is the raw material for data processing, so I is false. An organisation's
financial accounting records are an internal source of information, so II is false. The main
objective of a non-profit making organisation (eg, a charity) is to deliver some stated objective
which will not usually be employment of staff, so III is false. Thus none of I, II or III are true, so
Option D is correct.
7 A Vision concerns the charitys future aspirations. Mission would go further and set out the
charitys fundamental purpose together with reference to its strategy, behaviour and values.
Objectives are the specific goals of the charity and strategy is a course of action that might
enable it to achieve its objectives.
8 C The desire to increase market share is a strategic plan. The annual sales quotas are part of a
tactical plan to help achieve this. The quotas will be broken down into individual quarterly sales
targets for each sales representative (operational plans). Management control is concerned with
decisions about the efficient and effective use of resources to achieve the organisations
objectives or targets.
CHAPTER 2
1 C
$
Loss in net realisable value of the machine
through using it on the special order $(8 000 7 500)
Costs in excess of existing routine maintenance costs $(120 80)
Total marginal user cost
500
40
540
If you selected option A you incorrectly included the depreciation cost. Depreciation is not
relevant because it is not a future cash flow.
Option B is incorrect because it allows for only one month's increased maintenance cost. The
special order will take two months.
Option D is incorrect because it includes all of the maintenance cost to be incurred. $40 per
month would be incurred anyway so it is only the incremental $20 that is relevant.
2 D Total relevant cost needs to include the opportunity cost.
3 B This is not an assumption in relevant costing. Absorbed overhead is a notional accounting cost
hence should be ignored for decision making purposes. Only incremental overheads arising as
a result of the decision are relevant.
4 B
Relevant cost of 85 litres in inventory
(Realisable value = 85 $2)
Relevant cost of 15 litres to be bought
(Purchase cost = 15 $10)
$170
$150
$320
5 A
$ 000
160
15
100
115
NET INCOME
($180 000)
HIGHER OF
REPLACEMENT
COST
($210 000)
NRV
($150 000)
REVENUES
EXPECTED
($180 000)
CHAPTER 3
1 A Option A is correct because it is the manager responsible for implementing the budget that
must prepare it, not the budget committee.
2 D Expansion Item I is not in itself an objective of budgeting. Although a budget may be set
within a framework of expansion plans, it is perfectly normal for an organisation to plan for a
reduction in activity.
Co-ordination Item II is an objective of budgeting. Budgets help to ensure that the activities
of all parts of the organisation are co-ordinated towards a single plan.
Communication Item III is an objective of budgeting. The budgetary planning process
communicates targets to the managers responsible for achieving them, and it should also
provide a mechanism for lower level managers to communicate to more senior staff their
estimates of what may be achievable in their part of the business.
Resource allocation Item IV is an objective of budgeting. Most organisations face a situation
of limited resources and an objective of the budgeting process is to ensure that these resources
are allocated among budget centres in the most efficient way.
3 B The principal budget factor is the factor which limits the activities of an organisation.
Although cash and profit are affected by the level of sales (options C and D), sales is not the
only factor which determines the level of cash and profit. It does not mean that nothing matters
other than the sales level (option A).
4 C Output = 36 000 kg
Wastage = 10% of input
Therefore input = 36 000/0.90 = 40 000 kg
Closing inventory
Used in production
Less Opening inventory
Purchases
kg
14 000
40 000
54 000
(16 000)
38 000
5 A All invoices are sent out at the end of the month; therefore payments within 7 days occur in the
following month. In May, 20% of April sales customers will pay within 7 days and take the
settlement discount; another 30% of April sales customers will pay before the end of May.
Irrecoverables are 1%; therefore 49% of March sales will be collected in May
Cash receipts
Customers taking 2% discount: 20% $600 000 98%
Other customers paying within one month of invoice: 30% $600 000
Receipts from March sales: 49% $500 000
Total receipts
$
117 600
180 000
245 000
542,600
6 D The high-low method can be used to estimate fixed and variable costs
Total cost of 36 000 units
Total cost of 29 000 units, adding $49 000 to remove fixed cost difference
Variable cost of 7 000 units
$
370 200
340 800
29 400
$
370 200
151 200
219 000
$
219 000
130 200
349 200
CHAPTER 4
1 C Independent Variable x = advertising expenditure
Dependent variable y = sales revenue
Highest x = month 6 = $6 500
Highest y = month 6 = $225 000
Lowest x = month 2 = $2 500
Lowest y = month 2 = $125 00
Using the high-low method:
Highest
Lowest
Advertising expenditure
$
6 500
2 500
4 000
Sales revenue
$
225 000
125 000
100 000
$100 000
= $25 per $1 spent.
$4 000
If $6 500 is spent on advertising, expected sales revenue = $6 500 $25 = $162 500
Sales revenue expected without any expenditure on advertising = $225 000 $162 500 = $62
500
Sales revenue = 62 500 + (25 advertising expenditure)
2 B
Activity level
$
10 000
5 000
5 000
Highest
Lowest
Cost
$
400 000
250 000
150 000
$150 000
= $30
5 000 units
3 C
Level 2
Level 1
Production
Units
5 000
3 000
2 000
$2 500
2 000 units
Total cost
$
9 250
6 750
2 500
$
1 680
(1 350)
330
If you selected option B you forgot to allow for the variable cost of distributing the 3 000 units
of Product Z. Option C is based on a five per cent increase in revenue from the other products;
however extra variable costs will be incurred, therefore the gain will be a five
per cent increase in contribution.
If you selected option D you made no allowance for the variable costs of either product Z or
the extra sales of other products.
5 C At planned activity level, Total contribution target = Fixed costs + Profit target
Total contribution target = $60 000 + $25 600 = $85 600
Contribution per unit = Sales Price x Contribution/Sales ratio = $40 0.4 = $16.00
Budgeted/planned activity level
$85 600
$16
= 5 350 units
6 B P/V ratio
If you selected option A you calculated profit per unit as a percentage of the selling price per
unit.
Option C excludes the variable selling costs from the calculation of contribution per unit.
Option D excludes the variable production overhead cost, but all variable costs must be
deducted from the selling price to determine the contribution.
CHAPTER 5
1 D Indirect costs are those which cannot be easily identified with a specific cost unit. Although the
staples could probably be identified with a specific chair, the cost is likely to be relatively
insignificant. The expense of tracing such costs does not usually justify the possible benefits
from calculating more accurate direct costs. The cost of the staples would therefore be treated
as an indirect cost, to be included as a part of the overhead absorption rate.
Options A, B and C all represent significant costs which can be traced to a specific cost unit.
Therefore they are classified as direct costs.
2 C The correct answer is C.
Total Maintenance overheads
Budgeted overheads
$350 000
=
= $14 per machine hour
Budgeted machine hours
25 000
= $45 400
If you selected option B you calculated the profit on the actual sales at $9 per unit. This utilises
a unit rate for fixed overhead which is not valid under marginal costing.
If you selected option C you used the correct method but you based your calculations on the
units produced rather than the units sold.
If you selected option D you calculated the correct contribution but you forgot to deduct the
fixed overhead.
5 D
$
Sales (5 200 at $30)
Materials (5 200 at $6)
Labour (5 200 at $7.50)
Variable overhead (5 200 at $2.50)
Total variable cost
Fixed overhead ($5 5 200)
Over-absorbed overhead (*)
Absorption costing profit
*Working
Overhead absorbed (5 800 $5)
Overhead incurred
Over-absorbed overhead
$
156 000
31 200
39 000
13 000
(83 200)
(26 000)
1 600
48 400
$
29 000
27 400
1 600
If you selected option A you calculated all the figures correctly but you subtracted the overabsorbed overhead instead of adding it to profit.
Option B is the marginal costing profit.
If you selected option C you calculated the profit on the actual sales at $9 per unit, and forgot
to adjust for the over-absorbed overhead.
6 C All of the methods are acceptable bases for absorbing production overheads. However, the
percentage of prime cost (item IV) has serious limitations and the rate per unit (item I) can only
be used if all cost units are identical or very similar.
CHAPTER 6
1 D Neither statement is correct. Statement I is incorrect because although ABC will lead to a
greater understanding of cost drivers, it will only reduce costs if action is taken. Statement II is
incorrect because there will be a benefit of a greater understanding of cost drivers.
2 B Order processing costs
Transport costs
=
=
Customer cost
$30 299.28
3 A None of the statements are correct. Statement I is not correct because some costs will be driven
by volume, for example, machine running costs may depend upon the volume of production.
Statement II is not correct because some costs may be driven by more than one cost driver, for
example, energy costs may depend upon the volume of production as well as the physical size
of a production department. Finally, statement III is not correct because although overhead cost
calculated using ABC will often be significantly different from the overhead cost calculated
using absorption costing, it is not always so.
4
Cost
description
Purchase order
processing
Cost
amount
$
450 000
180 000
Machine running
640 000
Cost
driver
Activity
level
Purchase
orders
6 000
Overhead
Allocation
Rate
(OAR)
$
75
450
32 000
Production
runs
Machine
hours
Product
activity
30
Cost
$
2 250
400
400
20
750
15 000
17 650
35.30
CHAPTER 7
1 A Finished good production
2 D Expected output = 2 000 units less normal loss (5%) 100 units = 1 900 units
In situation I there is an abnormal loss of 1 900 1 800 = 100 units
In situation II there is an abnormal gain of 1 950 1 900 = 50 units
In situation III there is an abnormal gain of 2 000 1 900 = 100 units
3 D
Equivalent units
Total
Opening inventory
Fully worked units*
Output to finished goods
Closing inventory
Units
300
9 55
9 85
(100%)
450
10 300
Material
s
Units
300
9 550
9 850
450 (30%)
10 300
Conversion costs
Units
300
9 550
9 850
135
9 985
Input costs
Expected output
$22 040
1 900 units
4 000
6 000
10 000
Apportioned cost
$
($20 000 4/10)
($20 000 6/10)
8 000
12 000
20 000
If you selected option B you made no adjustment for inventories when calculating the total
costs.
If you selected option C you apportioned the production costs on the basis of the units sold.
Option D is the total cost of product R.
6 D Process costing is a costing method used where it is not possible to identify separate units of
production, or jobs, usually because of the continuous nature of the production process. The
manufacture of liquid soap is a continuous production process.
CHAPTER 8
1 C A payroll manager would usually keep information concerning the expected rates of pay for
employees with a given level of experience and skill.
A newspaper (option A) may provide information regarding average rates of pay for an industry
sector but this would not necessarily reflect the standard pay rate for particular employees.
Option B is also incorrect because although the trade union is involved in negotiating future
rates of pay for their members, they do not take decisions on the standard rate to be paid in the
future.
A production manager (option D) would provide information concerning the number of
employees needed and the skills required, but they would not have the latest information
concerning the expected rates of pay.
2 A An attainable standard cost is an inappropriate basis for measuring inventory values, unless the
standard is actually attained. Attainable standards are much more relevant to planning and
control.
3 D Item I is incorrect because standard costs are an estimate of what will happen in the future, and
a unit cost target that the organisation is aiming to achieve. Standard costing provides the unit
cost information for evaluating the volume figures contained in a budget (item II). Standard
costing provides targets for achievement, and yardsticks against which actual performance can
be monitored (item III). Inventory control systems are simplified with standard costing. Once
the variances have been eliminated, all inventory units are valued at standard price (item IV).
4 C It is generally accepted that the use of attainable standards has the optimum motivational
impact on employees. Some allowance is made for unavoidable wastage and inefficiencies, but
the attainable level can be reached if production is carried out efficiently.
Option B and option D are not correct because employees may feel that the goals are
unattainable and will not work so hard.
Option A is not correct because standards set at a minimal level will not provide employees
with any incentive to work harder.
5 C When management by exception is adopted within a standard costing system, only the
variances which exceed acceptable tolerance limits need to be investigated by management
with a view to control action. Option A has nothing to do with management by exception.
Unfavourable and favourable variances alike may be subject to investigation, therefore option
D is incorrect.
Any efficient information system would ensure that only managers who are able to act on the
information receive management reports, even if they are not prepared on the basis of
management by exception. Therefore option B is incorrect.
100
$9 = $90
90
You should have been able to eliminate option A because it is less than the basic labour cost of
$81 for 9 hours of work. Similar reasoning also eliminates option B. If you selected option C
you simply added 10% to the 9 active hours to determine a standard time allowance of 9.9
hours per unit. However the idle time allowance is given as 10% of the total labour time.
CHAPTER 9
1 C Since inventories are valued at standard cost, the material price variance is based on the
materials purchased.
12 000 kgs material purchased should cost ($3)
but did cost
Material price variance
$
36 000
33 600
2 400 (F)
11 200 kgs
11 500 kgs
300 kg (A)
$3
$900 (A)
If you selected options A or B you based your calculation of the material price variance on the
material actually used. If you selected option B you forgot to evaluate the usage variance in kg
at the standard price per kg.
If you selected option D you evaluated the usage variance at the actual price per kg, rather
than the standard price per kg.
2 C Statement I is not consistent with a favourable labour efficiency variance. Employees of a lower
skill level are likely to work less efficiently, resulting in an unfavourable efficiency variance.
Statement II is consistent with a favourable labour efficiency variance. Time would be saved in
processing if the material was easier to handle.
Statement III is consistent with a favourable labour efficiency variance. Time would be saved in
processing if working methods were improved.
3 B Direct material cost variance = material price variance + material usage variance.
The unfavourable material usage variance could be larger than the favourable material price
variance. The total of the two variances would therefore represent a net result of an
unfavourable total direct material cost variance.
Option A is incorrect because the sum of the two favourable variances would always be a larger
favourable variance.
Option C will sometimes be correct, as unfavourable price and usage variances will lead to an
overall unfavourable direct material cost variance. However it will not always be correct as
Option B and/or D could sometimes arise.
The situation in option D would sometimes arise depending on the relative size of the variances,
but not always, because of the possibility of the situations described in options B and C.
4 B
53 000 kgs should cost ( $2.50)
but did cost
Material price variance
$
132 500
136 000
3 500 (A)
5 D Total standard cost of material purchased actual cost of material purchased = Price variance
Total standard cost
= $21 920 + $1 370
= $23 290
Standard price per kg
$23 290
6 850
$3.40
=
Option A is the favourable price variance per kg. This should have been added to the actual
price to determine the standard price per kg. If you selected option B you subtracted the price
variance from the actual cost. If the price variance is favourable then the standard price per kg
must be higher than the actual price paid. Option C is the actual price paid per kg.
6 D Raising prices in response to higher demand would result in a favourable selling price variance.
Early payment discounts, option A, do not affect the recorded selling price.
Reducing selling prices, option B, is more likely to result in an unfavourable selling price
variance.
Market penetration pricing, option C, is a policy of low prices. This would result in an
unfavourable selling price variance, if the original planned policy had been one of market
skimming pricing, which involves charging high prices.
CHAPTER 10
1 B Soft capital rationing is a limit on capital investment imposed from within the company. Options
A, C and D are all restrictions imposed internally, whereas B is an external constraint and
represents hard capital rationing.
2 D All the statements are advantages of carrying out a PCA.
3 C The consultancy fee of $10 000 has already been incurred and is irrelevant.
Payback
Year
Cash flow
$
(90 000)
25 000
35 000
40 000
0
1
2
3
Cumulative
$
(90 000)
(65 000)
(30 000)
10 000
Payback is after 2 years plus 30 000/40 000 of Year 3, i.e. after 2.75 years.
4 A Payback
Add back depreciation to annual profits to get cashflows.
Depreciation = 46 000 6 000/4 = 10 000 pa
Cash flow
Cumulative
(46 000)
(15 500)
(17 500)
CHAPTER 11
1 D Just in time (JIT) features machine cells which help products flow from machine to machine
without having to wait for the next stage of processing or returning to store. Lead times and
Work in Progress (WIP) are therefore reduced.
2 D Total holding costs and total ordering costs each year are the same when inventories are
purchased in the EOQ size. The EOQ purchasing system is incompatible with JIT, and the size
of the order quantity does not depend on the lead time for re-ordering and re-supply. If
discounts for bulk purchases are offered, the EOQ may increase (since the value of the holding
cost H may fall).
3 D The inventory level control system is designed to avoid a situation where there is no inventory
when it is needed. The minimum inventory level acts as a warning sign that inventory levels are
getting low. It is possible however that inventory levels may fall below this, for example if there
is maximum demand in the supply lead time period, and the supply lead time is at its longest.
JIT purchasing does depend on complete trust between buyer and supplier, for example so
that the supplier is aware of what quantities the buyer will need and when, and the buyer is
aware of the state of the suppliers production and inventory. JIT production has elimination of
waste as an objective: this includes the elimination of bottlenecks and hold-ups in production.
4 A After the product concept has been created, the first step is to set a price that customers are
likely to pay for it. After price, a target profit margin is established, so that the target cost can
be identified.
5 B It could be argued that there is market skimming at the beginning of the products life cycle,
but the changes in prices as the product goes through the stages of its life cycle is an example
of life cycle pricing.
CHAPTER 12
1 B Both relate outputs to inputs and are therefore measures of efficiency.
2 D Managers should be held responsible for costs over which they have some influence. Although
it is the responsibility of the maintenance department manager to keep maintenance costs
within budget, their costs will be partly fixed and partly variable, and the variable cost element
will depend on the volume of demand for the service. If the production department staff don't
use their equipment appropriately we might expect higher maintenance costs. The production
department manager should be made accountable for the costs that his department causes the
maintenance department to incur on its behalf.
3 B If higher quality standards are required, more material may be used as wastage rates will likely
be higher.
4 C Return on investment
Residual income
395
CHAPTER 1
1
FINANCIAL ACCOUNTS
MANAGEMENT ACCOUNTS
2 Cost accounting and management accounting are terms which are often used interchangeably. It is
not correct to do so. Cost accounting is part of management accounting. Cost accounting provides
a bank of data for the management accountant to use.
Cost accounting is concerned with the following:
Preparing statements (e.g. budgets, costing).
Cost data collection.
Applying costs to inventory, products and services.
Management accounting is concerned with the following:
Using financial data and communicating it as information to users.
3 An objective is the aim or goal of an organisation (or an individual) whereas is strategy is a possible
course of action that might enable an organisation (or an individual) to achieve its objectives.
Step 1
Step 2
Step 3
Step 4
Step 5
Select an alternative
State the expected outcome
and check that the expected
outcome is in keeping with
the overall goals or objectives.
Step 6
PLANNING
5 Anthony divides management activities into strategic planning, management control and
operational control.
6
7 Data is the raw material for data processing. Data relates to facts, events and transactions whereas
information is data that has been processed in such a way as to be meaningful to the person who
receives it. Information is anything that is communicated.
8 Good information should be relevant, complete, accurate, clear, it should inspire confidence, it
should be appropriately communicated, its volume should be manageable, it should be timely and
its cost should be less than the benefits it provides.
9 Title
Who is the report intended for?
Who is the report from?
Date
Subject
Appendix
10 Globalisation and increased competition.
Information technology changes resulting in changes in production and information flows.
Changes in organisations including internal reorganisations and external mergers.
CHAPTER 2
1 Relevant costs are future cash flows arising as a direct consequence of a decision. Remember
decisions should be made based on relevant costs.
2 Avoidable costs are costs which would not be incurred if the activity to which they relate did not
exist.
3 Differential cost is the difference in total cost between alternatives. An opportunity cost is the value
of the benefit sacrificed when one course of action is chosen in preference to an alternative.
4 A sunk cost is a past cost which is not directly relevant in decision making.
5 The relevant cost of an asset represents the amount of money that a company would have to
receive if it were deprived of an asset in order to be no worse off than it already is. We can call this
the deprival value.
6 An easy way to generate ideas here is to think about an organisation that you know and what
factors stop it making more revenue.
(a) Sales. There may be a limit to sales demand.
(b) Labour. There may be a limit to total quantity of labour available or to labour having particular
skills.
(c) Materials. There may be insufficient available materials to produce enough products to satisfy
sales demand.
(d) Manufacturing capacity. There may not be sufficient machine capacity for the production
required to meet sales demand.
CHAPTER 3
1 A budget is a quantitative statement, for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows, or non-monetary items such as staff numbers
2
3 The principal budget factor is the factor which limits the activities of an organisation and is
therefore the starting point for the creation of budgets.
4 Pay creditors early to obtain discount.
Attempt to increase sales by increasing debtors and inventories.
Make short-term investments.
5 A fixed budget is a budget which is set for a single activity level whereas a flexible budget is a
budget which, by recognising different cost behaviour patterns, is designed to change as volume
of activity changes.
6 Incremental budgeting is concerned mainly with the increments in costs and revenues which will occur
whereas zero based budgeting involves preparing a budget for each cost centre from a zero base.
7 Ideal standards, attainable standards, current standards and basic standards.
8 They are based on information from employees most familiar with the department operations.
Budgets should therefore be more realistic.
Knowledge spread among several levels of management is pulled together, again producing
more realistic budgets.
Because employees are more aware of organisational goals, they should be more committed to
achieving them.
Co-ordination and cooperation between those involved in budget preparation should improve.
Senior managers' overview of the business can be combined with operational-level details to
produce better budgets.
Managers should feel that they 'own' the budget and will therefore be more committed to the
targets and more motivated to achieve them.
Participation will broaden the experience of those involved and enable them to develop new skills.
9 They consume more time.
Budgets may be unachievable if managers are not qualified to participate.
Managers may not co-ordinate their own plans with those of other departments.
Managers may include budgetary slack (padding the budget) in their budgets. This means they
have over-estimated costs or under-estimated income. Actual results are then more likely to be
better than the budgeted target results.
An earlier start to the budgeting process could be required.
10 The aim is to 'get it right first time' which means that there is a striving for continuous improvement
in order to eliminate faulty work and prevent mistakes.
11 The budgeting process is about setting standards or targets for all aspects and functions of the
business to meet. If the budgeting process is successful it can help in the continuous process of
improvement (Total Quality Management) by setting targets that eventually eliminate all
unnecessary waste and mistakes.
CHAPTER 4
1 A fixed cost is a cost which is incurred for a particular period of time and which, within certain
activity levels, is unaffected by changes in the level of activity.
2 A variable cost is a cost which tends to vary with the level of activity.
3
Fixed cost
$
Cost
Volume of output
$000
120
le
Sa
Budgeted profit
100
Break-even point
80
60
a
Tot
ts
cos
Fixed costs
40
Safety
margin
20
20
40
60
80
100
120
Units
CHAPTER 5
1 A direct cost is a cost that can be traced in full to the product, service, or department that is
causing the cost to be incurred.
2 An indirect cost, or overhead, is a cost that is incurred in the course of making a product,
providing a service or running a department, but which cannot be traced directly and in full to the
product, service or department.
3 Direct wages are all wages paid for labour, either as basic hours or as overtime, expended on work
on the product.
4 Overhead is the cost incurred in the course of making a product, providing a service or running a
department, but which cannot be traced directly and in full to the product, service or department.
5 The main reasons for using absorption costing are for inventory valuations, pricing decisions, and
establishing the profitability of different products.
6 The three stages of absorption costing are allocation, absorption and apportionment.
7
Step 3 Divide the estimated overhead by the budgeted activity level. This produces the
overhead absorption rate.
8 Marginal cost is the variable cost of one unit of product or service.
9 (a) Period fixed costs are the same, for any volume of sales and production provided that the
level of activity is within the 'relevant range'.
(b) Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution
earned from the item.
(c) Profit measurement should therefore be based on an analysis of total contribution.
(d) When a unit of product is made, the extra costs incurred in its manufacture are the variable
production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output
is increased.
CHAPTER 6
1 The major reason is the failure of traditional costing systems to adapt to changes in organisations
and their environments.
2 Activity based costing (ABC) is an approach to the costing and monitoring of activities which
involves tracing resource consumption and costing final outputs. Resources are assigned to
activities and activities to cost objects based on consumption estimates. The latter utilise cost
drivers to attach activity costs to outputs.
3 The principal idea of ABC is to focus attention on what causes costs to increase, i.e. the cost
drivers.
4 ABC should only be introduced if the additional information it provides will result in action that will
increase the organisation's overall profitability.
5 Product-sustaining activities are activities undertaken to develop or sustain a product or service.
Product sustaining costs are linked to the number of products or services, not to the number of
units produced.
6 Facility-sustaining activities are activities undertaken to support the organisation as a whole, and
which cannot be logically linked to individual units of output, batches or products.
7 (a) The complexity of manufacturing has increased, with wider product ranges, shorter product life cycles
and more complex production processes. ABC recognises this complexity with its multiple cost
drivers.
(b) ABC facilitates a good understanding of what drives overhead costs.
(c) ABC is concerned with all overhead costs and so it takes management accounting beyond its
'traditional' boundaries.
(d) By controlling the incidence of the cost driver, the level of the cost can be controlled.
(e) The costs of activities not included in the costs of the products an organisation makes or the
services it provides can be considered to be not contributing to the value of the product or
service (that is non-value adding).
(f) ABC can help with cost management.
(g) Many costs are driven by customers, delivery costs, discounts, after-sales service and so on, but
traditional absorption costing systems do not account for this.
(h) Simplicity is part of its appeal.
8 Customer profitability analysis is the analysis of the revenue streams and service costs associated
with specific customers or customer groups.
9 (a) Can a single cost driver explain the cost behaviour of all items in its associated pool?
(b) The number of cost pools and cost drivers cannot be excessive otherwise an ABC system would
be too complex and too expensive.
(c) Unless costs are caused by an activity that is measurable in quantitative terms and which can be
related to production output, cost drivers will not be usable. What drives the cost of the annual
external audit, for example?
(d) The costs of ABC may outweigh the benefits.
(e) Some measure of (arbitrary) cost apportionment may still be required at the cost pooling stage
for items like rent, rates and building depreciation.
CHAPTER 7
1 Process costing is a costing method used when it is not possible to identify separate units of
production, or jobs, usually because of the continuous nature of the production processes involved.
2 Process costing is a form of costing applicable to continuous processes where process costs are
attributed to the number of units produced.
3 On the left hand side of the process account the inputs to the process and the cost of these inputs
are recorded.
4 On the right hand side of the process account we record what happens to the inputs by the end of
the period.
5
Step
Step
Step
Step
1
2
3
4
6 The normal loss is expected loss, allowed for in the budget, and normally calculated as a
percentage of the good output, from a process during a period of time. Normal losses are
generally either valued at zero or at their disposal values.
Abnormal loss is any loss in excess of the normal loss allowance.
Abnormal gain is improvement on the accepted or normal loss associated with a production activity.
7 The valuation of normal loss is either at scrap value or nil.
8 Equivalent units are used to apportion costs between closing work in process and completed
output. These are the notional number of whole units that could have been fully produced in the
period. They represent the sum of the proportion of incomplete units that have been completed.
(e.g. 1,000 units of WIP which are 60% complete equates to 600 Equivalent units and would attract
600 units worth of value)
In many industries, materials, labour and overhead may be added at different rates during the
course of production. In this case, equivalent units, and a cost per equivalent unit, is calculated
separately for each type of material, and also for conversion costs.
If the weighted average cost method of valuing opening Work in Progress (WIP) is used, it makes
no distinction between units of opening WIP and new units introduced to the process during the
current period. The cost of opening WIP is added to costs incurred during the period, and
completed units of opening WIP are each given a value of one full equivalent unit of production.
9 Joint products are two or more products produced by the same process and separated in
processing, each having a sufficiently high saleable value to merit recognition as a main product.
For example, in the oil refining industry the following joint products all arise from the same
process.
Diesel fuel.
Petrol.
Paraffin.
Lubricants.
10 A by-product is output of some value produced incidentally while manufacturing the main
product. Meat processing produces meat for human consumption as well as dog bones, glue and
so on.
11 Job costing is the method used when work is undertaken to a customer's special requirements
and each order is of comparatively short duration.
CHAPTER 8
1 A standard cost is a predetermined estimated unit cost, used for inventory valuation and control.
2 To value inventories and cost production for cost accounting purposes.
To act as a control device by establishing standards (planned costs), highlighting (via variance
analysis which we will cover in the next chapter) activities that are not conforming to plan and
therefore alerting management to areas which may be in need of corrective action.
3 A variance.
4 Ideal, attainable, current and basic.
5 The purchasing department are most likely to be involved in estimating the standard price of
materials.
They will do this using:
CHAPTER 9
1 A variance is the difference between a planned, budgeted, or standard cost and the actual cost
incurred. Basically it is a just a difference.
2 The direct material total variance can be subdivided into the direct material price variance and
the direct material usage variance.
3 The way inventory is valued will change the value of the variance.
4 The direct labour rate variance and the direct labour efficiency variance.
5 The variable production overhead expenditure variance and the variable production overhead
efficiency variance.
6 The expenditure variance and the volume variance.
7 The reasons for cost variances arising are summarised in the table that follows.
FAVOURABLE
(a) Material price
ADVERSE
Price increase
Careless purchasing
Change in material standard
Defective material
Excessive waste
Theft
Stricter quality control
Errors in allocating material to jobs
Machine breakdown
Non-availability of material
Illness or injury to workers
Under-utilisation of assets
8 Variances should only be investigated where the amount is material, i.e. significant to decision
makers and when the reasons for the variance can be controlled through management action.
9 The difference between what the sales revenue is and should have been for the actual quantity
sold.
10 The difference between the actual units sold and the budgeted (planned) quantity, valued at the
standard profit per unit. In other words, it measures the increase or decrease in standard profit as a
result of the sales volume being higher or lower than budgeted (planned).
11 A proforma operating statement reconciling budgeted profit and actual profit.
Budgeted (planned) profit before sales and administration costs
Sales variances:
price
volume
X
X
X
X
X
(F)
$
X
X
X
X
X
X
X
X
X
(A)
$
X
X
X
X
X
X
X
X
X
X
X
X
X
X
CHAPTER 10
1 Origination of proposals; project screening; analysis and acceptance; and monitoring and review.
2
Step 1
Step 2
Classify the project by type to separate projects into those that require more or less
rigorous financial appraisal, and those that must achieve a greater or lesser rate of
return in order to be deemed acceptable.
Step 3
Step 4
Step 5
Step 6
Step 7
8 (a) It ignores the timing of cash flows within the payback period, the cash flows after the end of the
payback period and therefore the total project return.
(b) It ignores the time value of money which is a concept incorporated into more sophisticated
appraisal methods.
(c) The method is unable to distinguish between projects with the same payback period.
(d) The choice of any cut-off payback period by an organisation is arbitrary.
(e) It may lead to excessive investment in short-term projects.
(f) It takes account of the risk of the timing of cash flows but does not take account of the
variability of those cash flows.
9 (a) Assesses period for which capital is tied up.
(b) Focus on early payback will encourage strong liquidity.
(c) Investment risk is increased if payback is longer.
(d) Shorter-term forecasts are likely to be more reliable.
(e) The calculation is quick and simple.
(f) Payback is an easily understood concept.
10
11 The ARR method has the serious drawback that it does not take account of the timing of the profits
from a project
There are a number of other drawbacks:
(a) It is based on accounting profits which are subject to a number of different accounting
treatments.
(b) It is a relative measure rather than an absolute measure and hence takes no account of the size
of the investment.
(c) It takes no account of the length of the project.
(d) Like the payback method, it ignores the time value of money.
Advantages of the ARR method:
(a) It is quick and simple to calculate.
(b) It involves a familiar concept of a percentage return.
(c) Accounting profits can be easily calculated from financial statements.
(d) It looks at profits throughout the entire project life.
(e) Managers and investors are accustomed to thinking in terms of profit, and so an appraisal
method which employs profit may therefore be more easily understood.
12 Risk involves situations or events which may or may not occur, but whose probability of occurrence
can be calculated statistically and the frequency of their occurrence predicted from past records.
Uncertain events are those whose outcome cannot be predicted with statistical confidence.
CHAPTER 11
1 Just-in-time (JIT) is a system whose objective is to produce or to procure products or components
as they are required by a customer or for use, rather than for inventory. A JIT system is a pull
system, which responds to demand, in contrast to a push system, in which inventories act as buffers
between the different elements of the system, such as purchasing, production and sales.
2 JIT aims to eliminate all non-value-added costs. Value is only added while a product is actually
being processed. While it is being inspected for quality, moving from one part of the factory to
another, waiting for further processing and held in store, value is not being added. Non valueadded activities, or diversionary activities, should therefore be eliminated.
3 (a) It is not always easy to predict patterns of demand.
(b) JIT makes the organisation far more vulnerable to disruptions in the supply chain.
(c) Wide geographical spread of suppliers and manufacturing makes JIT difficult.
4
2C D
0
C
H
where:
CH = cost of holding one unit of inventory for one time period
C0 = cost of ordering a consignment from a supplier
D = demand during the time period
7 1 Order cycling method
Under the order cycling method, quantities on hand of each item are reviewed periodically
(every 1, 2 or 3 months).
2 Two-bin system
The two-bin system of stores control, or visual method of control, is one whereby each stores
item is kept in two storage bins.
3 Classification of materials
Materials items may be classified as expensive, inexpensive or in a middle-cost range.
(a) Expensive and medium-cost materials are subject to careful stores control procedures to
minimise cost.
(b) Inexpensive materials can be stored in large quantities because the cost savings from careful
stores control do not justify the administrative effort required to implement the control.
This selective approach to stores control is sometimes called the ABC method whereby
materials are classified A, B or C according to their expense-group A being the expensive,
group B the medium-cost and group C the inexpensive materials.
CHAPTER 12
1 A responsibility centre is a section of an organisation (a function or department) that is headed by a
manager who has direct responsibility for its performance.
2 Materiality, controllability and variance trend.
3 Interdependence refers to the fact that the cause of one variance may be wholly or partly explained
by the cause of another variance. For example, if the purchasing department buys a cheaper
material which is poorer in quality than the expected standard, the material price variance will be
favourable, but this may cause material wastage and an unfavourable usage variance. It may also
have a negative impact on labour variances as the cheap material may be harder to work with. Thus
individual variances must not be considered in isolation. Investigation of variances should highlight
the underlying cause of the inefficiency or efficiency, in this case the poor quality material and lead
to control action to avoid the purchasing decision being repeated. This may remove the favourable
material price variance but will also address the unfavourable material usage and labour efficiency
variances.
4 The direct labour efficiency variance, which could identify problems with labour productivity.
Distribution costs as a percentage of turnover, which could help with the control of costs.
Number of hours for which labour was idle, which could indicate how well resources are being
used.
Profit as a percentage of turnover, which could highlight how well the organisation is being
managed.
5 Indices show how a particular variable has changed relative to a base value.
6 The two key measures are Return on investment (ROI) and Residual income (RI). Both these show
how well resources are being used in that centre.
7 Customer; Internal; Learning and growth; and Financial.
8 Conflicting measures, selecting measures, expertise, interpretation and the possibility of too many
measures.
9 Reward is 'all of the monetary, non-monetary and psychological payments that an organisation
provides for its employees in exchange for the work they perform'. Bratton
415
GLOSSARY OF TERMS
Absorption costing. A method for sharing overheads between different products on a fair basis.
Activity Based Costing (ABC). An approach to the costing and monitoring of activities which involves
tracing resource consumption and costing final outputs. Resources are assigned to activities and
activities to cost objects based on consumption estimates.
Administration costs. The costs of managing an organisation.
Allocation. The process by which whole cost items are charged direct to a unit or cost centre.
Apportionment. A procedure whereby indirect costs are spread fairly between cost centres.
Avoidable costs. Costs which would not be incurred if the activity to which they relate did not exist.
Balanced scorecard approach. An approach to the provision of information to management to assist
strategic policy formulation and achievement. It emphasises the need to provide the user with a set of
information which addresses all relevant areas of performance in an objective and unbiased fashion.
The information provided may include both financial and non-financial elements, and cover areas such
as profitability, customer satisfaction, internal efficiency and learning and growth.
Break-even analysis. See Cost-volume profit analysis.
Budget. A quantitative statement, for a defined period of time, which may include planned revenues,
expenses, assets, liabilities and cash flows.
Budget manual. A collection of instructions governing the responsibilities of persons and the
procedures, forms and records relating to the preparation and use of budgetary data.
By-product. Output of some value produced incidentally while manufacturing the main product.
Cash budget. A statement in which estimated future cash receipts and payments are tabulated in
such a way as to show the forecast cash balance of a business at defined intervals.
Contribution. The difference between the selling price and the variable cost of a product.
Controllable costs. Items of expenditure which can be directly influenced by a given manager within
a given time span.
Cost behaviour. The way in which costs are affected by changes in the volume of output.
Cost centre. Any part of an organisation which incurs costs.
Cost driver. A factor influencing the level of cost. Often used in the context of ABC to denote the
factor which links activity resource consumption to product outputs.
Cost pool. A grouping of costs relating to a particular activity in an activity-based costing system.
Cost, or expense, centre. Any part of an organisation which incurs costs.
Cost-volume-profit (CVP) analysis. The study of the interrelationships between costs, volume and
profit at various levels of activity. Also known as break-even analysis.
Customer profitability analysis (CPA). The analysis of the revenue streams and service costs
associated with specific customers or customer groups.
Cusum chart. A chart which shows the cumulative sum of variances over a period of time.
Data. The raw material for data processing. Data relates to facts, events and transactions.
Development costs. The costs incurred between the decision to produce a new or improved product
and the commencement of full manufacture of the product.
Differential cost. The difference in total cost between alternatives.
Direct cost. A cost that can be traced in full to the product, service, or department that is incurring
the cost.
Direct labour costs. The specific costs of the workforce used to make a product or provide a service.
Direct labour costs are established by measuring the time taken for a job, or the time taken in 'direct
production work'.
Direct labour efficiency variance. The difference between the hours that should have been worked
for the number of units actually produced, and the actual number of hours worked, valued at the
standard rate per hour.
Direct labour rate variance. The difference between the standard cost and the actual cost for the
actual number of hours paid for.
Direct material costs. The costs of materials that are known to have been used in making and selling
a product, or providing a service.
Direct material price variance. The difference between the standard cost and the actual cost for the
actual quantity of material used or purchased.
Direct material total variance. The difference between what the output actually cost and what it
should have cost, in terms of material used.
Direct material usage variance. The difference between the standard quantity of materials that
should have been used for the number of units actually produced, and the actual quantity of materials
used, valued at the standard cost per unit of material.
Economic Order Quantity (EOQ). The order quantity which minimises inventory costs. The EOQ can
be calculated using a table, graph or formula.
Facility-sustaining activities. Activities undertaken to support the organisation as a whole, and which
cannot be logically linked to individual units of output.
Financing costs. Costs incurred to finance a business such as loan interest.
Fixed budget. A budget which is set for a single activity level.
Fixed cost. A cost which is incurred for a particular period of time and which, within certain activity
levels, is unaffected by changes in the level of activity.
Fixed overhead expenditure variance. The difference between the budgeted fixed overhead
expenditure and actual fixed overhead expenditure.
Fixed overhead total variance. The difference between fixed overhead incurred and fixed overhead
absorbed. In other words, it is the under or over-absorbed fixed overhead.
Fixed overhead volume capacity variance. The difference between budgeted (planned) hours of
work and the actual hours worked, multiplied by the standard absorption rate per hour.
Fixed overhead volume efficiency variance. 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 variance. The difference between actual and budgeted (planned) volume
multiplied by the standard absorption rate per unit.
Flexible budget. A budget which, by recognising different cost behaviour patterns, is designed to
change as volume of activity changes.
Full cost-plus pricing. A method of determining the sales price by calculating the full cost of the
product and adding a percentage mark-up for profit.
Indirect cost, or overhead. A cost that is incurred in the course of making a product, providing a
service or running a department, but which cannot be traced directly and in full to the product, service
or department.
Information. Data that has been processed in such a way as to be meaningful to the person who
receives it.
International Accounting Standard 2 (IAS 2). States that costs of all inventories should comprise
those costs which have been incurred in the normal course of business in bringing the inventories to
their 'present location and condition'.
Investment centre. A section of an organisation whose manager has some say in investment policy in
their area of operations as well as being responsible for costs and revenues.
Job analysis. The 'systematic process of collecting and evaluating information about the tasks,
responsibilities and the context of a specific job' (Bratton).
Job costing. The costing method used where work is undertaken to customers' special requirements
and each order is of comparatively short duration.
Job evaluation. 'A systematic process designed to determine the relative worth of jobs within a single
work organisation' (Bratton).
Job. A customer order or task of relatively short duration.
Joint products. Two or more products produced by the same process and separated in processing,
each having a sufficiently high saleable value to merit recognition as a main product.
Just-in-time (JIT). A system whose objective is to produce or to procure products or components as
they are required by a customer or for use, rather than for inventory. A JIT system is a 'pull' system,
which responds to demand, in contrast to a 'push' system, in which inventories act as buffers between
the different elements of the system, such as purchasing, production and sales.
Just-in-time production. A system which is driven by demand for finished products whereby each
component on a production line is produced only when needed for the next stage.
Just-in-time purchasing. A system in which material purchases are contracted so that the receipt and
usage of material coincide to the maximum extent possible.
Kaizen. A Japanese term for continuous improvement in all aspects of an entity's performance at
every level.
Limiting factor. Anything which limits the activity of the entity.
Management accounting systems. Provide information specifically for the use of managers within an
organisation.
Management control. The process by which managers assure that resources are obtained and used
effectively and efficiently in the accomplishment of the organisation's objectives.
Margin of safety. The difference in units between the budgeted sales volume and the breakeven
sales volume. It is sometimes expressed as a percentage of the budgeted sales volume.
Marginal cost. The variable cost of one unit of product or service.
Market penetration pricing. Adopting a policy of low prices when a product is first launched in order
to obtain sufficient penetration into a market.
Market skimming. Involves charging high prices when a product is first launched and spending
heavily on advertising and sales promotion to obtain sales.
Monopoly. One seller who dominates many buyers. The monopolist can use their market power to set
a profit-maximising price.
Objective. The aim or goal of an organisation (or an individual).
Oligopoly. Relatively few competitive companies dominate the market. While each large company
has the ability to influence market prices, the unpredictable reaction from the other large competitors
makes the final industry price indeterminate.
Operating statement. A regular report for management of actual costs and revenues, usually
showing variances from budget.
Operational control. The process of assuring that specific tasks are carried out effectively and
efficiently.
Opportunity cost. The value of the benefit sacrificed when one course of action is chosen in
preference to an alternative.
Outsourcing. The use of external suppliers as a source of finished products, components or services.
This is also known as contract manufacturing or sub-contracting.
Overhead absorption. The process whereby overhead costs allocated and apportioned to
production cost centres are added to unit, job or batch costs. Overhead absorption is sometimes
called overhead recovery.
Payback. The time required for the cash inflows from a capital investment project to equal the cash
outflows.
Perfect competition. Many buyers and many sellers all dealing in an identical product. Neither
producer nor user has any market power and both must accept the prevailing market price.
Post-Completion Audit (PCA). An objective independent assessment of the success of a capital
project in relation to plan. It covers the whole life of the project and provides feedback to managers to
aid the implementation and control of future projects
Price Elasticity of Demand. Measures the extent of change in demand for a product following a
change to its price.
Prime costs. The sum of all the direct costs.
Principal budget factor. The budgeted factor which limits the activities of an organisation.
Process costing. A form of costing applicable to continuous processes where process costs are
attributed to the number of units produced.
Production costs. The costs which are incurred by the sequence of operations beginning with the
supply of raw materials, and ending with the completion of the product ready for warehousing as a
finished goods item.
Product-sustaining activities. Activities undertaken to develop or sustain a product or service.
Product sustaining costs are linked to the number of products or services, not to the number of units
produced.
Profit centre. Any section of an organisation, for example, a division of a company, which earns
revenue and incurs costs. The profitability of the section can therefore be measured.
Relevant cost of an asset. Represents the amount of money that a company would have to receive if
it were deprived of an asset in order to be no worse off than it already is.
Relevant costs. Future cash flows arising as a direct consequence of a decision.
Research costs. The costs of researching new or improved products.
Residual income (RI). Pre-tax profits less a notional interest charge for invested capital.
Responsibility accounting. A system of accounting that makes revenues and costs the responsibility
of particular managers so that the performance of each part of the organisation can be monitored and
assessed.
Responsibility centre. A section of an organisation that is headed by a manager who has direct
responsibility for its performance.
Return on capital employed (ROCE). Also called Return on investment (ROI). Is calculated as
(profit/capital employed) x 100% and shows how much profit has been made in relation to the amount
of resources invested.
Revenue centre. A section of an organisation which creates revenue but has no responsibility for
production. A sales department is an example.
Reward. 'All of the monetary, non-monetary and psychological payments that an organisation
provides for its employees in exchange for the work they perform'. (Bratton)
Risk averse. Decision maker acts on the assumption that the worst outcome might occur and requires
compensation for risk in the form of higher returns.
Risk. Involves situations or events which may or may not occur, but whose probability of occurrence
can be calculated statistically and the frequency of their occurrence predicted from past records
Risk neutral. Decision maker is indifferent to the level of risk in an investment and only concerned
about the level of expected return.
Risk seeker. A decision maker who is interested in the best outcomes no matter how small the chance
that they may occur, and is attracted to risk.
Sales volume profit variance. The difference between the actual units sold and the budgeted
(planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or
decrease in standard profit as a result of the sales volume being higher or lower than budgeted
(planned).
Scrap. Discarded material having some value.
Selling costs. Sometimes known as marketing costs, are the costs of creating demand for products
and securing firm orders from customers.
Selling price variance. A measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have
been for the actual quantity sold, and what it was.
Semi-variable/mixed cost. is a cost which contains both fixed and variable components and so is
partly affected by changes in the level of activity.
Standard cost. A predetermined estimated unit cost, used for inventory valuation and control.
Step-fixed cost. A cost that is fixed for a certain range of activity but increases to a new fixed level
once a critical level of activity is reached.
Strategic information. Used by senior managers to plan the objectives of their organisation, and to
assess whether the objectives are being met in practice.
Strategic Management Accounting. A form of management accounting in which emphasis is placed
on information which relates to factors external to the entity, as well as to non-financial information
and internally-generated information.
Strategic planning. The process of deciding on objectives of the organisation, on changes in these
objectives, on the resources used to attain these objectives, and on the policies that are to govern the
acquisition, use and disposition of these resources.
Strategy. A possible course of action that might enable an organisation (or an individual) to achieve its
objectives.
Sunk cost. A past cost which is not directly relevant in decision making.
Tactical information. Used by middle management to decide how the resources of the business
should be employed, and to monitor how they are being and have been employed
Target costing approach. A process that begins with the development of a product concept and
then determination of the price customers would be willing to pay for that concept. The desired profit
margin is deducted from the price, leaving a figure that represents total cost. This is the target cost.
Total Quality Management (TQM). A philosophy that means that quality management is the aim of
every part of the organisation. The aim is to 'get it right first time' which means that there is a striving
for continuous improvement in order to eliminate faulty work and prevent mistakes.
Uncertain events. Those events whose outcome cannot be predicted with statistical confidence.
Value-added cost. Costs incurred for an activity that cannot be eliminated without the customer's
perceiving a deterioration in the performance, function, or other quality of a product.
Variable cost. A cost which tends to vary with the level of activity.
Variable production overhead expenditure variance. The difference between the amount of
variable production overhead that should have been incurred in the actual hours actively worked, and
the actual amount of variable production overhead incurred.
Variance. The difference between a planned, budgeted, or standard cost and the actual cost incurred.
Weighted average cost method of inventory valuation. An inventory valuation method that
calculates a weighted average cost of units produced from both opening inventory and units
introduced in the current period.
Zero based budgeting (ZBB). Involves preparing a budget for each cost centre from a zero base.
Every item of expenditure has to be justified in its entirety in order to be included in the next year's
budget.
423
INDEX
INDEX | 425
A
ABC method of stores control, 310
Abnormal gain, 197
Abnormal loss, 197
Absorption base, 154
Absorption costing, 143, 177
Absorption costing and marginal costing
compared, 161
Account-classification method, 84
Accounting rate of return (ARR) method, 285
Activity based costing (ABC), 174, 175
Activity based management (ABM), 175, 185
Activity cost pool, 176
Activity ratio, 339
Administration overhead, 140
Advanced manufacturing technology, 174
Advantages of ABC, 183
Allocation, 145
Assumptions about cost behaviour, 108
Attainable standard, 88, 239
Attributable fixed costs, 44
Average inventory, 307
Avoidable costs, 42
B
Balanced scorecard, 341
Balanced scorecard approach, 342
Base remuneration, 344, 345
Bases of absorption, 155
Basic standard, 88, 239
Berry, Broadbent and Otley, 342
Blanket absorption rates, 156
Blanket overhead absorption rate, 156
Bottom up, 89
Bottom up (participatory budget), 89
Break-even analysis, 111
Break-even charts, 118
Break-even point, 112, 114
Budget, 66, 68
Budget variance, 81
Cash, 72
Fixed, 78
Incremental, 85
Master, 77
Responsibility for, 69
Budget bias, 91
Budget committee, 69
Budget manual, 69
Budgetary slack, 90
Budgeting and TQM, 93
By-product, 214
C
Capacity ratio, 339
D
Data, 15, 16
Decision-making problems, 48
Demand-based approach to pricing, 315
Deprival value, 47
Deprival value of an asset, 46
Designing a management accounting system,
23
Development of managing accounting
information, 4
Differential costs, 42
Differential pricing, 314
Direct cost, 138
Direct expenses, 139
Direct labour costs, 138
Direct labour efficiency variance, 252
Direct labour rate variance, 252
Direct labour total variance, 252
Direct material, 139
Direct material costs, 138
Direct material total variance, 250
Direct wages, 139
Disadvantages of ABC, 184
Discretionary cost items, 87
E
Effectiveness, 13, 335
Efficiency, 13, 335
Efficiency ratio, 339
Elastic demand, 315
Empire building, 91
EOQ formula, 308
Equivalent units, 206
Expense centre, 326
Expenses, 138
Extrinsic rewards, 343
F
Facility-sustaining activities, 182
Factory overhead, 140
Favourable variance, 250
Features of a report, 18
Feedback Information, 68
Feedback loop, 68
Financial accounts, 7
Financial analysis of long-term decisions, 278
Financial information, 18
Fixed budget, 78
Fixed cost, 43, 102, 104
Fixed overhead expenditure variance, 256
Fixed overhead total variance, 256
Fixed overhead volume variance, 256
Fixed production overhead variances, 255
Flexible budget, 78
Full cost-plus pricing, 310
Functional costs, 141
J
Job, 216
Job accounts, 216
Job costing, 216
Joint costs, 214
Joint products, 213
Just-in-time (JIT), 26, 300
Just-in-time production, 26, 300
Just-in-time purchasing, 26, 301
Just-in-time systems (JIT), 300
K
Kaizen, 27
Kanban, 301
Key budget factor, 70
L
G
Goal congruence, 91
Gross profit margin, 337
Growth, 313
H
Hierarchy of activities, 181
High-low method, 79, 84, 108
Holding costs, 304
I
Ideal standard, 88, 239
Imposed budget, 89
Incremental costs, 42
Indices, 336
Labour, 138
Lean management accounting, 27
Life cycle costing, 27
Limiting budget factor, 70
Limiting factor, 47
Long-term financial plan, 68
Long-term plan, 68
Long-term planning, 9, 10
Long-term strategic planning, 10
M
Machine cells, 301
Management accounting
Development of managing accounting
information, 4
Management accounting function, 4
Management accounting system, 20
Designing, 23
INDEX | 427
Management control, 13
Management control information, 24
Management control system, 9, 14
Margin of safety, 113
Marginal cost, 157
Marginal costing, 157, 160
Marginal costing and absorption costing
compared, 161
Marginal costing principles, 158
Marginal cost-plus pricing, 311
Market penetration pricing, 314
Market skimming pricing, 314
Marketing overhead, 140
Mark-up pricing, 311
Master budget, 77, 78
Materiality, 260, 328
Materials, 138
Materials variances and opening and closing
stock, 251
Maturity, 313
Maximum level, 306
Minimum level, 306
Mission, 9
Mixed cost, 106
Monopoly, 313
Mutually exclusive projects, 286
N
Negotiated style of budgeting, 91
Non-financial information, 18
Non-linear variable costs, 106
Non-relevant variable costs, 44
Non-value-added costs, 302
Normal loss, 197
O
Objective, 9
Objectives of organisations, 9
Oligopoly, 313
Operating statement, 263
Operational control, 14
Operational control information, 24
Operational information, 15, 24
Opportunity costs, 42
Optimal ABM, 185
Optimum production plan, 49
Order cycling method of stores control, 309
Ordering costs, 305
Origination of proposals, 277
Other direct expenses, 138
Outsourcing, 52
Overhead, 138, 143
Overhead absorption, 153
Overhead absorption rate, 156, 157, 255
Overhead allocation, 145
P
Padding the budget, 90
Pareto (80/20) distribution, 310
Participation, 89
Participatory budget, 89
Payback, 282
Payback method, 282
Perfect competition, 313
Performance indicators, 334
Performance measurement, 24
Performance measures, 333
Performance measures for cost centres, 335
Performance measures for investment centres,
340
Performance measures for profit centres, 336
Performance measures for revenue centres,
336
Performance standards, 239
Performance-related remuneration, 344
Planning, 9, 67
Planning and control cycle, 67
Position audit, 67
Post-completion audit (PCA), 280
Predetermined overhead absorption rate, 153
Price elasticity of demand (PED), 315
Price leadership, 314
Principal budget factor, 70
Process accounts, 195
Process costing, 194
Procurement costs, 305
Product life cycle, 312
Production overhead, 140
Production volume ratio, 339
Productivity, 335
Product-sustaining activities, 182
Profit centre, 327
Profit margin, 336
Profit targets, 114
Profit/volume (P/V) chart, 118, 122
Profit/volume (P/V) ratio, 112
Project screening, 277
Q
Qualitative issues in long-term decisions, 278
Qualitative performance measure, 335
Qualities of good information, 16
R
Reciprocal (repeated distribution) method of
apportionment, 150
Target costing, 28
Target profit, 115
Top down, 89
Top down (imposed budget), 89
Total cost, 316
Total Quality Management (TQM), 26, 93
Transfer price, 317
Transfer price, 317, 318
Transfer pricing, 318
Two-bin system of stores control, 309
U
Uncertain events, 288
Uncertainty, 288
Uncontrollable costs, 43
Unfavourable variance, 250
Uniform loading, 301
V
S
Sales variances, 261
Sales variances significance, 262
Sales volume profit variance, 261, 262
Saturation, 313
Scatter graph method, 84
Scrap, 201
Selling price variance, 261
Semi-variable cost, 106
Short-term tactical planning, 10
Spend to budget, 85
Standard cost system, 236
Standard costing, 236, 238
Standard hour, 339
Standard operation sheet, 241
Standard product specification, 240
Step-fixed cost, 105
Stockout costs, 305
Strategic ABM, 185
Strategic analysis, 67
Strategic information, 14
Strategic Management Accounting, 23
Strategic planning, 13
Strategy, 9
Sub-contracting, 52
Sunk cost, 43
Sustainability, 30
Sustainability accounting, 30
T
Tactical information, 15, 24
Value-added, 302
Variable cost, 43, 102, 105
Variable overhead total variance, 254
Variable production overhead expenditure
variance, 254
Variable production overhead variance, 254
Variance, 250, 334
Control chart, 330
Control limits, 330
Significance of, 329
Variances
Interdependence between, 332
Vision, 9
W
Weighted average cost method, 210
World-Class Manufacturing (WCM), 25
Y
Yardsticks, 334
Z
Zero base budgeting (ZBB), 85
Advantages of, 86
Disadvantages of, 86
Using, 87
NOTES | 429
430 | NOTES