Mt Kenya University

P.O. Box 342-01000

Thika
Email: [email protected]
Web: www.mku.ac.ke

DEPARTMENT OF BUSINESS AND

SOCIAL STUDIES

COURSE CODE: BBM 221

COURSE TITLE: MANAGEMENT

ACCOUNTING I

Instructional Material for BBM- Distance Learning

BBM 221: MANAGEMENT ACCOUNTING I
Contact Hours: 42
Pre-requisites: BBM 114, BBM 125 and BBM 221

Purpose: To provide the student with the knowledge of important concepts and techniques needed by
managers in planning, control, management and decision making in business organization

Expected Learning Outcomes of the Course:

By the end of the course unit the learners should be able to:-
i) Explain the importance of management accounting in the management of organizations
ii) Apply management accounting techniques to solve various management dilemmas
iii) Explain the importance of budgeting and responsibility accounting in management of
organizations

Course Content:
Nature, Purpose and scope of Management Accounting; Decision Making environments and
techniques; Cost Behavior; Cost Estimation; Relevant costing; Cost-Volume- Profit Analysis;
Variable and absorption costing; Master Budget and Responsibility Accounting

Course Outline
WEEK 1
Chapter: Nature, Purpose and Scope of Management Accounting
Sub Topics:
• Definitions- Managerial Accounting, Cost Accounting, Financial Accounting
• Evolution of Management Accounting
• Objectives of Management Accounting
• Difference between Management and Financial Accounting
• Management Accounting System
• The Management Accounting Guidelines
• Role of management accounting in management process

Week 2 & 3
Chapter: DECISION MAKING
Sub Topics:
• Decision Making Process
• Decision Making Conditions
• Decision Making Techniques- Decision trees analysis; Maximin, Maximax, Laplace
and Minimax regret criteria; Probability distributions, Expected values, standard
deviation, coefficient of variation; Portfolio analysis, Grid Analysis

Week 4 & 5
Chapter: COST ESTIMATION AND FORECASTING
• Cost Concept
• Cost Classifications- Stock valuation and profit measurement; Planning control and
decision making- Cost behavior, According to the degree of traceability to the final
product, Relevance
• Managerial ability to avoid, According to functions of department,

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• Cost Estimation Methods- Accounts analysis (Accounts inspection method), The
two point method (High-Low Method), Regression analysis (least-square method),
Graphical method, Conference method, Engineering methods

Week 6 & 7
Chapter: SHORT TERM PLANNING
• Sub Topics:
• Cost Volume Profit Analysis
• Assumption of CVP analysis
• The Break- Even Point
• B. E. P in Graphical Form
• B. E. P in Mathematical Formula
• Margin of safety
• C V P in Multi-product Environment
• Criticisms of CVP analysis

Week 8 & 9
Chapter: RELEVANT COSTS FOR NON ROUTINE DECISION
Sub Topics:
• The concept of cost relevance to decision making
• Assumptions of Relevant Costing
• Quantitative and qualitative factors in decision making
• Limiting factors in decision making
• Special pricing decisions
• Make or buy decisions
• Discontinuation decisions
• Equipment replacement decisions

Week 10 & 11
Chapter: ABSORPTION COSTING AND MARGINAL COSTING
Sub Topics:
• Absorption Costing
• Overhead Cost Allocation
• Overhead Cost Apportionment- Direct method, The step (elimination) method,
Continuous (repeated distributed) method, Algebraic method
• Overhead Absorption
• Application of Overhead to Product
• Marginal / Variable Costing Vs Absorption Costing
• A comparison of the impact of variable costing and absorption costing on profit
• Activity Based Costing (ABC)

Week: 12 & 13
Chapter: BUDGETING
Sub Topics:
• Budgetary Control

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• The role and rationale of budgeting- Functions of budgets, Advantages of budgets
and budgetary control systems
• Types of budgets
• Mechanics of budgeting
• Stages in the budgeting process
• Steps in developing a master budget
• Human aspects of budgeting
• Alternative Budgeting Procedures- Zero-Based Budgeting (ZBB), Activity-Based
Budgeting, Incremental budgeting

Course Assessment
Examination - 70%; Continuous Assessment Test (CATS) - 20%; Assignments - 10%; Total - 100%

Recommended Text Books:

i) Horngren C.T and Foster, G: (2003), Cost Accounting: A Managerial Emphasis, (11th
Edition)
ii) Hansen (2008); Management Accounting; Cengage Learning ( Thompson )

Text Books for further Reading:

i) Horngren C.T Sundrem G L and Stratton W. O; (1996), An introduction to Management
Accounting, (10th International Edition), Prentice Hall International Inc

Note: Sit in CATs cover work up to week 7 in the course outline

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Table of Contents
Page
1.0 Chapter One: Nature, Purpose and Scope of Management Accounting………1
1.1 Definitions……………………………………………………………………………...….1
1.2 Evolution of Management Accounting…………………………………………………8
1.3 Objectives of Management Accounting………………………………………………..8
1.4 Difference between Management and Financial Accounting………………………9
1.5 Management Accounting System………………………………………………………10
1.6 The Management Accounting Guidelines…………………………………………….11
1.7 Role of management accounting in management process………………………….12
1.8 Review Questions………………………………………………………………………..12

2.0 Chapter Two: Decision Making…………………………………………………13

2.1 Decision Making Process……………………………………………………………….13
2.2 Decision Making Conditions……………………………………………………………15
2.3 Decision Making Techniques…………………………………………………………...16
2.3.1 Decision trees analysis..…………………….………..……………………………….16
2.3.2 Maximin, Maximax, Laplace and Minimax regret criteria……………………….18
2.3.3 Probability distributions Expected values, standard deviation and
coefficient of variation……………………………………………………………………….20
2.3.4 Portfolio analysis………………………………………………………………………22
2.3.5 Grid Analysis……………………………………………………………………………24
2.4 Review Questions…………………………………………………………………………25

3.0 Chapter Three: Cost Estimation and Forecasting……………………………..27

3.1 Cost Concept……………………………………………………………………………..28
3.2 Cost Classifications……………………………………………………………………..29
3.3 Cost Estimation Methods…………………………………………………………........33
3.3.1 Accounts analysis (Accounts inspection method)…………………………………33
3.3.2 The two point method (High-Low Method)………………………………………..34
3.3.3 Regression analysis (least-square method)………………………………………..36
3.3.4 Graphical method……………………………………………………………………..41
3.3.5 Conference method……………………………………………………………………42
3.3.6 Engineering methods ………………………………………………………………...43
3.3.7 Learning curve ……………………………………………………………………….44
3.4 Review Questions……………………………………………………………………….49

4.0 Chapter Four: Short Term Planning…………………………………………...51

4.1 Cost Volume Profit Analysis……………………………………………………………51
4.2 Assumption of CVP analysis……………………………………………………………51
4.3 The Break- Even Point………………………………………………………………….52
4.4 B. E. P in Graphical Form……………………………………………………………..52
4.5 B. E. P in Mathematical Formula……………………………………………………..54
4.6 Margin of safety………………………………………………………………………….57
4.7 C V P in Multi-product Environment…………………………………………………59
4.8 Criticisms of CVP analysis……………………………………………………………..61

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4.9 Review Questions……………………………………………………………………….62

5.0 Chapter Five: Relevant Costs for Non Routine Decision

5.1 The concept of cost relevance to decision making…………………………………63
5.2 Assumptions of Relevant Costing…………………………………………………….64
5.3 Quantitative and qualitative factors in decision making………………………….64
5.4 Limiting factors in decision making…………………………………………………65
5.5 Special pricing decisions……………………………………………………………...66
5.6 Make or buy decisions…………………………………………………………………67
5.7 Discontinuation decisions…………………………………………………………….68
5.8 Equipment replacement decisions……………………………………………………69
5.9 Review Questions………………………………………………………………………72

6.0 Chapter Six: Absorption Costing and Marginal Costing……………………73

6.1 Absorption Costing…………………………………………………………………….73
6.2 Overhead Cost Allocation…………………………………………………………….74
6.3 Overhead Cost Apportionment……………………………………………………….74
6.4 Overhead Absorption…………………………………………………………………..78
6.5 Application of Overhead to Product…………………………………………………82
6.6 Marginal / Variable Costing Vs Absorption Costing……………………………...84
6.7 Activity Based Costing (ABC)………………………………………………………..94
6.7 Review Questions………………………………………………………………………97

7.0 Chapter Seven: Budgeting……………………………………………………..99

7.1 Budgetary Control……………………………………………………………………..99
7.2 The role and rationale of budgeting………………………………………………..100
7.3 Types of budgets………………………………………………………………………101
7.4 Mechanics of budgeting……………………………………………………………...101
7.5 Steps in developing a master budget……………………………………………….103
7.6 Human aspects of budgeting………………………………………………………..114
7.7Alternative Budgeting Procedures………………………………………………….115
7.8 Review Questions…………………………………………………………………….119
Sample Exam Papers……………………………………………………………………..121

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1.0 CHAPTER ONE: NATURE AND PURPOSE OF MANAGEMENT
ACCOUNTING
Learning Objectives

By the end of this chapter the learner should be able to:

i) Distinguish between managerial accounting, cost accounting and financial
accounting
ii) State objectives of management accounting
iii) Describe the management accounting system
iv) Explain the role of management accounting in management process

1.1 Definitions
Managerial Accounting
Management accounting is the application of the professional knowledge and skills in
preparation and presentation of accounting information in such a way as to assist
management in formulation of policies and planning and control of the operations of
undertakings. It measures and reports financial and non-financial information that helps
managers make decision to fulfill the goals of an organization.
It is focused on internal reporting.
It is concerned with the provision of information to people within the organization so as
to help them make decision and improve efficiency and effectiveness of existing
operations.
Management accounting provides information required by management for such
purposes as:-
1. Formulation of policies
2. Planning and controlling activities of the enterprises
3. Decision making on alternative causes of action.
4. Disclosure to those external to the entity
5. Disclosure to employees
6. Safeguarding assets
The above involves participative management to ensure that there is effective:-
1. Formulation of long tern plans to meet objectives
2. Formulation of short term operation plans
3. Recording of actual transactions

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4. Corrective actions required to bring future actual transactions into line.
5. Obtaining and controlling finance
6. Reviewing and reporting on systems and operations
Cost Accounting
Cost accounting measures and reports financial and non-financial information that relates
to the cost of acquiring or consuming resources by an organization, it includes those parts
of management and financial accounting where information cost is collected or analyzed.
It provides information both managerial accounting and financial accounting.
Financial Accounting
It focuses on reporting to external parties. It measures and records business transactions
and provides financial statements that are based on generally accepted accounting
principles.
It is defines as that part of accounting which covers the classification and recording actual
transactions of an entity in monetary terms in accordance with established concepts,
principles, accounting standards and legal requirements and present as accurate view as
possible of the effect of those transactions over a period of time and at the end of that
time.
Note: - All the above three branches of the accounting should be integrated into the
company’s reporting system where:
Financial accounting maintains records of each transaction and helps control the firm’s
assets and liabilities e.g. plant, equipment, stock, debtors and creditors.
It satisfies the legal and taxation requirements and also provides input into the costing
system.
Cost accounting analyses the financial data into more detail and provides a lot of other
information used for control
It also provides key data such as stock valuation and cost of sale which are fed back into
the financial accounting system so that accounts can be finalized.
Managerial accounting gets information from financial and cost accounting system and
uses this and other available information in order to advice management on matters such
as cost control, pricing, investment decisions and planning.

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1.2 Evolution of Management Accounting
Financial accounting used to be considered adequate for making information needs of the
management for the control of the business operations.
The annual financial statements which comprised of a balance sheet and profit and loss
account are still prepared and presented to management by the financial accountant.
However the management needs much more detailed information than those supplied by
this financial statement.
Management accounting compared to financial accounting is a young discipline and so
management accounting concept and tools are still evolving as new ways are found to
provide information that assists management. Management accounting evolved as a
result of rapidly changing business environment. Several changes that are especially
pertinent to management accounting are:-
Globalization, deregulation, emergency of new industries, just in time inventory
management, continuous improvement, computer integrated manufacturing, product
quality etc.
1.3 Objectives of Management Accounting
1. Planning
All organization should plan a head in order that they can set objectives and decide how
they can meet them. Management accounting uses past data to predict the future
2. Control
The production of the company internal accounts enable the firm to concentrate on
achieving its objectives by identifying which areas are performing and which are not.
The use of management by exception reports enables control to be exercised where it is
most useful.
3. Organization
There is a direct relationship between the organizational structure and the management
accounting system. Management accounting system should therefore produce the right
information at the right cost, at the right time.
4. Communication
The existence of budgetary and management accounting system is an important part of
communication process. Plans are outlined to managers so that they are fully aware of

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what is required of them and the management accountant tells them whether or not the
desired results are achieved.
5 Motivation
The use of budget and achievable targets motivates the employees to work hard so as to
achieve these targets.
1.4 Difference between Management and Financial Accounting
1. Legal requirements
It is a legal requirement for a public limited company to produce annual financial
accounts regardless of whether or not management regards this information as useful.
However it is optional for management accounting to prepare this statement.
2. Financial accounts
Financial accounts must be prepared to conform to legal requirements and generally
accepted accounting principles established by regulatory bodies. These requirements are
essential to ensure consistency and formality that is needed for external financial
statement. In contrast management accountings are not required to adhere to generally
accepted accounting principles when providing managerial information for internal
purposes.
3. Time dimensions
Financial accounting reports what has happened in the past in an organization where as
management accounting is concerned with both past and future information.
Management requires details of expected future cost and revenues.
4. Reporting frequency
Financial accounting is published annually while management accounting requires
information frequently so as to make decisions.
5. Focus on individual parts or segments of the business
Financial accounting report focuses on all parts of the business whereas management
accounting focuses on a small part of the business.
6. Type of information
Management accounting includes non monetary and monetary information while
financial accounting includes monetary information only. Management accounting
includes quantities of materials as well as monetary cost of material, number of

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employees as well as Labor cost etc. Financial accounting records this information in
monetary terms only.
1.5 Management Accounting System
Accounting system is the system of procedures, personnel and computers used to
accumulate and store financial data in the organization.
Managerial accounting constitutes one of several system used by managers in running an
organization. A system consists of a set of inputs, process and outputs. Those are known
as elements. The design of management accounting system should be guided by the
challenges facing managers. There are several factors which should be borne in mind
when a system is being set up.
1. What information is required?
i) What data is required to produce the information?
ii) What are the sources of this data?
iii) How should it be converted?
iv) How often should it be converted?
2 Who requires it?
3 How often is it required?
The following factors should also be considered
1. What data is required to produce the information?
2. What are the sources of this data?
3. How should it be converted?
4. How often should it be converted?
The organizational structure, cost and accuracy should be taken into account.
The following steps should be followed while setting management accounting system.
1. The organizational manual should be drafted which gives communication line
within the organization.
2. All the systems should be integrated.
3. Setting up of the cost centre, profit centre, investment centre etc
4. Introduction of budget and budgetary control.
5. Standards should be set up and standard costing should be put in place.
6. The system should be introduced gradually

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7. The staff should be recruited and trained on the system
8. There should effective internal control system
9. Monitoring and evaluation after implementation.
Attributes of a Good Management Accounting Information
i) Timely
ii) Relevant
iii) Accurate
iv) Inspires users confidence
v) Appropriately communicated
1.7 The Management Accounting Guidelines
Management accounting is still evolving and therefore the guidelines available are not
generally accepted as those of financial accounting. However, some of the guidelines
include:-
1. Cost benefit approach
As management accounting continually face resource allocation decisions, cost benefit
approach should be used. They should weigh the cost and the benefits expected from any
spending. The benefits should make the organization to attain its goals.
2. Give full recognition to behavioral as well as technical considerations
Management accounting system should have two simultaneous missions for providing
information namely:-
i. To help managers make wise economic decisions
ii. To motivate managers and other employees to aim and strive for goals of the
organization.
3. Responsibility accounting principles.
This seeks to assign each employee some authority and responsibility where by the said
employee is responsible for success or failure of his sections.
Responsibility accounting is a system that measures the plans and actions of each
responsibility centers.
There are four major types of responsibility centre are:-
i) Cost centre where manager is accountable for cost duly
ii) Revenue centre – where manager is accountable for revenue only.

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iii) Profit centre where manager is accountable for profit only.
iv) Investment centre – where managers is accountable for investments, revenue and
costs.
4. Management by exceptional principle
This is a principle where management gives more attention to critical areas unusual or
exceptional out of line of the planned program.
Normal business activities are considered to be within the plan and so extra attention may
not be given.

Role of management accounting in management process

i) To allocate and accumulate data and provide reliable results for internal and
external profit reporting
ii) To provide relevant information to help managers make better decisions
iii) To provide information for planning,
iv) To provide information for control and
v) To provide information for performance measurement

Review Questions
i) What is the basic difference between financial and managerial accounting?
ii) What are the key attributes of a good management accounting system?
iii) Discuss the role of management accounting in the management process?
iv) Explain the objectives of management accounting

Suggested References for Further Reading

i) Horngren et. al., 2009, Introduction to Management Accounting, 14th Ed, Dorling
Kindersley, New Delhi Pg 2- 43.
ii) Garisson R. H., and Noreen E. W., 1997 Managerial Accounting, 8th Ed,
MacGrraw-Hill, New York, Pg 2-39

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2.0 CHAPTER TWO: DECISION MAKING
Learning Objectives

By the end of this chapter the learner should be able to:

i) Describe the decision making process
ii) Identify the decision making conditions
iii) Illustrate various decision making techniques

2.1 Decision Making Process

Information generated by management accounting is judged based on its ultimate effect
on the outcome of decisions, an understanding of the decision making process is therefore
imperative precedent to understanding management accounting.
The Decision-Making, Planning and Control Process

1. Identify objectives

2. Search for alternative course of action

Planning process 3. Gather data about alternatives

4. Select alternative course of action

5. Implement the Decision

6. Compare actual and planned outcomes

Control process

7. Respond to divergencies from plan

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The figure above represents a decision making process. Planning involves making
choices between alternatives and is primarily a decision making activity. The final two
stages represents the control process which s a process of measuring and correcting actual
performance to ensure that the alternatives that are chosen and the plans for
implementing them are carried out.
1. Identifying objectives
Objectives provide a direction aim or guide and are therefore a prerequisite to any
decision before any good decision can be made. Thus specification of organizational
goals or objectives is the first step in the decision making process. The overriding
objective of the firm is the maximization of shareholder’s value or maximization of
future cash flows (though controversy still exists). Some authors have argued that people
have a limited capacity for understanding and can only deal with limited amount of
information at a time (bounded rationality), they tend to search fro solutions until the
first acceptable solution is found and no attempt is made to find the best or optimal
solution this is referred to satisficing.
2. The search for alternative course of action
These are strategies that might enable the objectives to be achieved. To maximize future
cash flows management identifies potential opportunities and threats in its environment
and takes appropriate steps to grow the cash flows. The potential courses of action
include developing new products for existing markets, new products for new markets, or
new markets for existing products. The search for alternatives involves acquisition of
information concerning the future opportunities and environments
3. Gather data about alternatives
With the alternative courses of action selected, assessment should be made on the ability
of the company to establish adequate flows for each of the alternative activity for various
states of outcome. Strategic decisions that have a profound effect on the firms future
position are made based on collected data, it is therefore imperative that adequate data is
gathered about the firm’s future capabilities and the environment in which it operates.
Operation decisions or short term decisions which are a concern of lower level also need
collection of necessary data such as selling prices of competitors, estimated demand etc
when data have been gathered management must decide on which course of action to
take.

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4. Select alternative course of action
In practice decision making involve choosing of competing alternative courses of action
and selecting the alternative that best satisfies the objectives of the organization.
Assuming that the objective of the organization is the maximization of future cash flows,
an incremental analysis of the net cash benefits is applied to rank the alternatives, so that
the alternative with the greatest benefits is chosen, subject to consideration of other
qualitative factors.
5. Implement the Decision
The selected course of action should be implemented as part of the budgetary process.
The budget is a financial plan for implementing the various decisions that the
management has made. The budgets for various decisions are expressed in terms of cash
inflows and outflows revenues and expenses and merged together into a master budget
that brings out the budgeted profit and loss statement, cash flow statement and balance
sheet. The budgeting process communicates to everyone in the organization the part that
they should play in implementing management’s decisions.
6. Compare actual and planned outcomes and responding to divergencies from plan
The managerial function of control consists of measurement reporting and subsequent
correction of performance in an attempt to ensure that the firm’s objectives and plans are
achieved. Performance reports consisting of a comparison of actual outcomes with
budgeted or planned outcomes are produced and presented to management (feedback).
These reports highlight activities that don not conform to plans so that management can
focus they scarce time on those activities (management by exception). Effective control
ensures that corrective action is taken so that actual outcomes conform to planed
outcomes. This is indicated by the feedback loops linking stages 7and 5 and 7 and 2.

2.2 Decision Making Conditions

i) Decision making under certainty
When the decision maker knows with reasonable certainty about what the available
alternatives are, and what conditions are associated with each alternative; then a state of
certainty is said to exist. In making a choice under conditions of certainty, there is less
ambiguity and there is a relatively lower chance of making a bad decision

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For example, Kenya Airways needs to buy ten jumbo jets. The decision is from whom to
buy. Kenya Airways has three choices: Airbus, Boeing and McDonnell Douglas. Each of
these companies are known for their quality products. Kenya Airways can choose from
any of these alternatives.
ii) Decision making under risk
In some situations, a manager is able to estimate the level of probability at which certain
variables could occur. The ability to estimate may be due to experience, incomplete but
reliable information or, in some cases, an accurate report. When estimates are made, a
degree of risk is involved. However some amount of information about the situation is
available. The situation requires estimating the probability that one or more known
variables might influence the decision being made.
iii) Decision making under uncertainty
A condition of uncertainty exists when a manager is faced with reaching a decision with
no historical data concerning the variables and/or unknowns and their probability of
occurrence.
v) Decision under conditions of perfect information
Making decisions under conditions perfect information is straight forward because there
exist no unknowns.

2.3 Decision Making Techniques

2.3.1 Decision Trees Analysis
Decision Trees provide a highly effective structure within which one can explore options,
and investigate the possible outcomes of choosing those options. They also give a
balanced picture of the risks and rewards associated with each possible course of action.
This makes them particularly useful for choosing between different strategies, projects or
investment opportunities, particularly when your resources are limited.
In a decision tree, squares represent decisions, circles represent uncertain outcomes and
lines represent the options that you could select. A decision or factor is written above the
square or circle. If one has a completed the solution at the end of the line, it is left blank.
Note that that the joint probability of two events occurring is product of the two events.

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Example: A company is considering whether to develop a new product or consolidate
existing product. New product development can either be undertaken through thorough
development at a cost of Shs.150,000 or through rapid development at a cost of Shs
80,000 while product consolidation can either be achieved through strengthening the
products at a cost of shs 30,000 or through reaping the products at no extra cost. The
following are the expected outcomes, accompanying probabilities and the projected
revenue for of the options.
Thorough development Rapid development Strengthening product Reaping product
outcomes good mod poor good mod poor good mod poor good poor
probabilities 0.4 0.4 0.2 0.1 0.2 0.7 0.3 0.4 0.3 0.6 0.4
revenues 1000000 50000 2000 1000000 50000 2000 400000 20000 6000 20000 2000
Should the company develop a new product or consolidate existing product?

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2.3.2 Maximin, maximax, laplace and minimax regret criteria
Maximin: A pessimistic approach that takes into account the worst possible outcome for
each decision outcome alternative. Determine the worst possible payoff for each
alternative and choose the alternative that has the “best of worst” outcome. This
guarantees a minimum outcome.
Possible Future demand with probabilities
Decision Alternatives Low(0.3) Moderate (0.5) High(0.2)
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16

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Maximin Solution: minimum payoff for each of the decision alternatives is: $10, $7 and
$(4). Solution: build small ($10).
Maximax: An optimistic approach that takes into account the best possible outcome for
each decision outcome alternative. Determine the best possible payoff for each alternative
and choose the alternative that has the “best of best” outcome. Only takes into account
the best possible payoff.
Maximax Solution: Best payoffs are $10, $12 and $16. Solution: build large ($16).

Laplace: Determine the average payoff for each alternative; choose the alternative with
the best average “best weighted payoff’. This approach treats the states of nature as
equally likely.
Laplace Solution: first find the row totals; then divide each of these amounts by the
number of states of nature. Solution: build medium.
Decision Alternatives Row Total Row Average
Small Facility $30 $10
Medium Facility 31 10.33
Large Facility 14 $4.67

Minimax Regret – Determine the worst regret for each alternative; choose the alternative
with the “best worst regret.” This approach seeks to minimize the difference between the
payoff that is realized and the best payoff for each state of nature.
Minimax Regret Solution: first prepare a table of opportunity regrets (subtract every
payoff in each column from the best payoff in that column); second, identify the worst
regret for each alternative; third, select the best of the worst regrets.
Regrets
Decision Alternatives Low Moderate High Worst
Small Facility 0 (10-10) $2(12-10) $6(16-10) $6
Medium Facility 3 (10-7) 0(12-12) 4(16-12) 4
Large Facility 14(10-(4) 10(12-2) 0(16-16) 14

Solution: build medium ($4)

Expected monetary value: This is the weighted average of each state with the
probabilities being the weights “the best weighted average” is chosen

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Expected Monetary Values solution
Small Facility .30(10) + .50(10) + .20(10) = $10.00
Medium Facility .30(7) + .50(12) + .20(12) = $10.50
Large Facility .30(-4) + .50(2) + .20(16) = $ 3.00
Solution: build medium ($10.50)
Expected opportunity loss: The opportunity loss is computed by taking the difference
between the optimal decision for each state of nature and the other decision alternatives.
Opportunity Loss Table
Regrets
Decision Alternatives Low Moderate High
Small Facility 0 $2 $6
Medium Facility 3 0 4
Large Facility 14 10 0

Expected opportunity loss solution

Small Facility .30(0) + .50(2) + .20(6) = $4.6
Medium Facility .30(3) + .50(0) + .20(4) = $1.7
Large Facility .30(14) + .50(10) + .20(0) = $ 9.2
Solution: build medium ($1.7)

2.3.3 Probability distributions expected values and standard deviation and coefficient
of variation
The presentation of a probability distribution for each alternative course of action
provides useful additional information to management by indicating the degree of
uncertainty that exists for each alternative course of action. The expected value of a
decision represents the long-run average outcome that is expected to occur f a particular
course of action is undertaken many times. The standard deviation is the conventional
measure of dispersion or variability, while the coefficient of variation is the relative
variation expressed as the standard deviation divided by the expected value (mean)
Example: a manager is considering whether to make product A of B but only one product
can be produced. An estimation of the possible sales demand for each product gives the
following probability distribution of the profits for each product.

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Product A
Outcome (1) Estimated probability (2) Weighted (1)×(2)
Profits of 6,000 0.1 600
Profits of 7,000 0.2 1,400
Profits of 8,000 0.4 3,200
Profits of 9,000 0.2 1,800
Profits of 10,000 0.1 1,000
=1.0 Expected value = 8,000
Product B
Outcome (1) Estimated probability (2) Weighted (1)×(2)
Profits of 4,000 0.05 200
Profits of 6,000 0.1 600
Profits of 8,000 0.4 3,200
Profits of 10,000 0.25 2,500
Profits of 12,000 0.2 2,400
=1.0 Expected value = 8,900

Which product should the company make?

Expected values are obtained by getting the sum of the weighted outcomes of each
product (see above)
The standard deviation is given as:

n
σ= ∑ ( Xi − X )
i =1
2
( Pi )

Product A
(1) Profits (2) Deviation (3) Deviation (4) probability (5) Weighted
from expected squared amount (3)×(4)

value (Ai - A ) (Ai - A )2

6,000 -2,000 4,000,000 0.1 400,000
7,000 -1,000 1,000,000 0.2 200,000
8,000 0 0 0.4 0
9,000 1,000 1,000,000 0.2 200,000
10,000 2,000 4,000,000 0.1 400,000
Sum of sqd dev 1,200,000

16
σ 1095.4

Product B
(1) Profits (2) Deviation (3) Deviation (4) probability (5) Weighted
from expected squared amount (3)×(4)

value (Bi - B ) (Bi - B )2

4,000 -4,900 24,010,000 0.05 1,200,500
6,000 -2,900 8,410,000 0.1 841,000
8,000 900 810,000 0.4 324,000
10,000 1,100 1,210,000 0.25 302,000
12,000 3,100 9,610,000 0.2 1,922,000
Sum of sqd dev 4,590,000
σ 2142.4

Coefficient of variation is expressed as σ/ A , thus for A, C V is 1095.4/8000 = 0.137 or

13.7% and that of B is 2142.4/8900 = 0.241 or 24.1%. A is therefore more variable than
B. the decision on whether to pick A or B depends on the risk attitude of the decision
maker. However assuming risk aversion the manager would go for product A.
2.3.4 Portfolio analysis
A portfolio is defined as the range of investments held by an organization or a person. In
deciding the type of investments that a firm should invest in it is of critical importance
that the manager considers the revenue relationship between the investment and others
held by the firm. Consider a firm that produces a seasonal product such as ice cream with
annual sales of 1M and is considering producing another product and the available
options are overcoats or soft drinks each with estimated sales of 1M. If the company
chose to produce soft drinks, chances are that they will not make 2M in sales because soft
drinks and are all sold during hot seasons and they might cannibalize the ice cream sales,
worse still the company might have zero sales during cold seasons and be forced to lay
people off on the hand if it decided to make overcoats or umbrellas chances of hitting the
2M sales are high and better still sales throughout the year are assured.

17
We measure the relationship between individual assets in a portfolio using the
covariance. Covariance is a statistical measure of the degree to which two variables (e.g.
securities return) move together. A positive value means that on average, they move in
the some direction. A negative value means that on average they move in the opposite
direction and a zero covariance means that the two variables show no tendency to vary
together in either a positive or negative linear fashion.
n
Covariance is expressed as: COV = ∑ ( Xi − X )(Y − Y )( Pi )
i =1

Example: Consider data from our previous example on probability distributions expected
values and standard deviation and coefficient of variation for product A and B. If the
company had an objective of stabilizing earnings would a portfolio of product A and B
achieve this objective?
(1)Profits (1)Profits (2) Deviation (3) Deviation (4) probability (5) (Ai - A ) (6) (Ai - A ) ×
(A) (B) from expected from expected *(probability
for B chosen) × (Bi - B ) (Bi - B )(Pi)
value (Ai - A ) value (Bi - B ) (2) × (3) (4) × (5)
6,000 4,000 -2,000 -4,900 0.05 9,800,000 490,000
7,000 6,000 -1,000 -2,900 0.1 2,900,000 290,000
8,000 8,000 0 900 0.4 0 0
9,000 10,000 1,000 1,100 0.25 1,100,000 275,000
10,000 12,000 2,000 3,100 0.2 6,200,000 1,240,000
COV = 2,295,000

We use the correlation coefficient (r) in interpreting the covariance.

Correlation coefficient is a standardized statistical measure of the linear relationship
between two variables. It ranges from – 1.0 (perfect negative correlation) through 0 (no
correlation), to + 1.0 (perfect positive correlation).
Correlation coefficient (r) of A and B (rA,B), will be given by covariance of A of B
divided by their respective standard deviations i.e.

cov A, B 2,295,000
rA, B = = = 0.9779
σ A ×σ B 1,095.4 × 2,142.4

18
This is a near perfect positive correlation and therefore having a portfolio of product A
and B would not stabilize earnings. The firm should eliminate one product and replace it
with a product whose earnings are negatively correlated.
2.3.5 Grid Analysis
Grid Analysis (also known as Decision Matrix Analysis, Pugh Matrix Analysis or
MAUT, which stands for Multi-Attribute Utility Theory) is a useful technique to use for
making a decision. It is particularly powerful where one have a number of good
alternatives to choose from, and many different factors to take into account.
The technique works by getting one to list his options as rows on a table, and the factors
they need consider as columns. One then score each option/factor combination, weight
this score, and add these scores up to give an overall score for the option.

Example:
A CEO of a firm who is a windsurfing enthusiast is about to replace his car. He needs one
that not only carries a board and sails, but also that will be good for business travel. He
has always loved open-topped sports cars. No car he can find is good for all three things.
His options are:
• An SUV/4x4, hard topped vehicle.
• A comfortable 'family car'.
• A station wagon/estate car.
• A convertible sports car.
Criteria that he wants to consider are:
• Cost.
• Ability to carry a sail board safely.
• Ability to store sails and equipment securely.
• Comfort over long distances.
• Fun!
• Nice look and build quality to car.
Firstly one draws up the unweighted table shown below, and scores each option by how
well it satisfies each factor:

19
Figure 1: Example Grid Analysis showing unweighted assessment of how each type of
car satisfies each factor
Factors: Cost Board Storage Comfort Fun Look Total
Weights:
Sports Car 1 0 0 1 3 3
SUV/4x4 0 3 2 2 1 1
Family Car 2 2 1 3 0 0
Station
2 3 3 3 0 1
Wagon

Next he decides the relative weights for each of the factors. He multiplies these by the
scores already entered, and totals them. This is shown in Figure 2:
Figure 2: Example Grid Analysis showing weighted assessment of how each type of car
satisfies each factor

Factors: Cost Board Storage Comfort Fun Look Total

Weights: 4 5 1 2 3 4
Sports Car 4 0 0 2 9 12 27
SUV/4x4 0 15 2 4 3 4 28
Family Car 8 10 1 6 0 0 25
Station
8 15 3 6 0 4 36
Wagon

This gives an interesting result: Despite its lack of fun, a station wagon may be the best
choice.

Review Questions
i) A yatch company has developed a new cabin cruiser which they earmarked for
the medium to large board market. A market analysis has a 30% probability of
annual sales being 5000 boats, and a 40% probability of 4000 annual sales. This
company can go into limited production while available costs are sh.10,000 per
boat and a fixed cost and sh.800,000 annually. Alternatively they can go into full
production where variable cost are sh.9000 per boat and fixed costs are
sh.5,000,000 annually, if the new boat is to be sold for shs.11,000 should the

20
company go to limited or full scale production when the objective is to maximized
expected profits (use a tree diagram)
ii) Describe the decision making process
iii) Explain the situations where the following decision making techniques are used:
a) Grid analysis
b) Portfolio analysis

i) Drury c., 2008, Management and Cost Accounting, Cangage Learning, New York
Pg 2-50
ii) Horngren et. al., 2009, Introduction to Management Accounting, 14th Ed, Dorling
Kindersley, New Delhi Pg 2- 43.

21
3.0 CHAPTER THREE: COST ESTIMATION AND FORECASTING
Learning Objectives

By the end of this chapter the learner should be able to:

i) Explain the concept of cost
ii) Describe the methods of cost classifications
iii) Illustrate the various cost estimation methods- Accounts analysis; The two point
method; Regression analysis; Graphical method; Conference method;
Engineering methods; learning curve etc

3.1 Cost Concept and Classification

Cost
Cost is defined as the resources foregone or sacrificed to a specific objective
It is therefore the monetary unit that must be given up for goods and services.
Cost objects
This is any activity for which a separate measurement of cost is desired e.g. product,
services or a combination of product and services.
Cost objectives can further be divided into a cost unit or a cost centre.
A cost unit is a product / service in relation to which cost can be ascertained and
expressed. It is the basic control unit for costing purposes. Its nature depends on the
types of goods produced or the services offered by the firm e.g. a kg of sugar, tones of
chemicals, individuals orders etc.
A cost centre is allocation or person or an item of or equipment or group of these for
which cost may be ascertained and used for control purposes.
It therefore acts as a collecting place for units before they are analyzed further.
The total cost of a cost centre may be related to the cost limit which are passed through
the centre or it may be re-allocated over other cost centers e.g. production dept, service
department etc.
Cost drivers
This is a factor such as the level of activity or volume that casually affect cost of a given
true span i.e. a cause and effect relationship exist between a change in the level of activity
or volume and change in the level cost of that cost object.

22
3.2 Cost Classifications
Classification involves grouping items according to some characteristics. There are two
main way of classification namely:-
1. Stock valuation and profit measurement
For this reasons we have periodic cost and product cost.
Product costs are those costs that are identified with the goods and services purchased or
produced for sale. These are costs which are included in the stock valuation.
Periodic costs or overheads are the cost that are not included in the stock valuation and
therefore are treated as expenses in the year which they are incurred.
There is no attempt to attach period costs to products or stock valuation. They are mainly
incurred due to the passage of time.
Illustration:
Xyz Company produces 75,000 identical units of a product during period 1, whose costs
are as follows:
Manufacturing costs: Ksh Ksh
Direct materials 400,000
Direct labor 200,000
Manufacturing overheads 200,000 800,000
Non- manufacturing costs 300,000

If during period 1 the company sold 45,000 units only for Ksh 750,000 and there was no
opening stock at the start of the period, the profit and loss statement for period 1 will be:
Ksh Ksh
Sales (50,000) 750,000
Manufacturing costs(product costs)
Direct materials 400,000
Direct labor 200,000
Manufacturing overheads 200,000
Total product costs 800,000
Less closing stock (40% or 30,000 units) 320,000
Cost of goods sold (60% or 45,000 units) 480,000
Gross profit 270,000
Less non-manufacturing costs (period costs) 300,000
Operating profit (Loss) (30,000)

23
NB: the manufacturing cost of an unsold product is recorded as an inventory asset and
becomes an expense in the profit and loss account when the product is sold while the non
manufacturing cost or period cost is recorded a an expense in the profit and loss account
in the current accounting period
2. Planning control and decision making
Under this we have:
i) Cost behavior
This is classification of cost according to variability based on the level of output. Cost
can be variable, fixed or mixed.
Variable costs are the ones which vary in total in direct proportions to changes in the
related activity level or volume e.g. material costs, direct labor costs, purchases price,
sales commissions etc.
Fixed costs are costs that remain in total for a given time period despite wide changes in
the related level of activity e.g. rent, depreciation, management salaries etc.

Figure 1: Total costs

Total costs
V. C.

5,000 F. C.
Slope = V.C .e.g. Constant or intercept
$50 per kilo of of $5,000
four

2,000 4000
Output

Cost behavior is best seen through a cost function. A cost function is a mathematical
expression describing how cost changes with changes in the level of activity. The
behavior depicted in figure 1 can be summarized by the following cost function;
y = $5,000 + 50x
Where y represents total costs and x the kilos of floor milled

24
Figure 2: Unit costs

Unit costs

V. C.
$50 per Kilo

F. C.

2,000 4,000 6,000

Output

Unit fixed reduce as output increases as illustrated below:

Units produced Fixed cost per unit

1 5,000
10 500
100 50
1,000 5
5,000 1

NB: 1. since fixed costs are not constant per unit they should be used with caution for
decision making.
iv) in practice fixed costs are not constant over the full range of activity, they may
increase in steps as shown below:

Total Costs

Output

25
Mixed costs or semivariable cost contain both variable and fixed components and
therefore are partly affected by production in the level of activities e.g. consumption or
elasticity. As shown in the figure below:

Total Costs

Output
ii) According to the degree of traceability to the final product
Under this classification costs can be direct costs or indirect costs.
A direct cost is that cost which can be traced in total to the product of services that is
being costed.
E.g. direct material, labor and expenses which are also referred to as prime costs.
Individual costs are cost that cannot be traced directly and in full to the product or service
or department e.g. indirect materials, labor, expenses etc.
Indirect costs are referred to as overheads which include indirect materials, labor
expenses. Total cost is therefore prime costs plus overheads. I.e. the total cost is given
as:
Direct materials XXX
Direct labor XXX
Prime cost XXX
Overheads XXX
Total cost XXX

iii) Relevance
A relevant cost is one that will be required by a decision under consideration. Irrelevant
costs are not affected by the decision. To be relevant cost must be:-

26
a) Future cost
b) Incremental
c) Must involve cash flow
Irrelevant costs are sunk costs. Sunk costs are historical costs without future benefits. It
is the cost of resources already acquired where the total will not be affected by the choice
between various alternatives. It is a cost that has been created by a decision made in the
past and cannot be changed by any decision that would be made in the future.
An incremental cost also called differential cost is the difference between costs for the
corresponding items being considered. The incremental costs of increasing output from
100,000 to 110,000 per week are the costs of producing an extra 10,000. If as a result of
the fixed cost increase, the increase in costs represents an incremental cost and if the
fixed costs donnot change the incremental costs will be zero. Note that the incremental
cost per unit is referred to as marginal cost but he account is more interested in
incremental costs and the economist is more interested in the marginal cost.
iv) Managerial ability to avoid
Under this classification we have avoidable costs and non avoidable costs
Avoidable costs are those cost which may be saved by not adopting a given alternative.
Such costs are therefore relevant in decision making.
Unavoidable costs are those that will still be incurred regardless of whether the decision
is made or not.
v) According to functions of department
It can be manufacturing costs, selling and marketing distance cost, administration cost,
research and development cost etc.
Manufacturing or productions costs are the costs incurred by the segment or operations
beginning which when raw materials are supplied and ending with completion of the
product ready for warehouse and distribution.
Administration costs are the costs of managing an organization i.e. planning and
controlling its activities.
Sales and marketing costs are the costs of creating demand for a product or services and
securing firms orders from the customers.

27
Distribution costs are the costs of the segment of operation beginning with the receipts of
finished goods from the production department, making them ready for dispatch and
ending with reconditioning for re-use of returned empty containers which containers are
returnable.
Research and development costs are the costs of searching for new and improved
products and the cost producing such products.
3.3 Cost Estimation Methods
The following methods used to estimate cost.
i. Accounts analysis (Accounts inspection method)
ii. The two point method (High-Low Method)
iii. Regression analysis (least-square method)
iv. Graphical method
v. Conference method
vi. Engineering methods
3.3.1 Accounts analysis or inspection of accounts
This requires that departmental managers and accountants to inspect each item of
expenditure within the accounts and then classifying each of these items as wholly fixed,
wholly variable or mixed variable. A simple average unit cost figure is selected for this
items that are categorized as fixed and also variable.
Mixed costs are decomposed into their fixed and variable components and the
departmental manager and the accountant agree on a cost function that best describes the
cost behavior.
Illustration: The following cost information has been obtained from the latest monthly
accounts for an output level of 10,000 units for the manufacturing department of ABC
Company.
Item Ksh
Direct materials 100,000
Direct labor 140,000
Indirect Labor 30,000
Depreciation 15,000
Repairs and maintenance 10,000
295,000

28
An analysis of each of the accounts reveals the following as the variable and non-variable
elements of the accounts
Item Unit Variable Total non-
cost variable cost
Direct materials 10.00
Direct labor 14.00
Indirect Labor 30,000
Depreciation 15,000
Repairs and maintenance 0.50 5,000
Total 24.50 50,000
The cost function is therefore y = 50,000 + Ksh 24.50x.
Exercise: Estimate the total cost of producing 10,000 units

3.3.2 The two point method (High-Low) Or Range Method

This consists of selecting the periods of highest and lowest activity levels and comparing
the change in the cost that results from the two levels i.e. the period with the highest level
of output and the period with the lowest level of output.
The two points are then used to find the equation which is given by; y = a + bx where; b
= the gradient or slope, given by the difference between costs associated with the highest
and lowest observation of dependent variable divided by the difference between highest
and lowest observation of cost driver.
Illustration:
Assume that the product manager of ABC Ltd is concerned about the apparent
fluctuations in efficiency and therefore work done by employees which are related to the
volume. The result of this in most 12 weeks research carried out is as shown below;

Week Machine hours(cost driver) Indirect labor costs

1. 68 $1,190
2. 88 1,211
3. 62 1,004
4. 72 917
5. 60 770

29
6. 96 1,456
7. 78 1,180
8. 46 710
9. 82 1,316
10. 94 1,032
11. 68 752
12. 48 963

y=a+bx
machine hour (x) labor costs(y)
Highest 96 1,456
Lowest 46 710
50 746

Diff btw costs associated with highest & lowest cos t driver
Slope coefficient b =
Diff btw highest & lowest cos t driver
= $746 ÷ 50 = $14.92
To compute the constant, we solve for “a” in the equation y = a +bx using any of the
values of x and y i.e.
y = a +bx, a = y – bx.
Thus; a = 1456 – ($14.92×96) = $23.68
Therefore the High-low estimate of the cost function is
y = a +bx
= $23.68 + ($14.92 × Machine hours)

Exercise: (a) Find the indirect labor costs associated with 90 machine hours and (b) the
machine hours that $1,000 of indirect labor cost would produce
(a) If, x = 90
y = $23.68 + ($14.92 × 90)
= $1,366.48

(b) If, y = $1,000

$1000 = $23.68 + ($14.92x)

30
$14.92x = $1000 – $23.68
x =976.32/14.92
= 65.44

3.3.3 Regression Analysis (Ordinary Least Square Method)

A regression equation identifies the relationship between dependent variable y and
independent variable x.
If the relationship has one dependants and one independent variable it is referred to as
simple regression given by the function y = a + bx.
“a” and “b” are computed by solving the following simultaneous equations;

∑ y = na + b∑ x
∑ xy = a∑ x + b∑ x 2

Use the data from the previous example to compute the regression line and determine the
labor cost associated with 80 machine hours
Machine hours Indirect labor
Week /cost driver (x) costs (y) x2 xy
1. 68 $1,190 4,624 80,920
2. 88 1,211 7,744 106,568
3. 62 1,004 3,844 62,248
4. 72 917 5,184 66,024
5. 60 770 3,600 46,200
6. 96 1,456 9,216 139,776
7. 78 1,180 6,084 92,040
8. 46 710 2,116 32,660
9. 82 1,316 6,724 107,912
10. 94 1,032 8,836 97,008
11. 68 752 4,624 51,136
12. 48 963 2,304 46,224
Σ x=862 Σy=12,501 Σ x2= 64,900 Σxy=928,716

Solve for a and b in the simultaneous equations;

∑ y = na + b∑ x ……………………... (1)

31
∑ xy = a∑ x + b∑ x 2
............................. (2), this gives;

12,501 = 12a + 862b………………………… (1)

928,716 = 862a + 64,900b…………………… (2)
Multiply equation (1) by75.2900232 i.e. 64,900/862, this gives;
941,200.58 = 903.4803 + 64,900b………….. (1)
928,716 = 862a + 64,900b………….. (2)
Subtract equation (2) form equation (1), and then solve for “a” this gives;
12,484.58 = 41,4803a
a = 12,484.58/41.4803
= 300.98
Insert this figure in either equation (1) or (2) to solve for b. Inserting in equation (1)
gives; 12,501 = (12×300.98) +862b
12,501 = 3,611.76 +862b
12501 – 3611.6 = 862b
b = 8889.24/862
= 10.31
The cost function is therefore y = $300.98 + ($10.31×Machine hours)
If x = 80 then, y = $300.98 + ($10.31× 80) = $1125.78

“a” and “b” may also be computed using the following simplified expressions

b=
n∑ xy − ∑ x∑ y
, while a =
∑ y − b∑ x
n ∑ x − (∑ x )
2 2
n n
12 × 928716 − 12501 × 862
Using the above data, b =
12 × 64900 − 862 2

11,144,592 − 10,775,862
=
778,800 − 743044
368,730
= = 10.3124
35,756

12,501 10.3124 × 862

a= −
12 12

= 1041.75 − 740.774 = 300.976

32
Exercise: A hospital records show that the cost of carrying health checks in the last five
accounting periods has been as follows;
Period No of patients seen Total cost
1. 650 17,125
2. 940 17,800
3. 1260 18,650
4. 990 17,980
5. 1150 18360

Required: Estimate the cost of carrying out health checks on 850 patients using
i) Regression model
ii) High – low method
Period No of patients seen Total cost x2 xy
1. 650 17,125 422,500 11,131,250
2. 940 17,800 883,600 16,732,000
3. 1260 18,650 1,587,600 23,499,000
4. 990 17,980 980,100 17,800,200
5. 1150 18,360 1,322,500 21,114,000
Σ x=4990 Σy=89,915 Σ x2 = 5,196,300 Σxy = 90,276,450

i) Regression analysis method

An alternative formula of solving for “a” and “b” is:
n∑ xy − ∑ x∑ y
b=
n ∑ x 2 − (∑ x ) 2

a=
∑ y − b∑ x
n n
5 × 90,276,450 − 4,490 × 89,915
b=
5 × 5,196,300 − 4990 2
451,382,250 − 448,675,850
b=
25,981,500 − 24,900,100
b = 2.5

33
89,915 2.5 × 4990
a= −
5 5
a = 17983 − 2,495
= 15,488
The cost function is therefore;
y = $15,488 + ($2.5 × number of patients seen)
The cost of carrying out health checks for 850 patients is
y = $15,488 + ($2.5× 850)
=$17,613

ii) High - low method

x y
Highest 1,260 18,650
Lowest 650 17,125
610 1525

b = ∆y /∆x
= 1525/610
= 2.5
Filling in this value and solving for a,
y = a + bx.
17,125 = a + 2.5 (650)
17,125 = a + 1625
a = 17125 – 1625
= $15,500
The cost function is therefore;
y = $15,500 + ($2.5 × number of patients seen)
The cost of carrying out health checks for 850 patients is
y = 15,500 + 2.5 × 850
= $17,625

The coefficient of determination

34
The coefficient of determination r2 is a goodness of fit measure. It measures how well the
predicted values of y based on the cost driver x, match actual costs, y. It gives the
percentage variation of y explained by x. The coefficient of determination is expressed as:

r = 1−
2 Un exp lained var iation
= 1−
∑ ( ya − ye ) 2
Total var iation ∑ ( y a − y) 2
Example: calculate the r2 of the data on hospital checks and comment on the goodness of
fit.
Period No of patients seen Total cost ye =$15,488 + ($2.5
x)
1. 650 17,125 17,113
2. 940 17,800 17,838
3. 1260 18,650 18,638
4. 990 17,980 17,963
5. 1150 18,360 18,363
Σ x= 4,990 Σy=89,915

Σ(ya - ye)2 = (17,125 – 17,113)2 + (17,800 – 17,838)2 + (18,650 – 18,638)2 + (17,980 –

17,963)2 + (18,360 – 18,363)2 = 2,030
y = Σy/n = 89,915/5=17,983

Σ (ya - y ) = (17,125 – 17,983)2 + (17,800 – 17,983)2 + (18,650 – 17,983)2 + (17,980 –

17,983)2 + (18,360 – 17,983)2 = 1,356,680

r 2
= 1−
∑(y
a − ye ) 2
=
2,030
= 0.999
∑(y a − y) 2
1,356,680

r2 of 0.999 means that 99.9% of the variation in Y(indirect labor cost) is explained by
X(cost driver). Therefore only 0.1% variation in Y is unexplained by variation in the cost
driver. Generally an r2 of 0.30 or higher passes the goodness of fit test. Thus the
regression line is a near perfect predictor

Exercise; use the data on the machine hour example to calculate the coefficient of
determination and comment on the goodness of fit

35
Machine hours Indirect labor ye = $300.98 +
($10.31x)
Week /cost driver (x) costs (y)
1. 68 $1,190 1002,06
2. 88 1,211 1208.26
3. 62 1,004
4. 72 917
5. 60 770
6. 96 1,456
7. 78 1,180
8. 46 710
9. 82 1,316
10. 94 1,032
11. 68 752
12. 48 963 795.86
Σ x=862 Σy=12,501

Σ(ya - ye)2 = (1190 – 1002.06)2 + (1211 – 1208.26)2 +….+ (963 – 795.86)2 = 290,824
y = Σy/n = 12,501/12= 1041.75

Σ (y - y ) = (1190 – 1041.75)2 + (1211 – 1041.75)2 +…. + (963 – 1041.75)2= 607,699

r2 = 1−
∑(y a − ye )
=
290,824
= 0.52
∑(y a − y) 607699

r2 of 0.52 means that 52% of the variation in Y(indirect labor cost) is explained by X(cost
driver). Generally an r2 of 0.30 or higher passes the goodness of fit test.

3.3.4 Graphical or scatter graph method

This method involves plotting on a graph the cost of each activity level the total cost is on
represented on the vertical (y) axis and the activity level on the horizontal(x) axis. A
straight line is fitted to the scatter of plotted points by visual approximation. The point at
which the straight line cuts the vertical axis (y intercept) represents the non-variable costs
or item “a” in the equation y = a + bx. The unit variable cost “b” is obtained by
calculating the gradient of the straight line i.e. change in y/change in x

36
Example: Consider data from the previous illustration on ABC ltd, plot the scatter graph
and fit the line of best fit by visual approximation and estimate the cost 50 machine hours

$1,600

$1,400

$1,200

$1,000
Indirectlabour costs

$800

$600

$400

$200

$0
0 20 40 60 80 100 120
Machine hours(cost driver)

Y-intercept (constant) and thus “a” is approx 300 while, “b” is given by ∆y /∆x i.e.
1,000 − 800 200
b= = = 15.39
65 − 52 13
The cost function according to the graph method is therefore:
y = 300 + (15.39 × machine hours used)
If x = 50,
y = 300+ (15.39 ×50)
= KSh.1069.50
The graphical method is easy to use and it provides a useful visual indication of lack or
correlation or erratic behavior of costs. It however suffers from the disadvantage of the
determination of exactly where the straight line should lie, which is subjective with
different people drawing different lines with different slopes therefore giving different
cost estimated. To overcome this shortcoming, it is preferable to determine the line of
best fit mathematically using the least squares method.
3.3.5 Conference method

37
The conference method estimates cost functions on the basis of analysis and opinion
about costs and their drivers gathered from various departments of an organization
(purchasing, process engineering, manufacturing, etc) the conference method encourages
interdepartmental cooperation. The pooling of experts from the value chain gives the
method credibility. Because the method does not require detailed analysis of data, cost
functions and cost estimates can be developed quickly. However the emphasis on
opinions rather than systematic estimation means that the accuracy of the costs estimates
depends largely on the care and skill of the people providing the inputs. The cooperative
bank of UK estimates the cost functions for its retail banking products through a
consensus of estimates from personnel of the relevant departments.
3.3.6 Engineering methods (work measurement method)
This is based on the use of engineering analysis of technological relationship between
inputs and outputs in physical terms e.g. methods studies or time and motion studies.
The procedures for such analysis are to make an analysis based on direct observations of:
i) The physical quantity required for an activity and then convert the final results
into the cost estimate; Analyzing or breaking task into its constituent motion
elements or operations
ii) Determining time for each motion element or operation and several observations
are made on different persons performing the task; the average of this gives the
normal or base time required for each elements.
iii) Time allowance is made for fatigue, resetting of tools, idleness in recent in the
method of work.
Motion study is the study of movement of work and machines in performing the
operations. The objective of motion study is to eliminate unnecessary and wasteful
motion by workers and machines operated by them.
This method is useful in the estimating the cost of repetitive process where input and
output relationship are clearly defined.
For instance to set the direct labor standards, each operation is studied and an allowed
time computed, usually after carrying out time and motion study. The most efficient
methods of production, equipment and operating conditions are the standardized this is
followed by time measurements to determine the standard hours required by an average

38
worker to complete the job. Unavoidable delays such as machine breakdowns and routine
maintenance are included in standard time while the wage rates are a mater of company
policy or negotiation wit unions. The disadvantage is that the methods may be very
expensive to apply in practice.
3.3.7 Learning Curve Effects
The relationship between the various cost variables may not be linear all the time. If the
relationship is not linear the learning curve may be used to estimate the cost functions.
The first time a new operation is performed both the workers and operating procedures
are untried but as the operations is repeated the workers become more familiar with the
job so the less workers are required for production of additional units.
This phenomenon is called learning curve effect. As this continues a regular rate of
decline of the time taken can be established which can then be used in pre-determining
future costs. This rate is refereed to as learning curving improvement rate given by r.
This process can be illustrated practically as below

30hrs
Time per unit

20hrs

0 1 2 3 4 5 6 7
Cumulative units
Example
Assume that a certain process has an 80% learning curve effect and the first unit took
2000hrs to produce.
Required:
a) Compute the number of hours required to produce the first 32 units
b) Compute the number of hours required to produce 32nd unit.
c) Assume that the wage rate is Kshs.100 per hour, compute the Labor cost of
producing the last 16 units
i) Mathematical method

39
The learning curve effect is given by the expression:
Yx = aXb
Where;
Yx = is the cumulative average time taken to produce x units
a = is the time taken to produce the first unit
b = the natural log learning curve improvement rate divided by natural log of doubling,
ln(learning rate)
tripping etc i.e.
ln 2
a) The cumulative average time required to produce first 32 units
r = 80% or 0.8
ln(learning rate) ln 0.8
b= = = −0.3219
ln 2 ln 2
Y32 = a X b
= 2000 × 32-0.3219
= 655.42hrs
Cumulative number of hrs required to produce 32 units
= 655.42 hrs × 32
= 20,973.44 hrs
b) The cumulative average time required to produce the first 31 units
Y31 = 2000 × 31 -0.3219
= 662.16hrs
Cumulative number of hrs required to produce 31 units is
= 662.16 × 31
= 20,526.96
The cumulative average time taken to produce 32nd unit is
= 655.42 × 32 - 662.16 × 31
= 20,973.44 – 20,526.96
= 446.48hrs
c) Assume that the wage rate is Kshs.100 per hour, compute the Labor cost of
producing the last 16 units
Cumulative total hours for 32 units = 20,973.44

40
Cumulative total hours for the first 16 units = (2000 x 16-0.3219) × 16 = 13,108.22.
Cumulative total hours for the last 16 units = 20,973.44 – 13,108.22 = 7,865.22
The total labor cost for producing the last 16 units = 7,865.22 × KSh100 = 786,522
ii) The graphical method
(1) Cumulative (2) Cumulative (3) Cum total time Individual unit
production time per unit (1) × (2) time for X unit
1 2,000 2,000 2,000
2 1,600 3,200 1,200
4 1,280 5,120 1,920
8 1,024 8,192 3,072
16 819.2 13,107.2 4,915.2
32 655.36 20,971.52 7,864.32

To obtain the learning curve, average cumulative production time is plotted against
cumulative production in units:

2,500
Average cumulative production

2,000 2,000

1,600
1,500
1,280
1,000 1,024
819.2
655.36
500

0
0 5 10 15 20 25 30 35
Cumulative production (units)

Exercise
Assume that a company wishes to manufacture a product with a learning curve effect of
80%. The amount of time needed to produce the first product is 100 hours.
Required;
i) If direct manufacturing labor cost is $20 per hour and related overheads are $30 per
hour,

41
a) What is the cost of producing the first 7 products?
b) What is the cost of producing an additional 8 products?
ii) If direct manufacturing labor cost is $25 per hour and overheads are 80% of direct
manufacturing cost;
a) What is the cost of producing the first 10 products?
b) What is the cost of producing an additional 22 products?

i) (a) The cost of producing the first 7 products?

Y7 = (a X b) × (7) × (direct mfg labor cost per hr + related overheads per hr)
= (100 × 7-0.3219) × (7) × (20+30)
= (100 × 0.5345) × (7) × (50)
= 18,708.17
(b) For an additional 8 products the cumulative production will be 15
Y15 = (a X b) × (15) × (direct mfg labor cost per hr + related overheads per hr)
= (100 × 15-0.3219) × (15) × (20+30)
= (100 × 0.4182) × (15) × (50)
= 31,367.33
The difference between the cumulative production of 15 products and 7 products will give
the incremental cost of producing the extra 8 products i.e.
31,367.33
18,708.17
12,659.16

ii) (a) The direct manufacturing cost of producing the first 10 products will be:
Y10 = (a X b) × (10) × (direct mfg labor cost per hr)
= (100 × 10-0.3219) × (10) × (25)
= (100 × 0.5345) × (10) × (25)
= 11,913.52
The overheads are: 0.8 × 11,913.52 = 9,530.81
The total cost of manufacturing the first 10 products is 11,913.52 + 9,530.81=21,444.33

42
(b) For an additional 22 products the cumulative production will be 32, the direct
manufacturing cost of producing the 32 products will be:
Y32 = (a X b) × (32) × (direct mfg labor cost per hr)
= (100 × 32-0.3219) × (32) × (25)
= (100 × 0.3277) × (32) × (25)
= 26,216.95
The overheads are: 0.8 × 26,216.95 = 20,973.56
The total cost of manufacturing the first 32 products is 26,216.95+ 20,973.56= 47,190.51
The difference between the cumulative production of 32 products and 10 products will
give the incremental cost of producing the extra 22 products i.e.
47,190.51
21,444.33
25,746.18

Other cost methods include time series analysis, trend analysis, simulation analysis etc

Steps of cost estimation

The following steps are followed while estimating costs.
1. Identify or select the dependent variable or the response variable. The cost to be
predicted will depend in respond variables whose purpose is the reason for
estimation.
2. Identify the independent variables also referred to as cost drivers, explanatory
variables or predictor variables. This is any factor whose change cause, a change
in the dependent variable e.g. direct labor hours, direct labor cost, machine hours,
numbers or limits numbers or production runs, number of customer order etc.
3. Gathers data on both dependent and independent variables. A sufficient number
of past observations must be obtained to derive an acceptable cost function. This
should be adjusted to reflect any change of circumstances e.g. inflation or change
in the type of equipment being used.

43
4. Plot the data on the graph usually a scatter diagram. The graph will indicate the
general relationship between dependent and independent variable and will give
visual indication as whether there is a relationship or not.
5. Estimate the cost function. Either of the different methods learnt such as
regression, high-low etc may be use
6. Evaluation of the cost function this may be done through goodness of ft methods
such as the coefficient of determination.

Review Questions
i) What is a cost driver
ii) Explain how step costs can be fixed or variable depending on your perspective
iii) Explain how mixed costs are related to both fixed and variable costs
iv) How would account analysis be combined with engineering analysis?
v) Mr. Galgallo, CEO of a granite tiles manufacturing firm in Kenya is troubled by
fluctuations in productivity and wants to compute how manufacturing support
costs are related to the various sizes of batches of output. The following data
show the results of a random sample of 10 batches of one pattern of granite tiles:
Sample Batch size (X) Support costs $ (Y)
1 15 180
2 12 140
3 20 230
4 17 190
5 12 160
6 25 300
7 22 270
8 9 110
9 18 240
10 30 320

a) Using regression analysis measure the cost function of support costs

and batch size
b) Predict a support cost of a batch size of 25
c) Using the high- low method, repeat question a and b above

44
d) Should the manager use the high low or the regression method? Explain
vi) What can we learn from R2 the coefficient of determination?

i) Horngren et. al., 2009, Introduction to Management Accounting, 14th Ed, Dorling
Kindersley, New Delhi Pg 92- 133.
ii) Garisson R. H., and Noreen E. W., 1997 Managerial Accounting, 8th Ed,
MacGrraw-Hill, New York, Pg 238-276

45
4.0 CHAPTER FOUR: SHORT TERM PLANNING
Learning Objectives

By the end of this chapter the learner should be able to:

i) Explain the assumption of C.V.P analysis
ii) Illustrate the Break- Even Point, in graphical form and in mathematical formula
iii) Explain the margin of safety
iv) Explain C.V.P in Multi-product Environment
v) Discuss the criticisms of C.V.P analysis

4.1 Cost Volume Profit Analysis

Cost volume profit analysis examines the behavior of total revenues, total cost and
operating income as changes occur in the output level, selling price, variable costs per
unit and a fixed cost.
4.2 Assumption of CVP analysis
1. Cost revenue and volume relationship is valid only within a relevant range. A relevant
range is the expected band of activity or volume in which a specified form of
budgeted sales and cost relationship will be valid e.g.

$1,600

$1,400

$1,200

$1,000
Costs and revenue

$800

$600

$400
Relevant range
$200

$0 0
20 40 60 80 100 120
Units sold)

2. The behavior of the total cost and total revenue functions have been reliable
determined and is linear within the relevant range.
3. All costs can be divided into fixed and variable costs and therefore we decompose the
total cost into their variable and fixed components.
4. Total fixed cost remains constant over the relevant range e.g.

46
5. Unit selling prices are constant.
6. Total variable cost is directly proportional to volume within the relevant range.
7. There is no change in the level of inventory
8. Efficiency and productivity remains constant.
9. Prices of factors of production remain constant.
10. No limiting factors exist, no constraints.
4.3 The Break – Even Point
It is a form of CVP analysis. It specifies a way of presenting and studying
interrelationship between cost volume and profit. It establishes the relationship between
revenues and costs with respect to volume.
It shows the level of sales at which costs and revenue are in equilibrium.
The equilibrium point is known as the break even point where total revenue equal to total
costs i.e. no profit or loss. Break even point can either be shown graphically or computed
mathematically.

4.4 B. E. P in Graphical Form

The following steps are used:
1. The sales line
Plot the sales volume on the horizontal axis. Sale volume can be in terms of shillings
units, or as a percentage of capacity.
2. Cost and revenue lines
Revenues, variable costs and fixed cost are represented on the vertical axis.
3. Fixed cost line
They are down parallel to the horizontal axis.

47
Illustration:
A tour company has fixed cost estimates costs of Ksh 60,000 a variable cost of Ksh 10
for each ticket sold and a proposed ticket sale price of Ksh 20. Use the graphical method
to determine the break-even point
(1) Sales volume (2) Sales (3) Total costs (4) Variable (4) Operating
(q) revenue (20×q) {60,000 + costs profit =
(10×q)} (2) - (3)
1,000 20,000 70,000 10,000 -50,000
2,000 40,000 80,000 20,000 -40,000
3,000 60,000 90,000 30,000 -30,000
4,000 80,000 100,000 40,000 -20,000
5,000 100,000 110,000 50,000 -10,000
6,000 120,000 120,000 60,000 0
7,000 140,000 130,000 70,000 10,000
8,000 160,000 140,000 80,000 20,000
9,000 180,000 150,000 90,000 30,000
10,000 200,000 160,000 100,000 40,000

Break - Even Chart

Sales volume
280

Profit area
240

200 T. C.
B.E.P.
Costs/Revenue

160
Loss area
120 V. C.

80

40
F. C.
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Sales volume

48
Contribution Chart Sales volume

280

240
Profit area Contribution

200 B. E. P.
Costs/Revenue

160 F. C.
Loss area
120

80 V. C.

40

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Sales volume

Profit Volume Graph

60,000
Profit area
40,000
B. E. P.
Loss area
Cost/revenue

20,000

0
1 2 3 4 5 6 7 8 9 10
-20,000

-40,000

-60,000
Sales volume

4.5 B E P in Mathematical Formula

B E P can be computed in terms of units or in terms of money value or sales volume or as
a percentage of estimated sales.

49
Units sold will cover variable costs and leave a remainder known as contribution margin
Selling price per unit – variable cost per unit = contribution per unit
Unit contribution × units sold = total contribution
B E P in units is given by:
Fixed Costs Fixed Costs
B.E.P.(units ) = =
Selling Pr ice per unit − Variable Cost perunit Contribution

B. E. P. (shs) = B. E. P. (shs) × Selling price or

Fixed Costs
B.E.P.( Shs) = , where contribution margin ratio is:
Contribution m arg in ratio

Selling Pr ice − Variable cos ts

C.M .R. =
Selling price

Example: Assume that a company intends to sale product in the market, at a selling price
of sh.9 per unit. The V C is shs.5 per unit and the T F C is sh.2000
Required:
i. Compute the B E P in units and in shs.
ii. Assume that the company intends to make a profit before tax of 20% of sales,
determine the number of units that must be sold.
iii. Assume that the corporate tax rate is 30% and the company has a target profit
of 1640 after tax. Compute the number of units that must be sold to earn this
target profit.
iv. If the company expects to sale 600 units, compute the marginal of safety.
Solution
F. C. = Sh.2,000; S. P. = 9.00; V. C. = 5.00
2,000 2,000
i) B.E.P.(units ) = = = 500 units
9−5 4

B. E. P. (shs) = B. E. P. (shs) × Selling price

= 500 × 9 = 4,500 or

50
Fixed Costs
B.E.P.( Shs) =
Contribution m arg in ratio
Fixed cos t 2,000 2,000 2,000
= = = = = 4,500
selling price − var iable cos t 9−5 4 0.44444
selling price 9 9

ii) PBT = Sales – TC

= 9q – (2000 + 5q)
Since PBT = 0.2 of sales, then target PBT = 0.2 ×0.9q
0.2 × 0.9q = 9q – (2000 + 5q)
1.8q = 9q – 2000 – 5q
2000 = 9q – 5q – 1.8q
2000 = 2.2q
q = 2000/2.2
= 909.09
= 909.1 Units
Alternatively, let target before tax profit be Y and X be the number of units required to
earn the target before tax profit.
F .C. + Y
Then, X =
S .P. − V .C
Sales = S P × Units sold
= 9 × X = 9X
Since Profit = 20% of 9X = 1.8X
Thus, X = 2000 + 1.8X / 9 - 5
= 2000 + 1.8X/4
4X = 2000 + 1.8X
4X – 1.8X = 2000
2.2X = 2000
X = 2000/2.2
= 909.1 units

iii) PAT = 1640,

51
= PBT (1-Tax rate)
= PBT × 0.7
1640 = PBT × 0.7
PBT = 1640/0.7
PBT = Sales – TC
2343 = 9q – (2000 + 5q)
2343 = 9q – 2000 - 5q
2000+2343 = 9q - 5q
4343 = 4q
q = 1085.75
Alternatively assume the target after tax profit is Z, the number of units to earn the target
after tax profit is given by:
F .C. + 1−ZT
X =
S .P. − V .C
Where: T is the tax rate i.e. 1 – T = 1 – 0.3 = 0.7
X = 2000 + (1640/0.7) / 9 – 5
= 2000 + 2343/4
= 1085.75

4.6 Margin of safety

This is the amount by which actual sales may fall before incurring a loss. It measures the
risk that the company might make a loss if it fails to achieve the target. A high margin of
safety means a high profit expectation even if the budget or target is not achieved.
Margin of safety is given by:
Expected sales − B.E.P.sales
M arg in of safety = × 100 , or
Expected sales
Expected sales (units ) − B.E.P.units
M arg in of safety = × 100
Expected sales(units )
600 − 500
= × 100 = 16.67%
600
Example

52
Auto Robot Ltd which manufactures two products P & Q has provided the following
information.
P (shs) Q (shs)
Selling price per unit 10 12
Variable cost per unit 2 8
Fixed cost 50,000 34,000
Required:-
i) Calculate the B. E. P. of each product in units and in shs.
ii) Calculate the margin of safety if budgeted sales are 10,000 units each
iii) Compute the profit of each product if sales in units are 20% above the B. E. P.

F .C.
i) B E P (units) =
S .P. − V .C
P Q
50,000/10-2 34,000/12-8
= 50,000/8 34,000/4
= 6,250 units 8,500 units
B E P (Shs) = B E P (units) × S P
P Q
6250 × 10 8500 ×12
= Shs.62,500 Shs.102,000

Expected sales − B.E.P.

ii) M arg in of safety = × 100
Expected sales
P Q
10,000 − 6250 10,000 − 8,500
M arg in of safety = × 100 = × 100
10,000 10,000
= 37.5% = 15%

iii) Profit of each product if sales units are 20% above B. E. P.

Y = Target

53
X = No. of units required
F .C. + Y
X =
S .P. − V .C

P Q
F C = 50,000 34,000
S P = 10 12
VC=2 8
Profit = 20% of 10X profit = 20% of 12X
50,000 + 2 X 50,000 + 2 X
X = X =
10 − 2 10 − 2
8X = 50,000 + 2X 4X = 34,000 + 2.4X
8X-2X = 50,000 4X – 2.4X = 34,000
6X = 50,000 1.6X = 34,000
X = 8,333.33 units X = 21,250 units
Sales = 8,3333.33 × 10 Sales = 21,250 × 12
Profit = Sales- TC profit = Sales- TC
= 83,333.33 – [50,000 + (2 × 8,333.33)] = 255,000 – [34,000 + (8 × 21,250)]
= 16,666.7 = 51,000

4 .7 C V P in Multi-product Environment
The single product CVP analysis can be extended to handle more realistic question where
the firm produce more that one product. The objective of the company in such a case is
to produce a mix that maximizes total contribution.
Total B E P (Units) = Total fixed cost / Average contribution margin
B E P (shs) = B E P (units) × S P

Example
Assume that a company has the following budget for product A and product B.
Product A B Total
Sales units 120,000 40,000 160,000
Sales @sh.5 & 10 600,000 400,000 1,000,000

54
Variable cost @sh.4 & 3 480,000 120,000 600,000
Contribution @ sh.1 & 7 120,000 280,000 400,000
Total fixed cost 300,000
Profit 100,000
Required:
i) Compute the B E P in shillings in and units for the total product and also for
product A and B.
ii) Assume that the company proposes to change the sales mix to 1:1 in units, advice
the company on whether this change is desirable.
Solution:
Sales mix A B Total
1. In units 120,000/16,000 = 0.75 40,000/16,000 = 0.25 1
2. In shs. 600,000/1,000,000 = 0.6 40,000/1,000,000 = 0.4 1

i) Total B E P (Units) = F C / (Sales mix of A × Contribution per unit for A) + (Sales mix
B × contribution per unit for B)
= 300,000 / 0.75 × 1) + (0.25 × 7)
= 300,000/2.5
= 120,000 units
B E P (Units) A = Sales mix × Total B E P (Units)
= 0.75 × 120,000
= 90,000 units
B E P (units) B = 0.25 ×120,000
= 30,000 units
B E P (shs) = B E P (Units) × Unit S P
B E P (shs) A = 90,000 × 5 = 450,000
B E P (shs) B = 30,000 × 10 = 300,000
Total B E P (shs) = 750,000

ii)
Product A B Total
Sales units 80,000 80,000 160,000

55
Sales @sh.5 & 10 400,000 800,000 1,200,000
Variable cost @sh.4 & 3 320,000 240,000 560,000
Contribution @ sh.1 & 7 80,000 560,000 640,000
Total fixed cost 300,000
Profit 340,000
Sales mix (Unit):
A B Total
80,000/160,000 = 0.5 80,000/160,000 = 0.5 160,000/160,000 = 1

Total B E P (Units) = 300,000/0.5 × 1 + 0.5 ×7

= 300,000/4 = 75,000 units
B E P (units) A = 0.5 × 75,000 = 37,500units
B E P (units) B = 0.5 × 75,000 = 37,500 units

B E P (shs) = B E P (units) × S P
B E P (shs) A = 37,500 × 5 = 187,500
B E P (shs) B = 37,500 × 10 = 375,000
Total B E P (shs) = 562,500
The change is desirable because fewer sales are required to break even

5.8 Criticisms of CVP analysis

Most criticisms of CVP relate to its basic underlying assumptions this are:
i) CVP ignores the curvilinear nature of total revenue and total cost schedules in
effect it assumes that changes in volume have no effect on elasticity of demand
or on the efficiency of production factors
ii) CVP analysis is typically restricted to one time period in each case
iii) It does not measure the impact of decision on wealth
iv) It does not incorporate the effect of asset structure changes required by the
decision
v) It does not acknowledge the risk created by the decision

56
Review Questions
i) “Any future cost is a relevant cost” Do you agree? Explain
ii) “Avoidable costs are variable costs” Do you agree? Explain
iii) Mash Auto charges $4 to wash a car. The variable costs of washing a car are
15% of sales. Fixed costs total $1,700 a month. How many cars must be washed
each month for Mash Auto to break even?
iv) Super sales company is the exclusive distributer for a new product. The product
sells for $60 per unit and has a CM ratio of 40%. Te company’s fixed expenses
are $360,000 per year.
a) What are the variable expenses per unit?
b) Using the equation method:
1) What is the B.E.P.in units and in dollar sales
2) What sales level in units and in dollar sales is required to earn an
annual profit of $90,000?
3) Assume that through negotiations wit5h the manufacturer, super
sales company is able to reduce its variable expenses by $3 per unit.
What is the company’s new B.E.P. in units and in dollar sales
v) Repeat (b) above using the contribution margin method
i) Horngren et. al., 2009, Introduction to Management Accounting, 14th Ed, Dorling
Kindersley, New Delhi Pg 196- 293.
ii) Garisson R. H., and Noreen E. W., 1997 Managerial Accounting, 8th Ed,
MacGrraw-Hill, New York, Pg 276-323

57
5.0 CHAPTER FIVE: RELEVANT COSTS FOR NON ROUTINE DECISION
Learning Objectives

By the end of this chapter the learner should be able to:

i) Explain the concept of cost relevance to decision making
ii) State the assumptions of relevant costing
iii) Identify quantitative and qualitative factors in decision making
iv) State limiting factors in decision making
v) Illustrate methods of handling special pricing, make or buy, discontinuation and
equipment replacement decisions

5.1 The concept of cost relevance to decision making

Relevant costs are those expected future costs that differ among the alternative cause of
action being considered.
A relevant cost is appropriate to a specific management decisions and therefore are
affected by the decision at hand. The main features of relevant costs are:
1. Future costs
2. Cash flows
3. Incremental
1. Future Cost
A decision is usually at the future and may not change what has been done. A cost
incurred in the past is totally irrelevant to any decisions being made now. Such costs
include sunk and committed cost.
2. Cash Flows
It is assumed that decisions that are taken are the ones that maximizes the benefits to the
company i.e. they must increase the net cash inflows. The costs which do not reflect
additional cash to the company are regarded to be irrelevant and therefore cannot be used
for the purpose of decision making e.g. depreciation, amortization of rent or interest,
absorbed overheads etc.
3. Increment
A relevant cost occurs as a direct consequence of making a decision. It must therefore be
a differential cost i.e. the cost if the decision is not taken e.g. make or buy decision etc.

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5.2 Assumptions of Relevant Costing
1. The cost behavior pattern are known e.g. fixed, variable etc.
2. Units of fixed costs, variable costs, selling prices and demand are known with
certainty.
3. The objective of decision making is to maximize short term profits.
4. The information on which the decision is based is complete and reliable.

5.3 Quantitative and qualitative factors in decision making

Quantitative factors are outcomes that can be measured in numerical terms. Some
quantitative factors are financial
Qualitative factors are outcomes that cannot be measured in numerical terms such as
Relevant cost analysis generally emphasizes quantitative factors that can be expressed in
financial terms. It should be noted however that qualitative factors that can not be easily
measured in financial terms are very important and managers should give more weight to
this factors
Examples of quantitative factors
i) Profitability
ii) Effect on cash flow
iii) Sales volume
iv) Market share
v) Time value of money
vi) Efficiency
vii) Time taken to make a decision
Examples of qualitative factors
i) Competitors
ii) Customers
iii) Government
iv) Legal
v) Risk
vi) Staff morale
vii) Suppliers

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viii) Environment
ix) Availability of information

5.4 Limiting factors in decision making

In the short term, sales demand may be in excess of current productive capacity. Output
may for example be restricted by shortage of skilled labor, equipment or space. These
scarce resources are known as limiting factors
When limiting factors are present, profit is maximized when the greatest possible
contribution to profit is obtained each time a scarce resource or limiting factor is used.
Consider the following example:

Example:
Kawasaki Company Ltd manufactures a broad range of engines for commercial products.
At its Kenyan plant it assembles power saw engines and lawnmower engines.
Information on these products is as follows:

Engine type Power saw Lawnmower Motor bike

engines engines engines
Selling price Ksh 80,000 Ksh 100,000 Ksh 125,000
Variable cost per unit Ksh 56,000 Ksh 62,500 Ksh 75,000
Contribution per unit Ksh 24,000 Ksh 37,500 Ksh 50,000
Contribution margin percentage 30% 37.5% 40%
(Ksh 24/80; 50/125 & 37.5/100) in (000)
Estimated daily demand in units 60 60 60
Assume that only 600 machine hours are available daily for assembling engines,
additional capacity can not be obtained in the short run. The limiting factor is machine
hours. It takes 2, 5 and 5 machine hours produce one power saw, one lawnmower and one
motor bike engine respectively.
Required:
Advise on the product mix that Kawasaki should produce during the period

Solution:

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Engine type Power saw Lawnmower Motor bike
engines engines engines
Contribution per unit Ksh 24,000 Ksh 37,500 Ksh 50,000
Machine hrs required to produce 1 engine 2 5 5
Contribution per machine hr Ksh 12,000 Ksh 7,500 Ksh 10,000
(Ksh24/2; 37.5/5 & 50/5) in (000)
Rank per contribution 1 3 2

The limited 600 machine hours should be used to produce the products as per as per the
rankings i.e. 120 machine hrs (60 × 2) for power saw engines, 300 machine hrs (60 × 5)
for motor bike engines and the rest 180hrs (600 – 120 - 300) for 36 lawnmower engines
(180/5 = 36)

5.5 Special pricing decisions

Special pricing decisions typically involve one time only orders or orders at a price below
the prevailing market price. Differential or marginal costing is usually employed in such
decisions. Differential costing examines all revenue and cost differences between
alternatives so as to determine most appropriate decisions.

Example:
A company currently operating at full capacity manufacturers and sells, product X at Ksh
2 per unit each. The current volume is 100,000 units per annum with the following cost
structures.

Operating Statement for the Year

Sales100,000 units @ sh.2 each 200,000
Less: Marginal cost - Direct Labor 80,000
-Direct materials 50,000 (130,000)
Contribution 70,000
Less: Fixed cost (30,000)
Operating profit 40,000

An opportunity has arisen to supply an additional 30,000 units per annum at sh.1.80.

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Acceptance of this order would incur extra overtime premium of 20% for extra direct
labor required.
Required:
Should the order be accepted?
Solution
New order
Direct Labor cost (per unit) = 80,000/100,000 = 0.80cts per unit
Extra order labor cost (per unit) = 0.8 × 1.2 = 0.96cts per unit
Extra labor cost = 0.96 × 30,000 = 28,800
Direct materials = 50,000/100,000 = 0.5cts × 30,000 = 15,000

Present Projected Difference

(without order) (with order)
Sales (100,000 @ Ksh 2 & 30,000 @
Ksh 1.8) 200,000 254,000 54,000
Less: Variable cost- Direct labor (80,000) (80,000 + 28,000)= (108,800) (28,800)
-Direct materials (50,000) (50,000 + 15,000)= (65,000) (15,000)
Contribution 70,000 80,200 10,200
Less: Fixed cost (30,000) (30,000) 0
Operating profit 40,000 52,200 10,200
Accept the order because of an extra contribution net profit of 10,200

5.6 Make or buy decisions

A make or buy problems involves a decision by the organization about whether it should
make of product or carry out an activity its all intend resources or whether it should pay
another organization make the product or carry out the activity.
Examples of these decisions include:
i) Whether a company should manufacture its own components or buy from
suppliers.
ii) Whether a company should do some work with its own employees or it should
sub contract the work.
iii) Whether repair or maintenance should be dealt with by in house engineers or
maintenance contracts should be made with specialist organizations.

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Example
The total cost of component Y is as follows:
Per unit (Ksh) Units (20,000)
Direct Labor 8 160,000
Direct Materials 1 20,000
Variable overhead 4 80,000
Fixed overheads applied 5 100,000
Total manufacturing cost 18 360,000
The same component can be bought @sh.16 per unit.

Required:
Should the company buy or make the components if the fixed overhead is assumed to be
consumed whether company buys or makes the components.
Solution
Relevant cost Total
per unit relevant cost
Make Buy Make Buy
Direct labor 8 160,000
Direct material 1 20,000
Variable overhead 4 80,000
13 16 260,000 320,000
It economical to make the component: Making = 260,000, Buying = 320,000
5.7 Discontinuation decisions
Organizations are periodically confronted with the decisions of ether discontinuing or
adding operations in various branches or business segments. Periodic profitability
analysis provides attention directing information that highlights those unprofitable
activities that require discontinuation. Relevant costs can be applied to discontinuation
decisions as illustrated in the following example.

Example: Bidco Company, headquartered in Thika sells its products in the East African
region and has established regional offices in Kampala, Arusha, and Kigali, each staffed

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with marketing staff to serve the respective regions. The budgeted results for the next
quarter are as follows:
Kampala Arusha Kigali Total
(Ksh000) (Ksh000) (Ksh000) (Ksh000)
Cost of goods sold 800 850 1,000 2,650
Sales staff salaries 160 200 240 600
Sales office rent 60 90 120 270
Depreciation of sales office equipment 20 30 40 90
Apportionment of Thika warehouse rent 24 24 24 72
Depreciation of Thika warehouse equipment 20 16 22 58
Regional and Headquarters costs:
-Cause and effect allocations 120 152 186 458
-Arbitrary apportionment 360 400 340 1,100
Total costs assigned to each location 1,564 1,762 1,972 5,298
Reported profit (loss) 236 238 (272) 202
Sales 1,800 2,000 1,700 5,500

Assuming that the above results are likely to be typical of future performance, should the
Kigali territory be discontinued?
Solution:
i) Since cost of goods sold, sales staff salaries, office rent and cause and effect
allocations are specific to the regional offices and therefore
differential/incremental costs they are consequently relevant
ii) Depreciation of regional sales offices and Thika warehouse equipment are past or
sunk costs and therefore irrelevant
iii) Thika warehouse rent and costs apportioned arbitrarily will remain irrespective
of the decision and therefore are not a differential or incremental cost and
consequently they are irrelevant.

Total costs and revenues

Keep Kigali Discontinue Kigali Differential costs
(Ksh000) (Ksh000) & revenues (Ksh000)
Cost of goods sold 2,650 1650 1,000
Sales staff salaries 600 360 240

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Sales office rent 270 150 120
Depreciation of sales office equipment 90 90
Apportionment of Thika warehouse rent 72 24
Depreciation of Thika warehouse equipment 58 16
Regional and Headquarters costs:
-Cause and effect allocations 458 272 186
-Arbitrary apportionment 1,100 1,100 ____
Total costs assigned to each location 5,298 3,752 1,546
Reported operating profit (loss) 202 48 154
Sales 5,500 3,800 1,700
It is advisable to keep Kigali open because it will result in additional contribution of
Ksh.154, 000 to profits and fixed costs

5.8 Equipment replacement decisions

Replacement of equipment is a capital equipment decision or long term decision that
requires the use of discounted cash flow procedures. However one aspect of equipment
replacement decisions that can be addressed by relevant cost and revenue analysis is that
of book value of old equipment i.e. original cost minus accumulated depreciation. This is
a past or sunk cost and therefore irrelevant to decision making. Consider the following
example
Example:
East African Cables Ltd is considering replacing its metal smelting machine a newer
more efficient model but with an overall shorter life. Revenues from cables (Ksh. 1.1m)
will be unaffected by the replacement decision.

Old Machine New Machine

Original cost 1,000,000 600,000
Useful life 5 yrs 2 yrs
Current age 3 yrs 0 yrs
Remaining useful life 2 yrs 2 yrs
Accumulated depreciation 600,000 Not acquired yet
Book value 400,000 Not acquired yet
Current disposal price 40,000 Not acquired yet

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Terminal disposal price in 2 years 0 0
Annual operating costs (repairs coolants etc) 800,000 460,000

To focus on the main concept of relevance we ignore time value of money and income
taxes. Should E.A C. Ltd replace the existing machine?

Solution:
i) The cost of the old machine is a sunk cost therefore its book value (Ksh 400,000)
is irrelevant. However its disposal price of Ksh 40,000 is differential/incremental
revenue and thus relevant
ii) Annual operating costs are differential/incremental costs and thus relevant
iii) Since revenue from cables are unaffected by the decision they are irrelevant,
further disposal price for the two machines after two years is zero, not
differential/ incremental and consequently irrelevant

Keep Replace Differential costs & revenues

New machine cost - 600,000 (600,000)
Current disposal of old machine - (40,000) 40,000
Operating costs (for 2 yrs) 1,600,000 920,000 680,000
Total relevant costs 1,600,000 1,480,000 120,000

Review Questions
i) What is a relevant cost?
ii) Define the following terms: incremental cost, opportunity cost, sunk cost, and
avoidable cost
iii) XYC Co. estimates it will produce 30,000 units of a part that goes into their final
product. It currently produces this part internally, but is considering outsourcing
this activity. Currently internal capacity permits a maximum of 60,000 units of the
part. The production manager has prepared the following information concerning
the internal manufacture 60,000 units of the part.
Per unit ($)
Direct labor materials 3

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Direct labor 4
Variable overhead 5
Fixed overhead 6
Total cost 18
The fixed overhead of $6 per unit includes a $1.50 per unit allocation for salary paid to a
supervisor to oversee production of the part. The fixed cost would not be reduced by
outsourcing, except the supervisor would be terminated. Assume if XYZ outsources, its
purchase price from the outsourcer is $12 per unit.
a) Should XYZ outsource?
b) Assume XYZ has received a special order for 10,000 units of the part from ABC
Co. ABC will pay XYZ $23 per unit but will take the parts only if they are
manufactured by XYZ. Should XYZ accept the special order?
iv) Consider the following data concerning Copy Cat Photocopying Limited

Old equipment Proposed replacement

equipment
Useful life in years 5 3
Current age in years 2 0
Original cost $25,000 $15,000
Accumulated depreciation 10,000 0
Book Value 15,000 Not acquired yet
Disposal value(in cash ) now 7,000 Not acquired yet
Disposal value in 3 years 0 0
Annual cash operating costs for
power, maintenance, toner etc 14,000 8,000

Copy cat is trying to decide whether to replace the old equipment. Because of the rapid
changes in technology, copy cat expect the replacement equipment to have a 3year useful
life only. Ignore the effects of taxes

i) Horngren et. al., 2009, Introduction to Management Accounting, 14th Ed, Dorling
Kindersley, New Delhi Pg 196-293
ii) Garisson R. H., and Noreen E. W., 1997 Managerial Accounting, 8th Ed,
MacGrraw-Hill, New York, Pg 574-621

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6.0 CHAPTER SIX: ABSORPTION COSTING AND MARGINAL COSTING
Learning Objectives

By the end of this chapter the learner should be able to:

i) Differentiate absorption costing and marginal / variable Costing
ii) Explain overhead cost allocation
iii) Illustrate various methods of overhead cost apportionment
iv) Describe the methods of overhead absorption
v) Explain the application of overhead to product
vi) compare the impact of variable costing and absorption costing on profit
vii) Describe activity based costing (ABC)

There are two methods of costing namely:-

i) Absorption costing
ii) Marginal costing
6.1 Absorption Costing
Cost accumulation means building up cost of something usually the cost of the end
product such as a unit of production, a job a service. The main purpose of cost
accumulative system is to provide away in which cost can be recorded and accumulated.
Traditionally absorption costing or full costing has been used to measure the cost of
production is a period. The value of any finished or partly finished goods, the cost of
finished goods in a period and the profits earned.

Absorption costing is establishing the cost of work done by a downing indirect cost or
overheads to the direct cost of material and Labor incurred in producing the work. The
process of charging overheads to cost unit or product is known as overhead absorption.

The principle justifying use of absorption costing is the matching or the accrual concept
of accounting whereby revenues are to be matched with associated expenses both directly
and indirectly. Any item which is costed must have both direct and indirect cost.
Direct cost can easily be traced to the financial product, job or service. Overheads
however, cannot be directly traced to the final product and therefore a system must be
established to distribute overheads to the unit job or services. This can be done through
the process of

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a) Overheads cost allocation
b) Overhead cost apportionment
c) Overhead cost absorption or recovery

6.2 Overhead Cost Allocation

Allocation is the allotment of overhead items that can be directly identified with a
specific cost centre.
Cost allocation is that part of cost attribution which charges a specific cost to a cost unit
or a cost centre. Every item of the overhead must be chargeable to specific cost centre
and therefore cost accounting system must be defined with sufficient costs centers to
ensure this can be dome. Examples of costs centers include, production department,
administrative department, selling and distribution department, service cost centers e.g.
maintenance, tool room etc.
6.3 Overhead Cost Apportionment
This is that part of cost attribution which shares costs among two or more costs centers or
units in proportion to the estimated benefits received. The purpose of overhead cost
apportionment is to group overhead costs into three main categories namely production,
administration and marketing selling and distribution overheads. When overheads have
been allocated they can then be apportioned.
The first stage of overhead cost apportionment is to identify the overhead cost as
production, production service, administration or selling and distribution overhead. This
means that the shared overheads must be divided between other cost centers. This must
be dome on a fair basis and therefore a suitable base of apportionment for each cost item
should be identified e.g.
Overhead Base of Apportionment
Rent, Rates, repair & depreciation of building Floor area occupied by each department
Depreciation and insurance of equipment Cost of book value of equipment in each department
Personnel, office, canteen, welfare, administration Number of employees, labor cost, labor hours
cost worked in each department
Heat and lighting Volume or space or the floor area occupied by each
department.

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In order to add production overheads to the unit cost it is necessary to have all overheads
charged to the production department.
This requires that the service department be apportioned to the production department.
This can be done through various methods, namely:
i) Direct method
ii) The step (elimination) method
iii) Continuous (repeated distributed) method
iv) Algebraic method

i) The Direct Method

This method apportions the cost of each service cost centre in turn to the production
department only i.e. there is no inter service usage. Services produced by service
departments to one another are ignored when apportioning overheads.

Example
A B Ltd has two production, and two service departments the following information is
provided registration apportion the total overhead costs between production account and
balance.
Total Production Dept. Service Dept.
A B Stores Maintenance
Overheads allocated 37,000 10,030 8,970 10,000 8,000
Cost of material requisitions from store (Ksh) 100,000 30,000 50,000 - 20,000
Maintenance hrs Production dept. 10,000 8,000 1,000 1,000 -

Solution
Workings
Usage Total Production department Service department
A B Stores Maintenance
Stores 100,000 30,000/100,000 50,000/100,000 20,000/100,000
× 100 × 100 - × 100
= 30% = 50% = 20%
Maintenance 10,000 8,000/10,000 1,000/10,000 1,000/10,000
× 1,000 × 100 × 100 -
= 80% = 10% = 10%

Note:

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A B
Apportion of stores cost 10,000 = 30/80 ×10,000 =3,750 50/80 × 10,000 = 6,250
Apportion of maintenance cost 8,000 = 80/90 × 8,000 = 7111.1 10/90 ×8,000 = 888.9

Apportionment
Production department Service department
Total A B Stores Maintenance
Overhead allocation 37,000 10,030 8,970 10,000 8,000
Apportionment of 10,000 30/80 × 10,000 50/80 × 10,000 (10,000)
store cost = 3,750 = 6,250
Apportionment of 8,000 80/90 × 8000 = 10/90 × 8,060 = (8,000)
maintenance cost 7,111 889
Total 37,000 20,891 16,109 0 0

ii) The Step (Elimination) Method

The service department providing the highest service to the other service department is
identified. The overhead of this department will be apportioned first and once they are
apportioned no further reapportionment should done to this department i.e. it is closed
down.
The next department providing the highest service is identified and the re-apportionment
is done to the remaining department and first department will not share it, as it has
already been closed down.
Referring to the above example (previous D.M.) apportion the service cost using the
elimination method.
Production Department Service Department
Total A B Stores Maintenance
Overhead 37,000 10,030 8,970 10,000 8,000
Stores 100% 30% 50% 20%
Maintenance 100% 80% 10% 10%
Overhead 37,000 10,030 8,970 10,000 8,000

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Apportion Store overhead 3,000 5,000 (10,000) 2,000
Apportion maintenance 8,889 1,111 0 (10,000)
21,919 15,081 0 0
Working
Stores Maintenance
A 30/100 × 10,000 = 3,000 80/90 × 10,000 = 8,889
B 50/100 × 10,000 = 5,000 10/90 × 10,000 = 1,111
* Stores to maintenance = 20/100 × 10,000 = 2,000
iii) Continuous or repeated distributed method
This apportions the cost of each service cost centre to the production department and also
to the other service costs centers that makes use of its service. This therefore requires
repetitive apportions of the overhead and this process continuous until the service cost
centers costs are zero or approximately equal to zero.
Refer to the above example
Production Department Service Department
Total A B Stores Maintenance
Overhead 37,000 10,030 8,970 10,000 8,000
Apportion Stores 3,000 5,000 (10,000) 2,000
Apportion maintenance 8,000 1,000 1,000 (10,000)
Apportion Stores overhead 300 500 (1,000) 200
Apportion maintenance 160 20 20 (200)
Apportion Stores 6 10 (20) 4
0 4
Apportion maintenance 3.2 0.4 0.4 (4)
21,499.2 15,500.4 0.4 0
21,499.2 + 15,500.4 = 36,999.6

iv) Algebraic method or equation method

Note:
Let stores be S and maintenance be M
i) S = 10,000 + 0.1M S = 10,000 + 10%
ii) M = 8,000 + 0.2S M = 8,000 + 20%
S = 10,000 + 0.1 (8,000 + 0.2S)

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= S – 0.02S = 10,800
0.98S = 10,800
0.98S = 10,800
S = 11,020
M = 8,000 + 0.2 (11,020)
M = 10,204

Production Department Service Department

Total A B Stores Maintenance
Overhead 37,000 10,030 8,970 10,000 8,000
Apportion Stores 3,306 5,510 (11,020) 2,204
Apportion maintenance 8,163.2 1,020.4 1020.4 (10,204)
21,499.2 15,500.4 0 0

6.4 Overhead Absorption

After overhead are allocated and apportioned to production department a way has been
found for charging overhead to the units produced in each department.
The process of charging overhead to cost unit of product is known as overhead
absorption.
Overhead absorption is the last step in the distribution cost units. It is a means of
attributing overhead to a product or service based for example on:-
• direct labor hours
• direct labor cost
• machine hours etc
There are two methods in absorption of overhead namely:-
i) Computation of overhead absorption rate
ii) Computation of rates to cost units.

Computation of Overhead Absorption Rate

These are used to change overheads to the cost unit. If an unsatisfactory absorption rate
is selected it will lead to misleading result or cause overhead to be over or under stated

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for product costing purposes. The following factors must be considered when selecting
overhead absorption rate:
i) Nature of industry i.e. whether production is continuous
ii) Production method i.e. whether manual or mechanical
iii) Principal constituent of overhead i.e. what comprises overhead cost
iv) Stability of the raw material prices
v) The management policy with regard overhead absorption
There are several methods used for the purpose of overhead absorption. Generally
overhead absorption rate is computed as:
O. A. R. = Total budgeted overhead / budgeted units of a base (activity level)
Base on activity level is the method being adopted overhead absorption rate computation.
This method includes:
i) Unit of output
This is used adhere products produced in the department are similar.
If products are different in size or in terms of time taken, this method may not be
applicable.
O. A. R. = Total budgeted overhead / Units of output produced.
ii) Direct Labor hours rate:-
Overheads are changed on the basis of Labor hours spent in production. It recognizes the
time spent on production and unlike direct Labor cost it is not affected by bonuses and
overtime.
O. A. R. = Total budgeted overhead / Direct labor hours
iii) Machine hour rate
This is used where production is mechanical and overhead is assumed to be caused by
hours on machine during production. It recognizes price spent on work.
O. A. R. = Total budgeted overheads / Machine hours
iv) Direct material cost % rate
Overheads are changed on the basis of direct material cost of each product. This method
is used where raw material prices are stable.
O. A. R. = Total budgeted overheads / direct material cost × 100
v) Direct labor cost

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This is similar direct labor hours although overhead are charged as a % of labor cost per
product.
O. A. R. = Total budgeted overheads / Direct labor cost ×100
vi) Prime cost % Rate
Prime cost includes direct material and direct labor cost. It is therefore a combination of
the two.
O. A. R. = Total budgeted overheads / Prime cost × 100
Example 1:
Quick Construction Company accepted three jobs to which they allocated no.1, 2, and 3.
The following costs relates to these jobs.
Job 1 2 3
Direct material 70,000 130,000 250,000
Direct wages 90,000 140,000 150,000
Direct expenses 14,000 14,000 6,000

Overheads are absorbed as follows:

i) Production overhead is 100% on direct wages
ii) Administration overheads is 25% on prime cost
iii) Selling and distribution is 5% on factory cost

Required:
Show the total cost chargeable to each job

Solution
Job 1 2 3
Direct material 70,000 130,000 250,000
Direct wages 90,000 140,000 150,000
Direct expenses 14,000 14,000 6,000
Prime Cost 174,000 284,000 150,000
Production overhead cost (100% of Direct wages) 90,000 140,000 150,000
Factory cost 264,000 424,000 556,000
Administration (25% of prime cost) 43,500 71,000 101,500
Selling and distribution(5% of factory cost) 13,200 21,200 27,800

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Total cost charged to job 320,000 516,200 685,300

Example 2:
The cost department of A B C ltd made the following estimates for the coming year 2004
Factory overheads £425,000
Material cost £850,000
Production is 20,800 units
Labor cost £250,000
Labor hours £106,250
Machine hours 850,000
Required;
Compute the factory overhead rate based on:
i) Labor cost
ii) Labor hours
iii) Material cost
iv) Prime cost
v) Machine hours
vi) Units produced.

Solution
Factory overhead £425,000
i) Labor cost = Factory overhead / Labor cost × 100
= 425,000/250,000 × 100
= 170%
ii) Labor hours = 425,000 / 106,250
= £4 per labor hours
iii) Material cost = 425,000 / 850 000 × 100
= 50%
iv) Prime cost = 425 000 / (250000 + 850000) × 100
= 38.6%
v) Machine hours = 425,000 / 850,000

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= £ 0.5 per machine hour
vi) Units produced = 425,000 / 20,800
= £20.4 per unit

6.5 Application of Overhead to Product

Note: Once overhead absorption rates are computed overhead should be applied to
product or jobs overhead per unit is given by:
Overhead per unit = OAR × Unit of a base in product
Example:
Kahawa Ltd absorbs its production overhead by using predetermined rates i.e. a
percentage of direct labor cost for department P and machine hour rate for department Q.
The estimates made at the beginning of the financial year which ended 31st Oct were as
follows:

Department P Department Q
Direct labor cost £450,000 £150,000
Production overhead £517,000 £922,500
Direct labor hours 172,500 hrs 40,000hrs
Machine hours 20,000hrs 180,000hrs

For the month of October, the cost sheet for job number 186 shows the following information.
Job no.186 Department P Department Q
Material used £200 £800
Direct labor cost £360 £190
Direct labor hours 120hrs 47.5hrs
Machine hours 20hrs 260hrs

Following the end of financial year it was ascertained that actual production overhead
incurred by department P was £555,000 and Q was £900,000
Required:
i) To calculate the overhead absorption rate for each of the department P & Q

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ii) To determine the total production overhead cost to be charged to job no.186
for October.
iii) Show the over or under absorbed for each of the department and for the
company as a whole for the year ended 31st October assuming that actual
direct labor cost and machine hours worked as originally estimated.

Overhead Absorption Rates for Department P and Q

i) OAR for each department
P Q
Product Overhead / Direct labor × 100 Production overhead/Machine hrs
= 517,000/450,000 × 100 = 922,500/180,000
= 114.9% = £5.1 per machine hours

ii) Job no.186 Cost statement

P Q Total
Direct material 200 800 1000
Direct labor cost 360 190 550
Production overhead 114.9% × 360 413.60 1326 1,739.6
Cost of job 973.60 2316 3,289.6

iii) Over / under absorption of overheads

Overhead are usually absorbed on the basis predetermined OAR. If the predetermined
OAR is different from actual rates of overhead, the amount to be charged to production
(absorbed) will not be equal to actual overhead. This results in over or under absorption.
Over absorption arises where absorbed overheads is more than the amount of overheads
actually incurred. The effect is over stating the cost of job process and unit.

Under absorption is when the amount of overhead absorbed is less than the amount of
overheads incurred. The effect is understating the cost of jobs process since overheads
are not fully recovered or absorbed.
P Q

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Actual overhead (incurred) 555,000 900,000
Less estimated 517,000 922,500
Overheads absorbed 38,000 (22,500)

6.6 Marginal / Variable Costing Vs Absorption Costing

Marginal costing is defined as the accounting system in which variable costs are charged
to the cost unit and the fixed cost of the period are written if in full against the aggregate
contributions. It has a special value in decision making. In absorption costing fixed
manufacturing overheads are absorbed to the cost unit and for this reasons overheads are
charged in the profit and loss in the period in which the units are sold.
In marginal costing however, fixed manufacturing overheads are not absorbed in the cost
unit such that stocks are valued at variable cost only. This implies fixed manufacturing
overhead and treated as period costs and are charged in the profit and loss account of the
period in the overheads are incurred.
In marginal costing fixed costs are excluded from the inventorable costs. Inventorable
costs are all costs of products that are regarded as assets or cost of the goods sold when
goods are sold. Marginal costing is also referred to as contribution approach or direct
costing or variable costing.

The following are formats of profit and loss accounts under marginal and absorption
costing.
Profit and Loss Account
Marginal Costing
Ksh Ksh
Sales xxx
Opening stock xxx
Production cost - Direct material xxx
- Direct labor xxx
- Variable production overhead xxx
Less closing stock xxx
Cost of sales xxx
Contribution xxx
Lesscontribution
Net non production overheads xxx

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Less fixed cost xxx
Net profit xxx
Absorption Costing
Ksh Ksh
Sales xxx
Opening stock xxx
Production cost- Direct material xxx
- Direct labor xxx
- Variable production overhead xxx
- Fixed production overhead xxx
Less closing stock xxx
Cost of sales xxx
Adjustments for under/(over) recovery of overhead xxx
Gross profit xxx
Less non production overheads e.g. marketing xxx
Net profit xxx

Example:
The following information is available for XYZ Company
Period
1 2 3 4 5 6
Units sold (000) 150 120 180 150 140 160
Units produced (000) 150 150 150 150 170 140

Budgeted activity is expected to average 150,000 units per period and there is no opening
stock for period 1. Unit selling price is Ksh 10, Unit variable cost is Ksh 6, fixed costs
per period is Ksh 300,000 while non manufacturing overheads are 100,000 per period.

Required:
Prepare a profit and loss statement based on variable and absorption costing
Solution:
i) Variable costing
Period
1 2 3 4 5 6

80
Opening stock - - 180 - - 180
Production cost (units produced × 6) 900 900 900 900 1020 840
Closing stock ---- (180)* ---- ---- (180) (60)
Cost of sales 900 720 1,080 900 840 960
Fixed costs 300 300 300 300 300 300
Total costs 1,200 1,020 1,380 1,200 1,140 1,260
Sales 1,500 1,200 1,800 1,500 1,400 1,600
Gross profit 300 180 420 300 260 340
Less non mfg costs 100 100 100 100 100 100
Net profit 200 80 320 200 160 240
Note:* For period 150,000 units were produced but only 120,000 units were sold, the
difference 30,000 i.e. (150,000 - 120,000) needs to be subtracted from the production
cost to get the cost of sales and consequently becomes the opening stock for the next
period. The closing stock figure for period 4-6 are calculated in the same way

ii) Absorption costing

Since under absorption costing fixed costs are assigned to products, an overhead
absorption rate needs to be determined in our case; fixed costs may be divided by
budgeted activity to get the fixed costs absorption rate i.e. 300,000/ 150,000 = 2. This is
the unit fixed cost that should be added to the unit variable cost to get the unit production
cost
Period
1 2 3 4 5 6
Opening stock - - 240 - - 240
Production cost [units produced × (6 + 2)] 1,200 1,200 1,200 1,200 1,360 1,120
Closing stock ---- (240)* ---- ---- (240) (80)
Cost of sales 1,200 960 1,440 1,200 1,120 1,280
Adjustment for u/(o) recovery of overhead --- --- --- --- (40) 20
Total costs 1,200 960 1,440 1,200 1,080 1,300
Sales 1,500 1,200 1,800 1,500 1,400 1,600
Gross profit 300 240 360 300 320 300
Less non mfg costs 100 100 100 100 100 100
Net profit 200 140 260 200 220 200
A comparison of the impact of variable costing and absorption costing on profit

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i) When production equals sales
Whenever production equals sales profits will be the same under marginal and absorption
costing because inventories will neither increase nor decrease (as in period 1 and 4) and
consequently if opening inventories exist, the same amount of fixed overhead will be
carried forward as an expense to be included in the current period opening inventory
valuation as will be deducted in the closing inventory valuation from the production cost
figure

ii) When production exceeds sales

Whenever production exceeds sales profits will be the higher under absorption than under
marginal costing because inventories are increasing (as in period 2 and 5) and as a result
a greater amount of fixed costs in the closing inventory is being deducted from the
expenses of the period than is being brought forward in the opening inventory for the
period the previous period. For instance in period 2 opening inventory is zero but closing
inventory is 30,000 units which under absorption costing includes a fixed overhead
charge of Ksh 2 each as such Ksh 60,000 (Ksh 2 × 30,000) is deducted from production
cost for the period as a result only Ksh 240,000 of fixed cost is allocated instead of Ksh
300,000. The effect is a 60,000 increase in profit over marginal costing

iii) When sales exceeds production

Whenever sales exceeds production profits will be the higher under marginal than under
absorption costing because inventories are reducing (as in period 3 and 6) and as a result
a lesser amount of fixed costs in the closing inventory is being deducted from the
expenses of the period than is being brought forward in the opening inventory for the
period the previous period. For instance in period 3 opening inventory is 30,000 units but
closing inventory is zero the result being that Ksh 60,000 is included in the valuation of
opening inventory but non is deducted since all produced units are sold. Consequently
Ksh 360,000 of fixed costs is allocated to the period instead of Ksh 300,000 the effect is
Ksh 60,000 increase in profit over absorption costing.

Simplifying the relationship between absorption and variable costing mathematically:

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Recall that OPBT = Sales – TC, Thus;
= Sales – VC – FC
= Qs (unit selling price – unit variable cost) – FC
= Qs (UCM) – FC,
Where: UCM = Unit Contribution Margin
Qs = Quantity sold
Therefore: OPBTVC = Qs (UCM) – FC

From our analysis in the preceding question the difference in profit between variable
costing and absorption costing is attributable to the differences between production and
sales multiplied by the unit fixed cost or fixed overhead absorption rate. For instance in
period 1, the difference between profits is 60,000 i.e. [(150,000 – 120,000) × 2].
Symbolically this difference can be expressed as: (Qp – Qs) × UFC.
Where: UFC = Unit Fixed Cost
Qp= quantity produced
Therefore OPBTAC is given as OPBTVC plus the difference in profits between variable
and absorption costing i.e.
OPBTAC = OPBTVC + (Qp – Qs) × UFC
= Qs (UCM) – FC + [UFC (Qp – Qs)]

It can therefore be concluded that:

i) Under variable costing profit is driven by unit level of sales
ii) Under absorption costing profit is driven by (a) unit level of sales (b) unit level of
production and(c) the chosen fixed overhead absorption rate

Consider period 2 in the above example for instance:

OPBTVC =120(10 - 6) – 300 = 180
OPBTAC =120(10 - 6) – 300 + [2(150 - 120)] = 240

Arguments in support of variable costing

i) Variable costing provides more information for decision making

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The advantage of variable costing is that variable and fixed costs are highlighted this
provides relevant information for short term decision making. Though there is no reason
why absorption costing can not provide this information such an analysis is not a required
feature of absorption costing
ii) Variable costing removes from the profit the effect of inventory changes
Since profit is a function of sales volume only in variable costing it is not affected by
inventory changes. Whereas for absorption costing profit is a function of sales,
production and the unit fixed cost thus when stock fluctuate profits may be distorted.
Since stock levels are less likely to fluctuate on an annual basis than on a monthly or on a
quarterly basis there is a strong case for variable costing to be used for internal profit
measurement because it removes the effect of changes in stock.
A further argument in favor of variable costing for internal performance measurement is
that if absorption costing was used managers could deliberately influence the results by
unnecessarily increasing stocks in successive periods in the short term
iii) Variable costing avoids fixed overheads being capitalized in unsaleable stocks
With surplus socks that can not be sold, absorption costing will have allocated a portion
of fixed over heads for the period to the unsaleable stocks with only a proportion
remaining for be allocated to the be allocated to the sellable stocks. The overall effect is
that the current period’s profits will be overstated and the unsaleable stocks will be over
valued
iv) Simpler to understand and operate

Arguments in support of absorption costing

i) Absorption costing avoids fictitious losses being reported
In a business tat relies on seasonal sales and in which production is built up outside the
sales season to meet demand during the sales season, fixed overheads will be charged
against sales and since sales are low, losses will be reported. With an absorption costing
system however, fixed costs will be deferred by including it in the closing inventory and
only recorded as an expense when sales are made. Absorption costing therefore appears
to provide a more logical profit calculation
ii) Fixed overheads are essential for production

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Proponents of absorption costing argue that the production of goods is not possible if
fixed costs are not incurred ad as such the should be included in units produced and in the
valuation of inventory
iii) Consistency with external reporting
Absorption costing is the most commonly used method for external reporting. Since
managerial reward is often liked to external financial measures there is a strong case to
ensure tat internal accounting system does not conflict with external financial reporting
requirements
iv) Absorption costing does not understate the importance of fixed costs
Some people argue that decisions based on a variable costing system may concentrate
sales revenue only and forget that that fixed costs must be met in the long run. This is
however a misleading argument that s based on the assumption that managers are not
very bright
It is also argued that the use of absorption costing by allocating fixed costs to products
ensures that the fixed costs are covered. this is also incorrect because absorption costing
will not ensure tat fixed costs are covered if sales volume is less than the estimate used t
calculate the fixed overhead rate.

Exercise 1:
In a particular period 20,000 units of product Z were produced and sold. The costs and
revenues were as follows:
Ksh
Sales 100,000
Direct materials 20,000
Direct labor 15,000
Fixed 15,000
Administration & selling 20,000
Required:
Prepare profit and loss statement under marginal and absorption costing.

Solution
i) Marginal costing

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Ksh Ksh
Sales 100,000
Production cost - D. M. 20,000
D. L. 15,000
Cost of sales 35,000
Gross contribution 65,000
Less:- Fixed cost 15,000
-Administration & selling 25,000 40,000
Net profit 25,000

ii) Absorption costing

Ksh Ksh
Sales 100,000
Production cost- D. M 20,000
- D. L. 15,000
-Fixed cost 15,000
Cost of sales 50,000
Gross profit 50,000
Less administration & selling 25,000
Net profit 25,000

Exercise 2
A Company produces a single product. The following is the budget for the product
Budget
i) Selling price Ksh.10
ii) Direct material cost per unit Ksh.3
iii) Direct wages per unit Ksh.2
iv) Variable overhead per unit Ksh.1
v) Fixed production overhead Ksh.10,000 per month
vi) Production volume 5,000 units per months
Actual
i) Production 6,000 units
ii) Sales 4,800 units
iii) Assume that all costs were as budgeted

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Required;
Prepare a profit statement using:
i) Absorption costing
ii) Marginal costing
iii) Prepare a reconciliation statement to reconcile the two reported profit figures
under absorption and marginal costing

Solution
Use units budgeted to absorb fixed overhead to product units
O A R = Fixed overheads / No of units
= 10,000 / 5000 units
= Ksh. 2 per unit
Marginal costing Absorption costing
Direct material 3 3
Direct labor 2 2
Variable overhead 1 1
Fixed overhead 0 2
Cost per unit (E) 6 8
Absorption overhead (6,000 × 2) = 12,000
Actual overhead = 10,000
Over absorption = 2,000

Profit and loss statement

i) Absorption costing
Ksh Ksh
Sales (4,800×10) 48,000
Cost of sales
Opening stock 0
Production cost (8 × 6,000) 48,000
Less closing stock (6,000 - 4,800) × 8 9,600
Cost of sales 38,400

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Unadjusted gross profit 9,600
Add: under recovery 2,000
Adjusted profit 11,600
Note: If it is over recovery we subtract.

ii) Marginal costing

Ksh Ksh
Sales (4,800 × 10) 48,000
Marginal cost
Opening stock 0
Add production cost (6 × 6,000) 36,000
Less closing stock (6000 - 4,800) × 6 7,200
Cost of sales 28,800
Gross profit 19,200
Less fixed overheads 10,000
Net profit 9,200

Reconciliation statement under marginal and absorption costing

Profit under absorption costing = 11,600
Difference in opening stock (0 - 0) 0
Less: difference in closing stock (9,600-7,200) = (2,400)
Profit under marginal costing = 9, 200
Alternative method
Profit Statement
Marginal cost Absorption costing
Ksh Ksh Ksh Ksh
Sales (4 800× 10) 48,000 48,000
Less: Variable cost of sales
Direct material (6 000× 3) 18,000 18,000
Direct labor (6 000× 2) 12,000 12,000
Variable overhead (6000×1) 6,000 6,000
Fixed production (6000× 2) Nil 12,000
Total cost 36,000 48,000
Less closing stock 7,200 9,600

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Cost of sales 28,800 38,400
Contribution to gross profit 19,200 9,600
Less fixed cost 12,000 Nil
Unadjusted profit 7,200 9,600
Add over recovery of o/h Nil 2000
Net profit 9200 11,600

6.7 Activity Based Costing (ABC)

ABC System refines costing system by focusing on individual activities as the
fundamental cost objects. An activity is an event, task or unit of work with a specified
purpose e.g. designing product, setting up machines operating machines and distributing
products.
ABC systems calculates the cost of individual activities and assigns costs to cost objects
such as products and services on the bases of the activities undertaken to produce each
product and services.
ABC Seeks to attribute overhead costs to product on a more realistic basis rather than
production volume and also attempts to show the relationship between the overhead cost
and the activities that caused them.
The main steps in ABC are:
i) Identify the main activities in the organization e.g. production planning, material
ordinary, material handling, dispatch of goods, machine assembly etc.
ii) Identifying the factors which determine the cost of an activity called cost drivers.
iii) Collect the cost of each activity into a cost pool
iv) Charge the support overheads to products on the basis of the usage of the activity.
Mainly expressed as a percentage of the chosen driver.

In ABC overheads can be classified into three mainly:

a) Short term variable overhead - which varies with the volume of the activity.
b) Long term variable overhead – which is fixed in the short term but varies in the
long term
c) Fixed overheads – which do not vary

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a) Short term variable overhead
Are the costs that vary with production volume e.g. indirect labor, indirect material, cost
of power e.t.c.
Short terms variable overhead should be traced to the product using production volume
cost drivers. Such as direct labor hours, machine hours, direct material costs, number of
units etc
b) Long term variables
Are an overheads cost which do not vary with production volume but varies with other
measuring activities e.g. cost of support services like stock handling cost, production
scheduling, and machine set up etc.
These costs are fixed in the short term but vary in the long term in the short term but
varies in the long term according to the range and complexity of the product
manufactured. ABC requires that these overhead be traced to the product by transaction
based cost drivers.
c) Fixed overhead
Are costs that do not vary for a given time period with any activity indicator

Example:
ABC Ltd. makes 4 products 1, 2, 3 & 4. The following are the information related to
these products.
Products
1 2 3 4
Output 25 25 250 250
No. of production runs 3 4 7 10
Labor hours/unit 2 4 2 4
Machine hrs/unit 2 4 2 4
Material cost per unit (Ksh) 30 75 30 75
Material components (unit) 8 5 8 6
Direct labor hours cost Ksh.7 per unit
Overheads Ksh.
Short term variable 8,250

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Scheduling cost 7,680
Set up costs 3,600
Material handling 7,650
Total 27,180

Required:
Compute the cost per unit using
a) The convention/traditional absorption costing (use machine hours as
absorption base)
b) Using ABC and appropriate cost drivers

a) Absorption method
Total machine hours
= (25 × 2) + (25 × 4) + (250 × 2) + (250 × 4)
= 1,650 Hrs
O A R = 27,180 / 1,650
= Ksh. 16.47 per hour

Cost Schedule
Product 1 2 3 4
Direct material 30 75 30 75
Direct labor cost (7 × direct labor Cost) 14 28 14 28
Overheads (16.46 × overheads) 32.94 65.58 32.95 65.88

b) A.B.C. Method
Overheads Usage
Short term variable Machine hours
Scheduling cost Production runs
Set up costs Production runs
Materials handling Material components per unit

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ABC O. A. R.
i) Short term variable = 8,250/1650hrs
= Ksh.5 per machine hour
ii) Scheduling cost = 7,680 /24
= Ksh.320 per product run
iii) Set up cost = 3,650/24hrs
= Ksh.150 per production runs
iv) Material handling = 7,650/ (8 × 25) + (25 × 5) + (8 × 250) + (6 × 250)
= 7,650/3,825
= Ksh.2 per material component
Cost Schedule
Product 1 2 3 4
Direct material 30 75 30 75
Short term variable (2×5) = 10 (4×5) = 20 (2×5) = 10 (4×5) = 20
(Scheduling cost × no. of runs)/ no. of units (320×3)/25 = 38.4 51.2 8.96 12.8
Set up cost × no. of runs)/ no. of units (150×3)/25 = 18 24 42 6
Material handling cost × material components (2 × 8) = 16 10 16 12
Note: ABC is costly and undervalues the profits, absorption costing over values the
profits and is cheaper.

Review Questions
i) The Tea company had the following actual data for 20X4 and 20X5:
Units of finished goods 20X4 20X5
Opening inventory - 2,000
Production 15,000 13,000
Sales 13,000 14,000
Ending inventory 2,000 1,000
The basic production data at standard unit costs for the two years were:
Direct materials $12
Direct labor 18
Variable factory overhead 4
Standard variable cost per unit $44

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Fixed factory overhead was budgeted at $ per year. The expected volume of production
was 14,000 units so the fixed overhead rate was $98,000÷14,000=$7 per unit
Budgeted sales price was $75 per unit. Selling and administrative expenses were
budgeted at variable; $9 per unit sold and fixed $80,000 per year. Assume that there
were absolutely no variances from standard and variable costs or budgetd selling prices
or budgeted fixed costs in 20X4.
There was no beginning or ending inventories of work in progress.
a) For 20X4, prepare income statements based on standar4d variable (direct) costing
and standard absorption costing
b) Consider the following actual data for 20X5:
Direct materials $285,000
Direct labor 174,200
Variable factory overhead 36,000
Fixed factory overhead 95,000
Selling and administrative costs
Variable 118,000
Fixed 80,000
Sales 1,068,000
1) For 20X4, prepare income statements based on standar4d variable (direct)
costing and standard absorption costing
2) Explain why operating income differs between variable costing and
absorption costing. Be specific.

i) Horngren et. al., 2009, Introduction to Management Accounting, 14th Ed, Dorling
Kindersley, New Delhi Pg 588- 635.
ii) Garisson R. H., and Noreen E. W., 1997 Managerial Accounting, 8th Ed,
MacGrraw-Hill, New York, Pg 324-357

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7.0 CHAPTER SEVEN: BUDGETING
Learning Objectives

By the end of this chapter the learner should be able to:

i) Explain the meaning of budgetary control
ii) Describe the role and rationale of budgeting- functions of budgets, advantages
of budgets and budgetary control systems
iii) Identify the different types of budgets
iv) Illustrate the mechanics of budgeting
v) Identify the stages in the budgeting process and the Steps in developing a master
budget
vi) Discuss the human aspects of budgeting
vii) Describe alternative budgeting procedures- Zero-Based Budgeting (ZBB),
Activity-Based Budgeting, Incremental budgeting

The CIMA definition of a budget is: “A plan quantified in monetary terms, prepared and
approved prior to a defined period of time, usually showing planned income to e
generated and/or expenditure to be incurred during that period ad the capital to be
employed to attain the given objective”
A budget is therefore an agreed plan which evaluates in financial terms the various
targets set by a company’s management. It includes forecasts of profit and loss account
balance sheet accounting ratios and cash flow statement which are often analyzed by
individual months to facilitate control

7.1 Budgetary Control

The CIMA definition of a budget control is: “the establishment of budgets relating the
responsibilities of executives to the requirements of a policy and the continuous
comparison of actual with budgeted results, either to secure by individual action the
objective of that policy or to provide a basis for revision”
Budgetary control allows management to review variances in order to identify aspects of
the business that are performing better or worse than expected. This way a company will
be able to its sales performance, expenditure levels, capital expenditure projects cash
flow and asset and liability levels. Corrective action s then taken to reduce the impact of
adverse trends

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7.2 The role and rationale of budgeting
Functions of budgets
i) Planning annual operations
ii) Coordinating the activities of the various parts of the organization and
ensuring that the parts are in harmony with each other
iii) Communicating plans to the various responsibility center managers
iv) Motivating managers to strive to achieve the organization goals
v) Controlling activities
vi) Evaluating the performance of managers

Advantages of budgets and budgetary control systems

i) Agreed targets
Budgets establish targets for each aspects o the company’s operations. These targets are
set in conjunction with each manager with each manager in this way managers are
committed to achieving their budgets. The commitment also acts as a motivator
ii) Problems are identified
Budgets systematically examine all aspect of a business and identify factors which may
prevent it from achieving its objectives. Identifying problems in advance allows the firm
to take the necessary corrective action to alleviate difficulty
iii) Scope for improvement is identified
Budges will identify all the areas that can be improved thereby increasing efficiency and
profitability
iv) Improved coordination
All the managers’ plans are combined and evaluated so that a total budget for the
company can be prepared. During the process the company will ensure that each
individual plan fits in the company’s overall objectives
v) Control
Achievement of the budget will be aided by the use of budgetary control system which
constantly monitors the performance against the budget. All variances will be monitored
and positive action taken in order to correct those areas of the business that are failing to
perform

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vi) Raising finance
Any provider of finance will want to satisfy itself that the company is being managed
correctly and that funds advanced will be repaid and interest commitments honored. The
fact that a company has established a budgetary system will demonstrate that it is being
managed correctly ad the budget will show tat the company will be able to meet it
commitments.

7.3 Types of budgets

There are different types of budgets covering the operation of a firm they can however be
summarized into the following categories:
i) Operating budgets
Master budgets cover the overall plan of action for the whole organization and usually
include a budgeted profit and loss account and balance sheet. The master budget is
analyzed into subsidiary budgets which detail responsibility for generating sales and
controlling costs
ii) Capital budgets
These budgets detail all the projects on which capital expenditure will be incurred during
the following year and when expenditure is likely to be incurred. Capital expenditure is
money spent on the acquisition of fixed assets such as building and equipment. Capital
budgets enable the fixed asset section of the balance sheet to be completed and provide
information for the cash flow budget

iii) Cash flow budgets

This budget analyses the cash flow implications of each of the above budgets. It is
prepared on a monthly basis and includes details of all cash receipts and payments. The
cash flow budget will also include the receipt of finance from loans and other sources
together with forecast repayments.

7.4 Mechanics of budgeting

Stages in the budgeting process

96
i) Communication of the details of a budget policy and guidelines to those
people responsible for the preparation of budgets
It is essential that all managers be made aware of the policy of top management for
implementing the long term plan in the current year’s budget so that common guidelines
can be established. The process also indicates to managers responsible for preparing the
budgets how they should respond to expected environmental changes
ii) Determining the factors that restricts output
In every organization there is a factor that restricts performance for a given period. In
many organizations the factor is sales demand, but it is also possible for production
capacity to restrict performance if sales demand is in excess of production capacity. It s
this factor that determines the point at which that annual budgeting process should begin
iii) Preparation of the sales budget
When sales is the factor restricting performance the preparation of the sales budget
becomes the starting point of the budgeting process. It is therefore the most important
budget since other budgets are based on it and most difficult to prepare because it is
based on the action of customers, the state of the economy and competitors
iv) Initial preparation of various budgets
Managers responsible for meeting the budgeted performance should prepare the budgets
for those areas fro which they are responsible. A bottom- up process is usually preferable
v) Negotiation of budgets with superiors
To implement a participative approach to budgeting, the budget should be originated at
the lower levels of management. The managers at this level should submit their budgets
to their superiors for approval who in turn submit the budgets to their superiors for
approval and so on
vi) Coordination and review of budgets
As the individual budgets move up in the organizational hierarchy in the negotiation
process, they must be examined in relation to each other. This examination may indicate
that some budgets are out of balance with each other and need modifying so that they will
be compatible with other conditions, constraints and plans that are beyond a manger’s
knowledge or control
vii) Final acceptance of budgets

97
When budgets are in harmony with each other they are summarized into a muster budget
consisting of a budgeted profit and loss account, balance sheet and cash flow statement
the master budget is then approved by the responsibility center manager and then passed
down through the organization
viii) Ongoing review of budgets
Periodically usually on monthly basis the actual results are compared with budgeted
results. This enables management to identify those items not proceeding according to
plan, reasons investigated and if the reasons are within managements control corrective
action is taken
7.5 Steps in developing a master budget
1. Prepare a sales/revenue budget
2. Prepare the production budget (in units)
3. Prepare the direct material usage budget
4. Prepare the direct material purchase budget
5. Prepare the direct manufacturing labor budget
6. Prepare the direct manufacturing/factory overhead budget
7. Prepare ending inventories budget
8. Prepare the cost of goods sold budget
9. Prepare non-manufacturing/selling and administration budget
10. Prepare the cash budget
11. Prepare the budgeted income statement
12. Prepare the budgeted balance sheet
13. Prepare the departmental budgets*

Example: The following illustration is adapted from (Drury 2004: 601)

XTC Company manufactures two products; alpha and beta which are produced by
department 1 and 2 respectively. The following information is available for 200X

i) Standard material and labor costs:

Material X Ksh 7.20 per unit
Material Y Ksh 16.00 per unit

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Direct labor Ksh 12.00 per hour

ii) Overhead is recovered on a direct labor hour basis

iii) The standard material and labor usage for each product are as follows:
alpha beta
Material X 10 units 8 units
Material Y 5 units 9 units
Direct labor 10 hrs 15 hrs

iv) Finished products:

alpha beta
Forecast sales (units) 8,500 1,600
Selling price per unit (Ksh) 400 560
Required ending inventory(units) 1,870 90
Beginning inventory(units) 170 85

v) Direct material:
Material X Material Y
Beginning inventory 8,500 8,000
Required ending inventory 10,200 1,700

vi) Budgeted variable overhead rates per direct labor hour:

Dept 1(Ksh) Dept 2(Ksh)
Indirect materials 1.20 0.80
Indirect labor 1.20 1.20
Power (variable portion) 0.60 0.40
Maintenance(variable portion) 0.20 0.40

vii) Budgeted fixed overheads:

Dept 1(Ksh) Dept 2(Ksh)
Depreciation 100,000 80,000
Supervision 100,000 40,000
Power (variable portion) 40,000 2,000
Maintenance(variable portion) 45,600 3,196

viii) Estimated non-manufacturing overheads:

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(Ksh)
Administration – stationary etc 4,000
Salaries: -Sales 74,000
-Office 28,000
Commissions 60,000
Vehicle expenses(sales) 22,000
Advertising 80,000
Miscellaneous (office) 8,000
Total 276,000
ix) Budgeted cash flows:
Quarter 1 Quarter 2 Quarter 2 Quarter 2
(Ksh) (Ksh) (Ksh) (Ksh)
Receipts from customers 1,000,000 1,200,000 1,120,000 985,000
Payments: Materials 400,000 480,000 440,000 547,984
Payments for wages 400,000 440,000 480,000 646,188
Other costs & expenses 120,000 100,000 72,016 13,642

x) The balance sheet for the previous year end 200X was as follows:
Ksh Ksh Ksh
Fixed assets: Land 170,000
Buildings and equipment 1,292,000
Less depreciation 255,000 1,037,000 1,207,000

Current asset: Stocks -Finished goods 99,076

-Raw materials 189,200
Debtors 289,000
Cash 34,000
611,276
Less current liabilities: Creditors 248,800 362,476
Net assets 1,569,476
Represented by Shareholder’s Funds:
1,200,000 ordinary shares f Ksh 1 each 1,200,000
Reserves 369,467 1,569,476

Required:
Prepare a master budget for the year 200X and the following budgets

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i) Sales budget
ii) Production budget
iii) Direct material usage budget
iv) Direct material purchase budget
v) Direct labor budget
vi) Factory overhead budget
vii) Selling and administration budget
viii) Cash budget
Solution:
i) Sales/revenue budget
It shows the quantities of each product the company plans to sell and the intended selling
price. It is the foundation of all other budgets since all expenditure s ultimately depended
on the volume of sales.

Sales budget for the year 200X

Product (1) Units sold (2) Selling price (3)Total revenue= (1)×(2)
Alpha 8,500* 400* 3,400,000
Beta 1,600* 560* 896,000
4,296,000
*See information item (iv) - finished products
In practice total sales budget for the year is broken down into subsidiary monthly sales
budgets
ii) Production budget
This budget is expressed in units only and the responsibility of the production manager.
The objective is to ensure that production is sufficient to meet sales demand and that
economic inventory levels are maintained
Annual production budget
alpha beta
Units to be sold* 8,500 1,600
Required closing inventory* 1,870 90
Total units required for sale and inventory 10,370 1,670
Less Beginning inventory* 170 85

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Units to be produced 10,200 1,605
*See information item (iv) - finished products
Total production for each department should also be analyzed monthly

iii) Direct material usage budget

Supervisors for each department should prepare estimated of materials required to meet
the production budget

Annual direct material usage budget

Dept 1 Dept 2 (6) Total units to (7) Total
(1) Unit price (2) Units to be (3) Cost = (4) Units to be (5) Cost = be used = cost =
(Ksh) used (1) × (2) used (1) × (4) (2) + (4) (3) + (5)

Material X 7.20 102,000* 734,400 12,840*** 92,448 114,840 826,848

Material Y 16.00 51,000** 816,000 14,445**** 231,120 65,445 1,047,120
1,550,400 323,568 1,873,968
* The 10,200 units to be produced by dept 1 as shown in the production budget above × 10 the standard
material usage of material X as shown in information item (iii)
** The 10,200 units to be produced by dept 1 as shown in the production budget above × 5 the standard
material usage of material Y as shown in information item (iii)
***The 1,605 units to be produced by dept 2 as shown in the production budget above × 8 the standard
material usage of material X as shown in information item (iii)
****The 1,605 units to be produced by dept 2 as shown in the production budget above × 9 the standard
material usage of material Y as shown in information item (iii)

iv) Direct material purchase budget

This is the done by the purchasing manager who is responsible for obtaining the planed
quantities of raw materials to meet the production requirements. Te objective is to
purchase the materials at the right time and at the planned purchase price taking into
consideration the planned inventory levels
Annual direct material purchase budget
Material X Material Y
Quantity necessary to meet production
(as per material usage budget – column 6) 114,840 65,445
Required closing inventory* 10,200 1,700

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125,040 67,145
Less beginning inventory* 8,500 8,000
Total units to be purchased 116,540 59,145
Planned unit purchase price (Ksh) × 7.20 × 16
Total purchases of each material (Ksh) 839,088 946,320
Total purchase budget (839,088 + 946,320) 1,785,408
* See information item (v) –direct material

v) Direct labor budget

This is the responsibility of the departmental managers; they will prepare the estimates of
the department’s labor hour requirement to meet the planned production the budgeted rate
per labor hour is usually determined by the industrial relations or human recourses
department.
Annual direct labor budget
Dept 1 Dept 2 Total
Budgeted production (units)* 10,200 1,605
Production hours per unit** ×10 ×15
Total budgeted hours 102,000 24,075 126,075
Budgeted wage rate per hour (Ksh)*** ×12 ×12 ×12
Total wages(Ksh) 1,224,000 288,900 1,512,900
* See annual production budget
** See information item (iii) - direct labor usage
** See information item (ii) - direct labor cost

vi) Factory overhead budget

This is the responsibility of the respective production department managers. The
overhead budget will depend on the behavior of the costs of the individual overhead
items in relation to anticipated level of production. The overheads are analyzed according
to whether they are variable or fixed
Annual overhead budget: anticipate activity – 102,000 direct labor hrs for dept 1 and
24,075 direct labor hrs for dept 2
Variable overhead
Rate per hour Overheads Total

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Dept 1 Dept 2 Dept 1 Dept 2
(102,000) (24,075)
Variable overheads
Indirect material 1.20 0.80 122,400 19,260
Indirect labor 1.20 1.20 122,400 28,890
Power (variable portion) 0.60 0.40 61,200 9,630
Maintenance (variable portion) 0.20 0.40 20,400 9,630
326,400 67,410 393,810
Fixed overheads
Depreciation 100,000 80,000
Supervision 100,000 80,000
Power (variable portion) 40,000 2,000
Maintenance (variable portion) 45,600 3,196
285,600 125,196 410,796
Total overhead (variable + fixed o/h) 612,000 192,606 804,606
Budgeted departmental overhead rate (Total overhead ÷
budgeted hrs for each dept) 6.00 8.00

vii) Prepare ending inventories budget

Direct materials Material X Material Y Total
Required closing inventory 10,200 1,700
Planned unit purchase price (Ksh) × 7.20 × 16
Total value of each material (Ksh) 73,440 27,200 100,640
Finished products Alpha Beta
Required closing inventory 1,870 90
Planned finished goods cost* × 332 × 501.6
Total value of each finished product 620,840 45,144 665,984
Total planned closing inventory 766,624

*Finished goods cost is calculated as follows:

Alpha Beta
Cost Units used Ksh Units used Ksh
Direct materials

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X 7.20 10 72.00 8 57.60
Y 16.00 15 80.00 9 144.00
Direct labor 12 10 120.00 15 180.00
Factory overheads:
Dept 1 6 10 60.00 - -
Dept 2 8 - - 15 120.00
332.00 501.60

viii) Prepare the cost of goods sold budget

Ksh
Opening inventories:
Finished products (170 × 332.00) + (85× 501.60) 99,076
Direct materials (8,500×7.20) + (8,000×16.00) 189,200
Direct material purchases * 1,785,408
Direct labor* 1,512,900
Factory overheads* 804,606
Less closing inventories* (766,624)
Cost of goods sold 3,624,566
* See respective budgets

ix) Prepare non-manufacturing/selling and administration budget

Ksh Ksh
Selling: Salaries 74,000
Commissions 60,000
Car expenses 22,000
Advertising 80,000 236,000
Administration: Stationary 4,000
Salaries 28,000
Miscellaneous 8,000 40,000
276,000

x) Prepare the cash budget

The objective of the cash budget is to ensure that sufficient cash is available at all times
to meet the level of operations outlined in the various budgets. Cash budgets can help

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avoid surplus cash balances by enabling management to make advance arrangements for
their investment and also planned ahead to fill any anticipated shortfalls in cash

Cash budget for the year 200X

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
(Ksh) (Ksh) (Ksh) (Ksh) (Ksh)
Opening balance 34,000 114,000 294,000 421,984 34,000
Receipts from customers 1,000,000 1,200,000 1,120,000 985,000 4,305,000
1,034,000 1,314,000 1,414,000 1,406,984 4,339,000
Payments: Materials 400,000 480,000 440,000 547,984 1,867,984
Payments for wages 400,000 440,000 480,000 646,188 1,966,188
Other costs & expenses 120,000 100,000 72,016 13,642 305,658
920,000 1,020,000 992,016 1,207,814 4,139,830
Closing balance 114,000 294,000 421,984 199,170 199,170

xi) Prepare the budgeted income statement

Budgeted profit and loss account for the year ending 200X
Ksh
Sales -(sales budget) 4,296,000
Less cost of good sold -(cost of goods sold budget) (3,624,566)
Gross profit 671,434
Less non mfg cost/selling and administration expenses –
(Selling and Administration expenses budget) (276,000)
Budgeted operating profit for the year 395,434

xii) Prepare the budgeted balance sheet

Budgeted balance sheet for the as at 31st December 200X
Ksh Ksh
Fixed assets:
Land 170,000
Building and Equipment 1,292,000
Less accumulated depreciation* (435,000) 857,000
1,027,000
Current assets:

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Raw materials 100,640
Finished goods 665,984
Debtors ** 280,000
Cash -(closing cash balance figure in cash budget) 199,170
1,245,794
Less current Liabilities:
Creditors*** (307,884) 937,910
1,964,910
Represented by shareholder’s funds:
1,200,000 ordinary shares of Ksh 1 each 1,200,000
Reserves 369,476
Profit and loss account 395,434 1,964,910
* Opening balance for depreciation (255,000), see previous year balance sheet; plus current year
depreciation for department 1 (100,000) and for department 2 (80,000) i.e. (255,000+ 180,000)
** Opening balance for debtors (289,000) see previous year balance sheet; plus sales (4,296, 000) see
sales budget; minus total cash received (4,305,000) see cash budget i.e. (289,000 + 4,296,000 – 4,305,
000)
*** Opening balance for creditors (248,800) see previous year balance sheet; plus purchases (1,785,408)
see direct material purchases budget; plus indirect materials(141,660) see factory overhead budget; minus
total cash paid (1, 867,984) see cash budget i.e. (248,800 + 1,785,408 + 141,660 – 1, 867,984)

xiii) Prepare the departmental budgets*

Departmental budges may be prepared for judging how effective managers are in
controlling expenditure for which they are responsible the department annual budget for
department 1 will be as follows:

Annual budget for department 1

Ksh Budget (Ksh) Actual(Ksh)
Direct labor (see direct labor budget):
102,000 at Ksh 12 1,224,000
Direct material (see direct material usage budget):
102,000 units of material X at Ksh 7.20 per unit 734,400
51,000 units of material Y at Ksh 16 per unit 816,000 1,550,400
Variable overheads (see factory overheads budget):

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Indirect material 122,400
Indirect labor 122,400
Power (variable portion) 61,200
Maintenance (variable portion) 20,400 326,400
Fixed overheads (see factory overheads budget):
Depreciation 100,000
Supervision 100,000
Power (variable portion) 40,000
Maintenance (variable portion) 45,600 285,600
3,386,400

Exercise:
ABC Limited wishes to prepare an operating budget for the forthcoming period.
Information regarding products costs and sales levels is as follows:
Products
A B
Materials required:
X 2 3
Y 1 4
Labor hours required:
Skilled labor 4 2
Semi- skilled 2 5
Sales level(units) 2,000 1,500
Opening stock (units) 100 200

Closing stock of materials and finished goods will be supported to meet 10% of demand.
Opening stocks of material X was 300kg and for material Y were 1,000liters. The
material prices are Ksh 10 for material X and Ksh 7 for material Y labor costs are Ksh 12
per hour of skilled workers and Ksh 2 per hour for the semi skilled workers.
Required:
a) Prepare the following budgets;
i) Production in units
ii) Material usage (kg and litres)
iii) Materials purchase (kg, litres and Ksh)

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iv) Labor (hours and Ksh)
b) State and discuss the usefulness of budgets

7.6 Human aspects of budgeting

i) Reaction of mangers to budget levels
If the objective is to achieve success rather than avoid failure, then budgets which are set
difficult or too easy at as demotivators whereas those of moderate difficulty provide the
highest levels of motivation
If the objective id to avoid failure rather than achieve success, then even moderate
difficulty targets will not be attempted only those of easy level of difficulty will be
attempted.
ii) Need for employees to be committed
However comprehensive the budgetary control may be, it has to be operated by human
beings and to ensure its success it is essential that each employee is committed to the
project. Commitment may be enhanced by demonstrating to each employee the benefit
that they can derive from the process, using the process for future promotions,
recognizing and appreciating the efforts of implementers, identifiers of reasons for
variances and suggestions of corrective actions etc
iii) Problem of separate budget centers in relation to staff motivation
In big organizations it is very difficult to relate one budget center to the budget of the
remaining centers and although each center will know its results, it may not appreciate
how its results have contributed to the total business performance. Good communication
can ensure that employees do not feel that their contribution does not affect the end
results
iv) Need for staff participation
There is a very strong link between participation and motivation, when staffs have been
involved in the preparation f budgets they would want to see the projects succeed
participation is influenced by: culture of the organization, attitudes of the individual,
experience and social

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7.7 Alternative Budgeting Procedures
Zero – Based Budgeting (ZBB)
ZBB starts from the assumption previous budgets are meaningless in the context of those
currently being set and so all budgeting starts at a nil basis from which all expenditure is
identified.
The CIMA definition of ZBB is as follows:
“A method of budgeting whereby all activities are re-evaluated each time a
budget is formulated. Each functional budget starts with the assumption that the
function does not exist and is at zero cost. Increments of cost are compared with
increments of budget, culminating in the planned maximum benefit for a given
budgeted cost.
An American fostered concept, this definition shows that the benefit to be derived
exceeding its costs is a central factor, No activity can automatically assume that funds
will continue to be received, it is necessary to prove that any funds that are allocated will
achieve a positive benefit for the organization.

Stages of implementation of ZBB

• Definition of Objectives
Each area of the organization is analyzed according to its function and is given an
objective. In relation to the provision of health care for instance this might include
breaking it down into the distinct units of maternity care, psychiatric treatment and so on.
Each of these areas then has its own objective.
• Decision Units
Once the organization has been broken down into logical units the next step is to analyse
it into decision units which are basically any activity for which a decision needs to be
made about the resources to be allocated to it. Thus there may, for instance, be several
decision units within maternity care which itself is a function of overall health care for
which an objective has been set.
• Decision packages
Each decision unit has a budget prepared for it by the function concerned which details
the resources it requires and the benefits which should accrue. In order for this stage to be

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effective it is necessary for senior management to provide guidance and assistance in
term of, for instance, expected activity levels and so on.
Each package will be made up of a “base” package, which details the minimum
requirements for the decision unit concerned, and “incremental packages which are the
provision of greater levels of service that the manager concerned considers desirable. In
relation to road maintenance, for example, the base package may consist of a request for
resources to monitor a certain mileage of roads, and incremental packages may include
replacement of kerbstones, resurfacing of a certain number of roads, bridge strengthening
and so on. Each package will have its own budget and analysis of expected benefits.
• Evaluation and Ranking of packages
Each package is then ranked in accordance with low important it is considered to be. This
may be done by senior management, who are responsible for the overall allocation of
resources within the organization, or by the managers themselves, because, as you can
imagine, there is the potential for there to be a vast number of packages under
consideration.
One way of deciding on who evaluates what is to have a cut-off limit in terms of
spending such as 10,000 below this the ranking is carried out by the managers concerned
and above this figure it is the responsibility of senior management.
Each base package should be ranked as the highest priority for that particular decision
unit with each of the incremental packages ranked in descending order of importance.

Evaluation will be carried out using Cost-Benefit Analysis (CBA) based on the overall
level of resources available. It is possible therefore, that one decision unit may have all its
decision packages ranked high enough to be accepted; another unit may receive only a
portion because its expected benefits in terms of cost are ranked lower overall.
• Allocation of resources
Once the evaluation has taken place, the resources available can then be allocated
accordingly,

Advantages

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i) The allocation of scarce resources should be carried out much more efficiently
because of the practice of ranking each decision package.
ii) The traditional problem of slack being built into incremental budgeting
exercises should be eradicated because each request for funds starts from a
“zero base” and has to justify itself.
iii) Inefficient operations ie those whose costs exceeds their benefits, can be much
more easily identified and if necessary excluded.
iv) Past inefficiencies that have been built into the budget are excluded.
v) Because there is much more involvement in this type of process, those involved
should experience a high level of motivation towards budget achievement
vi) It is possible to apply the process selectively to those areas where scarceness of
resources poses the greatest problem.

Difficulties encountered
i) There is a large volume of extra work associated with starting the budgeting
process from scratch in each new period.
ii) It is a radical idea, which because of its emphasis on efficiency, can cause
conflict within some organizations, especially those which have practiced
traditional budgeting techniques for many years.
iii) There is the difficulty of deciding on benefits derived under cost-Benefit
Analysis.
iv) If major changes to the organization occur during the budgeting year, the
original CBA can be radically altered and may well become out of data. Thus,
packages which were originally accepted might be rejected if the analysis were
to be undertaken again and vice versa.
v) There could also be a lack of continuity if a package which is accepted in one
period is rejected in the following. This can be overcome by making sure that a
package is used as a “base” and therefore obtains a higher priority. An example
would be the construction or widening of a major road which obviously started
should be completed or the earlier work undertaken will lose its usefulness.

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ZBB despite its many advantages is much less widespread in the UK that it is in the
United States possibly because of the large amount of extra work involved and the much
more “tradition” outlook of British companies.
Note that ZBB as a technique is generally applicable to profit-seeking as well as not-for
profit (NFP) organizations

Activity-Based Budgeting
This is based on an amalgam of various planning and budgeting techniques such as
priority based budgeting (itself a derivative of zero-based budgeting) and activity based
costing. It also forms a link between planning and budgeting

The process begins with the breaking down of the strategic plan into plans or objectives
for individual business units and by the use of activity analysis, into plans for the
individual activities themselves. Minimum levels of activity are analyzed as are
incremental levels and key constraints are identified which in turn leads to the
qualification of resource requirements. Critical success factors are also an important
element in the process and once these are known, performance indicators can be set for
them to determine how the company is performing in comparison to its activity-based
budget. The technique also provides a method of feedback to the updating of strategic
plans.

The advantages claimed for the process are similar to those for activity based costing:
i) Identification of inefficient processes and unprofitable products is made easier
ii) Elimination of non-value added activities
iii) Enhanced performance measurements and control
iv) There is better control over the causes of cost of identifying them with the
activities they result from
v) It provides the ability to view the organization from a different perspective that
cuts across traditional departmentalization

Incremental budgeting

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This is the traditional method of budgetary control which uses the previous year’s budget
as the basis for the current year’s budget, usually with an allowance for change due to
inflationary activity or efficiency. The approach therefore assumes that the basis of the
current budget is correct. The disadvantages of such an approach, particularly when
compared to the previous two budgeting methods are as follows:
i) There is no focus on the efficient use of resources by identifying the activities
they emanate from.
ii) Because the change in the budget can be somewhat arbitrary, it is often the case
that cuts are made with regard to overall constraints rather than by identification
of inefficient products or processes.
iii) The link with the strategic plan is often non-existent
iv) A further result of its arbitrary nature is that commitment on the part of those
responsible for budget achievement may be low.
v) New activities can tend to be constrained, again because of the overall rigidity
of the technique
.

Review Questions
i) What are the major benefits of budgeting?
ii) Describe the mechanics of budgeting
iii) Explain the steps in developing a master budget
iv) Describe the advantages and limitations of various budgeting approaches
v) KPLC plans inventory levels (at cost) at the end of each month as follows: May,
$275,000; June, $220,000; July, $270,000 and August, 240,000. Sales are
expected to be June, $440,000: July, $350,000; August, $420,000. Cost of goods
sold is 60% of sales. Purchases in April were $250,000; May $180,000. Payments
for each month’s purchases are made as follows: 10% during that month; 80% the
next month and the final 10% the next month. Prepare budget schedules for June,
July and August for purchases and for disbursement for purchases

114
i) Horngren et. al., 2009, Introduction to Management Accounting, 14th Ed, Dorling
Kindersley, New Delhi Pg 294- 339.
ii) Garisson R. H., and Noreen E. W., 1997 Managerial Accounting, 8th Ed,
MacGrraw-Hill, New York, Pg 324-357

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Sample Papers

Mount Kenya University

DEPARTMENT OF ACCOUNTING AND FINANCE
BBM221: MANAGEMENT ACCOUNTING 1
Time: 2 Hrs
Instructions to Candidates: Answer question 1 (Compulsory) and any other TWO
questions.
Question 1
a) Explain the objectives of management accounting 5mks

b) KPLC plans inventory levels (at cost) at the end of each month as follows: May,
$275,000; June, $220,000; July, $270,000 and August, 240,000. Sales are expected to
be June, $440,000: July, $350,000; August, $420,000. Cost of goods sold is 60% of
sales. Purchases in April were $250,000; May $180,000. Payments for each month’s
purchases are made as follows: 10% during that month; 80% the next month and the
final 10% the next month. Prepare budget schedules for June, July and August for
purchases and for disbursement for purchases.10mks

c) A Company produces a single product. The following is the budget for the product
Budget
i) Selling price Ksh.10
ii) Direct material cost per unit Ksh.3
iii) Direct wages per unit Ksh.2
iv) Variable overhead per unit Ksh.1
v) Fixed production overhead Ksh.10,000 per month
vi) Production volume 5,000 units per months
Actual
i) Production 6,000 units
ii) Sales 4,800 units
iii) Assume that all costs were as budgeted
Required;
Prepare a profit statement using:
i) Absorption costing 6mks
ii) Marginal costing 6mks
iii) Prepare a reconciliation statement to reconcile the two reported profit figures
under absorption and marginal costing 3mks

116
Question 2
A yatch company has developed a new cabin cruiser which they earmarked for the
medium to large board market. A market analysis has a 30% probability of annual sales
being 5000 boats, and a 40% probability of 4000 annual sales. This company can go into
limited production while available costs are sh.10,000 per boat and a fixed cost and
sh.800,000 annually. Alternatively they can go into full production where variable cost
are sh.9000 per boat and fixed costs are sh.5,000,000 annually, if the new boat is to be
sold for shs.11,000 should the company go to limited or full scale production when the
objective is to maximized expected profits (use a tree diagram) 20mks

Question 3
Assume that the product manager of ABC Ltd is concerned about the apparent
fluctuations in efficiency and therefore work done by employees which are related to the
volume. The result of this in most 12 weeks research carried out is as shown below;
Week Machine hours(cost driver) Indirect labor costs
13. 68 $1,190
14. 88 1,211
15. 62 1,004
16. 72 917
17. 60 770
18. 96 1,456
19. 78 1,180
20. 46 710
21. 82 1,316
22. 94 1,032
23. 68 752
24. 48 963

Find the indirect labor costs associated with 90 machine hours and (b) the machine hours
that $1,000 of indirect labor cost would produce. Use the high-low method and the least
squares method 20mks

Question 4
Assume that a company intends to sale product in the market, at a selling price of sh.9 per
unit. The V C is shs.5 per unit and the T F C is sh.2000
Required:
i. Compute the B E P in units and in shs.
ii. Assume that the company intends to make a profit before tax of 20% of sales,
determine the number of units that must be sold.
iii. Assume that the corporate tax rate is 30% and the company has a target profit
of 1640 after tax. Compute the number of units that must be sold to earn this
target profit.
If the company expects to sale 600 units, compute the marginal of safety.10mks

Question 5
Kawasaki Company Ltd manufactures a broad range of engines for commercial products.
At its Kenyan plant it assembles power saw engines and lawnmower engines.
Information on these products is as follows:

117
Engine type Power saw Lawnmower Motor bike
engines engines engines
Selling price Ksh 80,000 Ksh 100,000 Ksh 125,000
Variable cost per unit Ksh 56,000 Ksh 62,500 Ksh 75,000
Contribution per unit Ksh 24,000 Ksh 37,500 Ksh 50,000
Contribution margin percentage 30% 37.5% 40%
(Ksh 24/80; 50/125 & 37.5/100) in (000)
Estimated daily demand in units 60 60 60
Assume that only 600 machine hours are available daily for assembling engines,
additional capacity can not be obtained in the short run. The limiting factor is machine
hours. It takes 2, 5 and 5 machine hours produce one power saw, one lawnmower and one
motor bike engine respectively.
Required:
Advise on the product mix that Kawasaki should produce during the period 20mks

118
Mount Kenya University
DEPARTMENT OF ACCOUNTING AND FINANCE
BBM221: MANAGEMENT ACCOUNTING 1
Time: 2 Hrs
Instructions to Candidates: Answer question 1 (Compulsory) and any other TWO
questions.
Question 1
a) Discuss the role of management accounting in the management process? 5mks
b) Describe the decision making process 5mks
c) The following information is available for XYZ Company
Period
1 2 3 4 5 6
Units sold (000) 150 120 180 150 140 160
Units produced (000) 150 150 150 150 170 140
Budgeted activity is expected to average 150,000 units per period and there is no opening
stock for period 1. Unit selling price is Ksh 10, Unit variable cost is Ksh 6, fixed costs
per period is Ksh 300,000 while non manufacturing overheads are 100,000 per period.
Required:
Prepare a profit and loss statement based on variable and absorption costing 10mks

d) KPLC plans inventory levels (at cost) at the end of each month as follows: May,
$275,000; June, $220,000; July, $270,000 and August, 240,000. Sales are expected to
be June, $440,000: July, $350,000; August, $420,000. Cost of goods sold is 60% of
sales. Purchases in April were $250,000; May $180,000. Payments for each month’s
purchases are made as follows: 10% during that month; 80% the next month and the
final 10% the next month. Prepare budget schedules for June, July and August for
purchases and for disbursement for purchases 10mks

Question 2
A company is considering whether to develop a new product or consolidate existing
product. New product development can either be undertaken through thorough
development at a cost of Shs.150,000 or through rapid development at a cost of Shs
80,000 while product consolidation can either be achieved through strengthening the
products at a cost of shs 30,000 or through reaping the products at no extra cost. The
following are the expected outcomes, accompanying probabilities and the projected
revenue for of the options.
Thorough development Rapid development Strengthening product Reaping product
outcomes good mod poor good mod poor good mod poor good poor
probabilities 0.4 0.4 0.2 0.1 0.2 0.7 0.3 0.4 0.3 0.6 0.4
revenues 1000000 50000 2000 1000000 50000 2000 400000 20000 6000 20000 2000

119
Should the company develop a new product or consolidate existing product? 20mks

Question 3
Assume that the product manager of ABC Ltd is concerned about the apparent
fluctuations in efficiency and therefore work done by employees which are related to the
volume. The result of this in most 12 weeks research carried out is as shown below;

Week Machine hours(cost driver) Indirect labor costs

25. 68 $1,190
26. 88 1,211
27. 62 1,004
28. 72 917
29. 60 770
30. 96 1,456
31. 78 1,180
32. 46 710
33. 82 1,316
34. 94 1,032
35. 68 752
36. 48 963

Find the indirect labor costs associated with 90 machine hours and (b) the machine hours
that $1,000 of indirect labor cost would produce. Use the regression method 20mks

Question 4 (20mks)
Auto Robot Ltd which manufactures two products P & Q has provided the following
information.
P (shs) Q (shs)
Selling price per unit 10 12
Variable cost per unit 2 8
Fixed cost 50,000 34,000
Required:-
iv) Calculate the B. E. P. of each product in units and in shs.
v) Calculate the margin of safety if budgeted sales are 10,000 units each
vi) Compute the profit of each product if sales in units are 20% above the B. E. P.

Question 5
Consider the following data concerning Copy Cat Photocopying Limited
Old equipment Proposed replacement
equipment
Useful life in years 5 3
Current age in years 2 0
Original cost $25,000 $15,000
Accumulated depreciation 10,000 0

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Book Value 15,000 Not acquired yet
Disposal value(in cash ) now 7,000 Not acquired yet
Disposal value in 3 years 0 0
Annual cash operating costs for
power, maintenance, toner etc 14,000 8,000
Copy cat is trying to decide whether to replace the old equipment. Because of the rapid
changes in technology, copy cat expect the replacement equipment to have a 3year useful
life only. Ignore the effects of taxes 20mks

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