KYAMBOGO UNIVERSITY

SCHOOL OF MANAGEMENT AND ENTREPRENEURSHIP

STUDY NOTES
MAF 3102: MANAGEMENT ACCOUNTING
BBS EDUC YEAR III: SEMESTER 1 2021

FACILITATOR
MRS. LUGANDA NAMUJJUZI SYLIVIA
MBA (Finance), BAF, DAF
Tel 0705-326065 ; Email: [email protected]

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TABLE OF CONTENTS

COURSE OUTLINE ...................................................................................................................... 3

INTRODUCTION TO MANAGEMENT ACCOUNTING ........................................................... 5
COST CONCEPTS AND BEHAVIOUR ..................................................................................... 10
ACTIVITY BASED COSTING ................................................................................................... 26
COST-VOLUME-PROFIT (CVP) ANALYSIS........................................................................... 35
SHORT TERM DECISION MAKING ........................................................................................ 48
BUDGETING AND BUDGETARY CONTROL ........................................................................ 59
STANDARD COSTING AND VARIANCE ANALYSIS .......................................................... 82
DIVISIONALISED PERFORMANCE MEASUREMENTS AND TRANSFER PRICING ...... 94

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COURSE OUTLINE
COURSE NAME: MANAGEMENT ACCOUNTING (4 CU)
COURSE CODE: MAF 3102
COURSE LEVEL: 111 (SEMESTER 1)
CREDIT UNITS: 4 CREDIT HOURS: 60

Brief course description

The course focuses on the way management accounting information is gathered, processed and
disseminated for decision-making. Topics covered include: definition and nature of management
accounting, short term techniques and decisions, budgeting, standard costing and variance
analysis, performance measurement and transfer pricing.

Course Objectives
By the end of the course, students should be able to:
• Be familiar with management accounting terminology;
• Be aware of the various techniques and systems of costing and their impact on decision making;
• Apply accounting information in decision making process;
• Plan, allocate and manage resources in an organization using the budget; and

Learning outcomes
By the end of the course students should be able to;
• Use cost information to make informed short and long- term decisions
• Use standard costs for planning and control purposes
• Prepare budgets for organisations
• Monitor budget performance
• Prepare organisational performance and evaluation reports.

Course content

Introduction to Management Accounting: (2hrs)

• Differences between cost accounting and management accounting;
• The functions of management accounting information;
• Emerging themes in management accounting,
• Evaluate performance of various units of an organization.
Cost concepts (review) (4 hrs)
• Cost and revenue behaviour in relation to the level of activity
• Cost classification for control
• Costs in manufacturing and service organisations
• Using cost behaviour patterns to predict costs
Costs-Volume Profit Relationships and Decision Making (10hrs)
• Break-even analysis: Assumptions and its importance in short term decision-making;
• Break-even and tax
• Margin of safety
• Multi-product break-even
Short-term decisions (8 hrs)

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• Relevant costing and decision making;
• Make or buy
• Special offers
• Shut-down
• Pricing decisions, calculating optimum prices
• Limiting factor situations
Budget and Budgetary Control Procedures (10 hrs)
Stages in budgeting process;
• The role of budgeting in organisational control;
• Approaches in budgeting (incremental, zero-base budgeting, activity based budgeting..
• Preparation of operating and master budgets,
• Fixed and flexible budgeting; budgetary control procedures.
Standard Costing: (10 hrs)
• Preparation of standard costs,
• Analysis of variance including, material cost variances, labour cost variances, overheads cost
variances, mix and yield variances, total cost variances; sales variances;
Divisionalised Performance Measurements and Transfer Pricing (6hrs)
• Functional and divisionalised organisational structure,
• Advantages and disadvantages of divisionalisation;
• Measuring divisional profitability;
• Objectives of transfer pricing;
Contemporary issues in management accounting (10 hours)
• Cost management
• Target costing
• Business process engineering
• Balanced scorecard
• Just-in-time production process
• Total Quality Management
• Continuous improvement

Delivery methodology
Lectures and tutorials

Assessment
Coursework 40%
End of semester Exam 60%

Reading List
1. Atrill, P (2012) Management accounting for decision makers, Harlow, England : Pearson.
2. Drury Colin (2010) Cost and Management accounting, 5th Ed. Thompson Business Press, London
3. Groot, T. (2013) Advanced management accounting Harlow, England ; New York : Pearson.
4. Hilton, R.W. and M. Favere-Marchesi. Managerial Accounting: Creating Value in a Dynamic
Business Environment, Canadian Edition, McGraw-Hill Ryerson, ON: Whitby, 2010.
5. Macintosh, N B (2010).Management accounting and control systems: an organizational and
sociological approach, Hoboken, NJ : John Wiley & Sons.

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INTRODUCTION TO MANAGEMENT ACCOUNTING
1. What is management accounting?

Management accounting is the application of the principles of accounting and financial

management to create, protect, preserve and increase value for the stakeholders of for-profit and
not-for-profit enterprises in the public and private sectors (Chartered Institute of Management
Accountants (CIMA) Official Terminology, 2005).

2. Work of Management

3. Planning and Control Cycle

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4. What is the role of management accounting?

Management accounting is an integral part of management. It requires the identification,

generation, presentation, interpretation and use of relevant information to:

• Inform strategic decisions and formulate business strategy

• Plan long, medium and short-run operations (budgeting)
• Determine capital structure and fund that structure
• Design reward strategies for executives and shareholders
• Inform operational decisions
• Control operations and ensure the efficient use of resources
• Measure and report financial and non-financial performance to management and other
stakeholders
• Safeguard tangible and intangible assets
• Implement corporate governance procedures, risk management and internal controls
(CIMA Official Terminology, 2005).

5. Management Accounting versus Financial Accounting

Management accounting is concerned with the provision of information to internal parties within
the organisation to help them make better decisions and improve the efficiency and effectiveness
of existing operations.

Financial accounting which mainly is concerned with the provision of information to external
parties.

Management Accounting Financial Accounting

Users Internal parties External parties

Forecasts of future and monitoring Report what happened in the past

information on current and past and current performance
Time Dimension of performance Focuses on whole of the business
Information
Focuses on small part of the organization,
e.g. cost of a particular product

Measurement Financial and non-financial Financial

Frequency Monthly/depending on organisation Annual (& Semi-annual)

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Little formal regulation (provide useful Law (e.g. CA1985/2006) &
information for decision-making, Accounting Standards (e.g. UK
Regulation planning & control) GAAP)

Relevance for specific management Truth & fairness – (T&Fv)

Criteria decisions

6. Emerging themes in management accounting

• According to Johnson and Kaplan (1987), most management accounting practices used in
mid-1980s had been developed by 1925 which were obsolete and no longer relevant to
today’s competitive environment.

• It is argued that for MA to be useful, it must be adapted to reflect changes to new business
processes and technologies, and deregulation and privatisation, and global competition.

• Since then, many management accounting theories, techniques and practices have been
innovated that are relevant to today’s environment, e.g.

• Strategic management accounting, including target costing, cost management

• Use of non-financial performance measures – e.g. to make customer complaints

(satisfaction) an overriding priority (Balanced Scorecard).

• Activity based costing

• Focus on simplicity of reports and quicker feedback

• Total quality management

7. The Balanced Scorecard

• Traditionally (i.e. prior to 1980s) MA focused mainly on financial performance

measures.
• Greater emphasis now being given to incorporating non-financial measures into the
formal reporting system – to compete in the global competitive environment.
• Result was a proliferation of performance measures.
• However, some of these measures conflicted with each other, unbalanced, etc.
• The need to integrate financial and non-financial performance measures that link them
to the company’s strategy led to the emergence of Balanced Scorecard (BS).

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• Balanced Scorecard seeks to link performance measures to an organization’s vision &
strategy – i.e. it is an integrated framework of performance that can be used to clarify,
communicate and manage strategy implementation.

• Balanced Scorecard advocates looking at the business from four different perspectives
by seeking to provide answers to the following four basic questions:

1. How do customers see us? (customer perspective),

2. What must we excel at? (internal business process perspective),
3. Can we continue to improve and create value? (learning and growth
perspective),
4. How do we look to shareholders? (Financial perspective).

The Balanced Scorecard

Financial
To succeed financially, how should we
appear to our shareholders?

Internal Business
Customer Vision Process
To achieve our vision, &
To satisfy our shareholders
how should we appear Strategy and customers, what
to our customers?
business processes must
we excel at?

Learning & Growth

To achieve our vision, how will we
sustain our ability to change and
improve?
Source: Kaplan & Norton, 1996 AC202 Lecture 1 13 details
See Drury pp. 999-1020 for further

8. The Changing Business Environment

A more competitive environment emphasising:

1. Higher quality products

2. Lower prices and costs
3. Global competition
4. Meeting and anticipating customer needs

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9. Meeting the Challenges of Changing Business Environment

10. Changes in Public sector management

a. New trends in public sector management

b. More use of performance indicators
c. More decentralization – e.g. in local governments
d. More contracting out- Private Finance Initiatives (PFI)or Public Private Partnerships
(PPP)
e. Greater awareness of cost and performance management

11. Summary

• Many changes and challenges especially globalisation.

• Faith in accounting shaken by scandals such as Enron, etc

• But also the commercial failures of the Dotcom bubble, etc.

• Question: Are firms’ management accounting systems up to scratch?

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COST CONCEPTS AND BEHAVIOUR
A central problem facing organisations is how to identify and evaluate the relevant costs and
benefits resulting from the various available alternatives. The cost concepts and terms will be of
help in demonstrating the multiple purposes of cost accounting systems.

Costing
It is the ascertainment of costs. Costing includes techniques (principles and rules applied for
ascertaining costs of products or serviced) and processes of ascertaining costs. This refers to the
classification, recording, and appropriate allocation of expenditure in order to determine the costs
of products or services.

Cost
Accountants usually define cost as a resource sacrificed or foregone to achieve a specific objective.
Other researchers (Jack Gray & Don Ricketts) define a cost as the total resources consumed to
accomplish a specific objective.

Cost Object
To guide decisions, managers need the cost of something. This something can be referred to as
the cost object which is anything for which a separate measurement of cost is desired. Examples
of cost objects include: a product, service, a project, a customer, a brand category, an activity, a
department, and a program. Cost objects are chosen to guide in decision-making.

Cost Unit
It is a unit of a product or service to which costs are ascertained by means of allocation,
apportionment and absorption. It is a useful measurement of costs for comparative purposes.

Cost Driver
This is any factor that affects costs. That is a change in the cost driver will cause a change in the
total cost of a related cost object.

Business function Examples of cost drivers

Research and Development No. of projects

Personnel hours on a project

Technical complexity of a project

Design of products, services and processes No. of products

No. of parts per product

No. of engineering hours

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Production No. of units produced

No. of set-ups

No. of engineering change orders

Direct manufacturing labour cost

Marketing No. of advertisements run

No. of sales personnel

Distribution No. of items distributed

No. of customers

Weight of items

Relevant Range
This is the range of the cost driver in which a specific relationship between cost and the driver is
valid.

Cost Centre
This refers to a production or service department in an organisation where costs are incurred for
the production of goods or the provision of services. Cost centres accumulate the cost directly
incurred and the costs apportioned. Cost centres enable the ascertainment of total cost accumulated
by a department for a particular period of time.

Profit Centre
This refers to a production or service department where costs as well as revenues are accumulated.
Profit centres measure the revenue and the cost accumulated over a period of time, thus giving the
profit earned by the centre for the period.

COST BEHAVIOUR

Cost behaviour is the way in which total costs or costs per unit are affected by fluctuations in the
level of activity. ‘costs’ can refer to particular items of cost, such as the total annual cost of motor
vehicle insurance or the total cost of postage and packing during a given period. Alternatively,
‘total costs’ might also refer to total production costs, or total selling and distribution overhead
costs, and so on.

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A common assumption in cost and management accounting is that costs belong to one of the
following categories:

Entirely fixed. Costs such as periodic rental charges and senior management salaries are
fixed
Entirely variable. Costs such as direct materials costs are entirely variable
Semi-fixed and semi-variable, although the fixed and variable elements can be separated
into their fixed and variable parts. Examples of mixed costs are telephone charges. It is
possible to take overhead costs in total and assume that taken together they are semi-fixed
and semi-variable.

Given this assumption, a formula for total costs (TC) can be stated as: TC = a + bx where;

a = the fixed cost for the given period

b = the variable cost per unit of activity, and

x = the number of units of activity

The nature of fixed and variable costs will be explained in the proceeding section.

The need to know about cost behaviour

Understanding cost behaviour is essential for forecasting or budgeting, and for controlling costs
and monitoring performance.

a. Budgeting
Once a decision has been taken about how much to produce and sell during the budget period, all
costs (and revenues) have to be budgeted for that activity level. These budgeted cost figures are
obtained by adding the total of all expected variable costs and fixed costs, so that the cost budget
is built up from its component elements.

b. Control of costs
A common method for controlling costs and monitoring performance is to compare budgeted
figures with actual and seek explanations for differences. Clearly, if any differences are to be
meaningful, the figures used as ‘yardsticks’ must take account of actual activity level (not that
originally budgeted for). Such adjustments to the original budget for changes in the activity level
can only be done if managers understand what happens to costs as the activity level changes.

Factors affecting cost behaviour

There are several major factors which affect cost behaviour either singly or in combination. Some
of these are discussed below.

a. Volume or activity level

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Many costs are affected by the level of activity. But there is more than one volume measure that
affects costs and it is vital that the correct activity is identified as the basis of variability of costs.
For example, selling costs may vary with either the volume or value of sales, distribution costs
may vary with volume, size, weight or value of sale, whilst production costs may vary with the
number of units produced, or the number of hours worked.

b. Nature of the cost

The nature of a cost will often aid in predicting its likely amount. For example, if the maintenance
of machines is a single overhaul each year, then maintenance is a fixed cost. If the maintenance
is needed once every so many units of output, it is a variable cost. Similarly, by their nature,
electricity and telephone costs are mixed costs, having a fixed element (or standing charge) and a
variable element that changes with the amount of use.

c. Nature of the production process

As production processes become more automated and less labour intensive so a higher proportion
of costs can be expected to be fixed rather than variable, because depreciation (which is a fixed
cost) replaces the variable cost of direct wages.

Production methods may change as output level increases and cost behaviour will also reflect such
changes.

d. The existence of spare capacity

If an organisation is working at less than full capacity, an increase in output may result in little
change in costs. But where the increase in output necessitates a change in capacity, all costs will
alter.

For example, consider a factory with 40 machines, each with its own machine operator, where it
takes one machine an hour to make each unit of output.

Capacity in an ordinary working week of 35 hours is:

35 x 40 = 1,400 units

If we assume that the machine operators are paid a fixed salary, then increasing output from say
45,000 units to 55,000 units will affect only the direct materials and variable expenses of
production. But an increase from 55,000 to 65,000 units could mean either having to acquire more
machines and workers, or to pay additional costs to persuade the current workers/operators to work
a night shift or overtime. There would be some increase in labour costs as well as the additional
direct materials and variable expenses.

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e. Other factors
Other factors to consider are whether a cost is incurred solely because of one activity, or whether
two or more activities jointly incur the same costs. In addition, the extent to which an organisation
can control a cost may affect its level.

A final factor is the degree of efficiency may affect costs. For example, labour costs per unit might
fall as workers become experienced and faster at making units of production. This is known as
the ‘learning effect’.

Cost Classification for Control

Costs can be classified in different ways, according to purpose for which they are to be used.

There are three broad classifications of costs:

1. Behavioural classification
2. Natural classification
3. Functional classification

Behavioural Classification

This grouping is done in accordance with how costs react to certain conditions. This classification
is further subdivided into 3 categories.

(a) According to variability

(b) According to normality
(c) According to traceability
(d) According to controllability
(e) According to function

(a) Classification of costs according to variability

This grouping of costs is done according to how costs change/respond with changes in the activity
levels in the short run. There are three ways in which costs can respond to changes in activity
levels:

(i) Fixed Costs

These costs remain constant in the short run irrespective of change in the activity levels.

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Types of Fixed Costs

 Standing Fixed Costs - these are costs incurred even when production has not commenced,
e.g. salaries of management staff, rent.
 Running Fixed Costs - these are fixed costs incurred only when production commences and
remains constant in the short run, e.g. salaries of production staff, insurance of production staff,
etc.
 Committed Costs - these are costs incurred by the firm and may not easily be reduced without
affecting the long-term strategy of the firm, e.g. salaries of established staff, rent, etc.
 Discretionary Fixed Costs - these are fixed costs incurred by the firm only when the firm can
meet them. They may be easily reduced without seriously affecting the operations of the firm,
e.g. advertising costs, donations, etc.

Step Fixed Costs

Step costs are costs which are constant for a range of activity and rise to a new constant level once
that range is exceeded. Some costs rise in a series of steps. Large steps (renting a second factory)
or small steps (renting a desktop computer) might occur.

a) If the steps are large, the concept of relevant range of activity usually applies, and within a
relevant range of activity the cost can be taken as fixed. For example, above a certain output
level it might be necessary to hire a second supervisor on a fixed salary. A second supervisor
might be needed if output each month rises above 20,000 units. However, if the business
expects to produce only between 10,000 and 15,000 units in a typical month, it should be safe
to assume that the cost of supervision is fixed for the relevant range.

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Rent of
Factory
$

Relevant
range

b) If the steps are small and frequent as the activity level rises, the steps may be ignored and the
cost may be treated as a variable cost, with reasonable accuracy.
Rental in Straight line
$ approximation of
cost

Units produced

An important example of step fixed costs that are usually treated as variable costs is the cost of
direct labour. As a factory produces more output, it takes on more direct labour. Labour might be
paid a rate per hour, but for a fixed length week. For example labour might be paid $8 per hour
for 38 hour week. If staff are at work but not doing anything, they are still paid. Even so, it is
useful to treat direct labour as a variable cost because:

It is normally a reasonably accurate assumption when output volumes are large

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It is a helpful assumption to use when planning direct labour requirements and budgeting,
and for monitoring and controlling labour productivity/efficiency.

(ii) Variable Costs

These are costs that change with activity levels, e.g. materials, production labour, etc.

Variable unit costs that change with activity level

Some times, the variable cost per unit of an item changes as the level of output rises. For example,
the cost per unit of purchasing materials might fall as purchase quantities rise. When buying items
such as tyres, it is normal to obtain special ‘bulk discount’ prices for large orders. The more tyres
purchased, the lower the cost for each tyre. In the cost graph below, the total cost of tyre purchases
is shown on the assumption that bulk purchase discount apply only to additional units purchased
above a given amount-for example, the $100 for each tyre up to 100 tyres, then $90 for each
additional tyre above 100 and up to 500, and then $70 for each tyre in excess of 500.

Graph of total cost of tyres against the output of cars

Cost of
tyres in $

0 Relevant range Output of Cars

Of activity

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However, in practice it is likely that only relatively limited changes in the level of production will
be considered. This is described as the relevant range of activity, and within that range unit
prices are likely to be constant.

Relevant range of activity is the limits within which output is expected to lie.

(iii) Semi-variable Costs/Semi-fixed Costs

These are costs that contain both variable and fixed elements. They change with activity
at one point and remain constant at other points, e.g. production overheads like factory
power, fuel, employees receiving salary packages based on basic pay (fixed) and
remuneration based on either time worked or units produced.

For better understanding of cost behaviour, variable elements of the mixed costs need to be isolated
from fixed elements.

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The Analysis of Mixed Costs and Cost Estimation Methods

1. Account Analysis
 In the account analysis or the inspection of accounts method, the departmental manager and
the accountant examine each item of expense for a particular period and then classify it as a
wholly fixed, wholly variable or a semi-variable cost.
 A single average unit cost figure is selected for the items that are categorized as variable,
whereas a single total cost for the period is used for the items that are categorised as fixed.
 For semi-variable items, the departmental manager and the accountant agree on a cost function
that appears to best describe the cost behaviour.
 Each account is classified as either fixed or variable based on the analyst’s knowledge of how
the account behaves

Account Analysis –drawbacks

 This method is very subjective (involves individual and arbitrary judgements). Therefore, cost
estimates based on this method lack the precision necessary when they are to be used in making
decisions.
 It uses the latest cost details (from the accounts of the most recent period) that may not be
typical of either past or future cost behaviour.

2. Engineering Estimates
 Engineering approach is based on the use of engineering analyses of technological
relationships between inputs and outputs –for example methods study, work sampling and time
and motion studies.
 This approach is appropriate when there is a physical relationship between costs and the cost
driver. For example, this approach is usually associated with direct materials, labour and
machine time, because these items can be directly observed and measured.

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 Cost estimates are based on an evaluation of production methods, materials, labour and
overhead requirements.

Engineering Estimates –drawbacks

 Engineering approach is not generally appropriate for estimating costs that are difficult to
associate directly with individual units of outputs, such as overhead costs.
 Methods study, work sampling and time and motion study techniques can be expensive to
apply in practice.

3. The High-Low Method

 The high-low method consists of:
◼ Selecting the periods of highest and lowest activity levels,
◼ Comparing the changes in costs that result from the two levels to determine variable
cost per unit of output, and
◼ Estimating the fixed cost at any level of activity (assuming a constant unit variable cost)
by subtracting the variable cost portion from the total cost

The High-Low Method-Example

 A firm recorded the following production activity and maintenance costs for two months:

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Activity 1

If sales salaries and commissions are £10,000 when 80,000 units are sold and £14,000 when
120,000 units are sold, what is the variable portion of sales salaries and commission?

The High-Low Method-drawbacks

 This method ignores all cost observations other than the observations for the lowest and highest
activity levels.
 Observations at the extreme ranges of activity levels are not always typical of normal operating
conditions, and therefore may reflect abnormal rather than normal cost relationships.
 The method, therefore, gives inaccurate cost estimates

4. The Scatter graph Method

 This method involves:
◼ Plotting on a graph the total costs (represented on the vertical axis -Y) for each activity
(recorded on the horizontal axis –X).
 Drawing a straight line through the middle of the plotted points by visual approximation.

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◼ The point where the straight line cuts the vertical axis represents the fixed cost.
◼ The unit variable cost is found by observing the differences (in costs and activity levels)
between any two points on the straight line.

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The Scatter graph Method-drawbacks

 This method suffers from the disadvantage that the determination of exactly where the straight
line should fall is subjective (i.e. different people will draw different lines with different slopes,
giving different cost estimates).

5. Regression Method
The knowledge of spreadsheets can enhance the use regression method in separating variable and
fixed elements from mixed costs. (Illustrate using spreadsheets here).

(b) Classification of costs according to normality

(i) Normal costs - these are costs that are incurred in the usual conditions in which normal
production is attained. These costs are vital for routine decision making, e.g. hydroelectric
power would be a normal cost if this is the power usually used for production.

(ii) Abnormal costs - these are costs that are incurred in unusual conditions from those that
normal production is attained. These costs would not influence routine decisions, e.g.
thermal power being used to clear production in case of hydroelectric power failure.

(c) Classification of costs according to traceability

(i) Traceable costs - these are costs that can easily be identified in the final product, e.g.,
materials.

(ii) Untraceable costs - these are costs that cannot be easily identified in the final product.

(d) Classification of costs according to controllability

(i) Controllable costs - these are costs that can be easily controlled by the actions of a cost
pool/cost centre manager in a given time period. Over a long enough time span most
costs are controllable by some one in the organisation, e.g. direct materials, direct
labour, fuel costs, and power, telephone and fax bills.
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(ii) Uncontrollable costs - these are costs that cannot be easily influenced by the actions
of a cot pool/cost centre, e.g. rent, salaries, and depreciation.

(e) Classification of costs according to function

This classification is based on what segments or functions of the organisation the costs relate. The
costs may be:

(a) Production costs

(b) Administration costs
(c) Selling and distribution costs
(d) Research and development costs

The main objective of this classification is to determine the cost of each function and to foster cost
control. In addition, it may serve as a way of justifying the existence of a certain function visa-a-
vis the benefits derived from them.

Activity 2

A manufacturing company produces a single product, the widget. It has established that its costs
are as follows.

• Direct materials $4 per unit

• Direct labour, 20 minutes per unit. Direct labour is paid at $6 per hour
• Production overheads consist of fixed costs of $60000 each month and variable costs of
$0.90 per direct labour hour.
• Administration overheads are fixed, $20000 per month
• Sales and distribution overheads are fixed costs of $30000 per month plus variable selling
costs of $2 per unit sold

During a given month, 10,000 widgets were produced and sold. What should be the total costs in
the month?

Natural Classification

This grouping is done according to what the costs are: the nature of the costs. Costs can be
categorised naturally into 3 groups.

(a) Materials

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(b) Labour
(c) Expenses

Materials - inputs to be worked on directly or indirectly in the process of producing output.

Labour - human effort to product.

Expenses - costs that cannot fall under materials or labour.

The natural classification is further subdivided into two: Direct costs and indirect costs.

Direct costs

These are costs that are attributed to a particular cost object or cost pool. These are costs that
are avoidable if the cost object in question is not produced. These costs include:

(a) Direct materials - e.g. raw materials

(b) Direct labour - e.g. production wages
(c) Direct expenses - e.g. royalties, carriage inwards, subcontracting

Indirect costs

These are costs that are incurred in an organisation for its wellbeing but cannot be attributed
to a particular cost object or cost pool. These costs are referred to as overheads. They include:

(a) Indirect materials - e.g. sand paper

(b) Indirect labour - e.g. administrative salaries

(c) Indirect expenses - e.g. rent and rates, electricity, telephone.

N.B.: Although indirect costs (overheads) cannot be easily identified with particular cost objects,
they are part of costs incurred in the production of output. They are supposed to be charged to
output (cost object) and cost pools through a process known as overhead analysis.

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ACTIVITY BASED COSTING
1. What is Activity Based Costing?

• It is ‘cost attribution to cost units on the basis of benefit received from direct activities e.g.
ordering, set-up, assuring quality’ (CIMA, 1991). [or]

• A system based on activities that links organisational spending on resources to the

products and services produced and delivered to customers (Atkinson et al., 2001). [or]

• A costing method that first assigns costs to activities, then assigns costs to products based
on their consumption of activities (Maher & Deakin, 1994).

• ABC’s basic principle = cost units should bear the cost of the activities they cause.

• Costs are driven by activities that take place in the business.

• Examples of activities:

– Storing of materials

– Setting up costs

– Ordering of materials

– Handling materials

– Organising production

– Testing/inspection of production quality

N.B. The objective of activity-based costing is to understand overheads and the profitability of
products

Many companies have evolved their costing system from using a single cost pool to using separate
indirect-cost rates for each department (cost centres approach).

2. Why ABC?
➢ Because the cost drivers of resources in each department differ from the single,
company-wide, cost-allocation base.
➢ ABC systems are a further refinement of department costing systems.

3. Implementing ABC is beneficial when ...

➢ significant amounts of indirect costs are allocated using only one or two cost pools.

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➢ products make diverse demands on resources.
➢ products that a company is well suited to make and sell show small profits, while
products for which a company is less suited show large profits.
➢ complex products appear to be very profitable and simple products appear to be
losing money.
➢ There are significant disagreements among staff about the costs of products and
services.

4. How does ABC work?

ABC forces management to consider what causes the cost. It uses multiple cost drivers in order
to attribute costs to activities and cost objects. Thus, overheads can be related to the activities
which cause them, i.e. which drive them and make them happen.

5. ABC and Traditional Costing in Practice

➢ During the last decade research shows that only few companies adopted ABC.

➢ Innes et al., (2000) found that there was a fall in adopting ABC in large companies. In
1994, 21% companies were using ABC. In 1999, survey showed that only 17.5% using
ABC.

➢ Size of the companies and the cost structure of the companies may influence
organisations to adopt ABC.

6. Why Traditional Costing is Still Favourite?

➢ Simplicity of traditional costing over the complexity of ABC.

➢ Internal organisational problems such as resistance.

➢ Problems associated with implementation such as identifying activities, finding out cost
drivers, and lack of resources.

➢ Research shows lack of top management support for ABC (Innes et al., 2000).

7. Can ABC help prevent under or over-costing?

➢ Activities generate transactions.

➢ Transactions generate costs.

➢ ABC traces costs to activities.

➢ This can prevent under or over-costing.

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8. Under-costing and Over-costing

Product under-costing:

⚫ A product consumes a relatively high level of resources but is reported to have a

relatively low total cost.

Product over-costing:

⚫ A product consumes a relatively low level of resources but is reported to have a

relatively high total cost.

Example: Jane, Stephen and Agnes meet occasionally for lunch. Each one orders separate items.

⚫ Jane’s order amounts to 5,000

⚫ Stephen consumed 6,000

⚫ Agnes’s order is 4,000

⚫ Total 15,000

Assuming they divide the bill equally, the average cost per lunch = 15,000 ÷ 3 = 5,000

Agnes will be over-cost and Stephen is under-cost.

9. Activity Based Costing Model

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10. Steps for Implementing ABC
➢ Identify the main activities of the organisation.
E.g. Materials handling, Purchasing, Dispatch, Machining.

➢ Collect the costs of each activity into cost pools.

➢ Identify the factors which determine the costs of the activity cost drivers.
E.g. Number of purchase orders, Number of set-ups.

➢ Charge costs to cost objects on the basis of their usage of the activity. This involves
calculating activity rates. Total cost of the cost pool ÷ Total of the cost driver

11. Activity cost drivers

Having shared out the resource costs (overheads) between the various activities (cost pools),
next step is to assign activity cost drivers to apportion such costs and/or allocating the whole
of the cost pool in cases where it is specific to the particular product or service. The activity
cost drivers may be at the:
Unit level – i.e. activities performed every time a unit is produced;
Batch level – i.e. activities which are performed every time a batch is produced;
Product level – i.e. activities which ensure that the product is produced;
Plant level – i.e. activities which ensure that facilities are sustained, e.g. cleaning,
insurance, etc. (will be discussed further in week 11)
So, activities cause the costs, and products (or services) consume those activities.

Examples of activity cost drivers:

12. Example of Using ABC

Prime Pottery produces two types of vases, known as Blue and Green. It has traditionally cost its
vases on a volume based overhead absorption basis. It is now considering using ABC. The
following budgeted data are available:

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The total overhead costs are as follows:
⚫ Machine maintenance £125,000
⚫ Materials handling £150,000
⚫ Set-up costs £225,000
£500,000
The existing absorption basis is to absorb total overheads on the basis of machine hours.

Required:

a. Calculate total unit costs (direct costs plus overhead) using the existing absorption basis
for overheads.
b. Recalculate unit costs using activity-based costing based on the three cost drivers given.

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Example 2:

The Chadus company manufactures two products, R & T. The following budgeted information
relating to the company for the forthcoming period has been made available to you:

Products

R T

Sales and production (000 units) 400 400

£ £
Selling price (per unit) 36 56
Prime cost (per unit) 16 36
Department 1 (machine hours per unit)…………...2 hours…………………4 hours
Department 2 (direct labour hours per unit)………1 hour………………… 6 hours

Details of the amounts assigned to activity cost pools and their cost drivers are:

Activity cost pool Activity cost driver

£000
Department 1…………… 1,020…………………………………Machine hours
Department 2………………820………………………………….Direct labour hours
Setting up costs…………… 80…………………………………No of set-ups
Computing…………………300…………………………………No of hours
Purchasing………………… 100…………………………………No of orders
2,320

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You have also been provided with the following estimates for the period under review:
Products
R T Total
(000) (000) (000)
Machine Hours 100 240 340
Direct labour hours 50 360 410
No of set-ups 32 48 80
Computer (hours) 40 20 60
Purchasing (no of orders) 40 10 50

Required:

Using an activity based costing approach prepare a profit statement which shows the profit or loss
for each product and the total profit or loss.

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Exercise

The following relates to M/s Alpha Manufacturing Ltd. for a given period:

Activity Overhead (Shs) Cost Driver

Output Related 50,000,000= Machine Hours

Material Handling 16,000,000= Kilogrammes of materials
Production set-up 14,000,000 Production runs
Despatch 10,000,000= Number of customers
Total Costs 90,000,000=

Production data

Product A Product B Total

Number of Units Produced 2,000 1,000 3,000
Direct materials per unit 3kg 2kg
Total Direct Materials 6,000kg 2,000kg 8,000kg
Machine hours per unit 9hours 7hours
Total machine hours 18,000hours 7,000hours 25,000hours
Production runs for the period 20 50 70

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Number of customers 4 16 20

Costs and Prices per unit

Product A Product B

Direct Material Cost 18,000 12,000

Direct Labour Cost 10,000 5,000

Selling Price 70,000 75,000

Required:

a) Using the conventional costing approach based on units of output, determine the total
overhead and total costs chargeable to each unit of product A and B.
b) Using Activity Based Costing (ABC) approach, determine the total overhead and total
costs chargeable to each unit of product A and B.

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COST-VOLUME-PROFIT (CVP) ANALYSIS
1. Introduction
i. Cost-volume-profit (CVP) analysis is a technique which uses cost behaviour theory to identify
the activity level at which there is neither a profit nor a loss (the breakeven activity level).
ii. It involves the analysis of how total costs, total revenues and total profits are related to sales
volume, and is therefore concerned with predicting the effects of changes in costs and sales
volume on profit.
iii. Cost-volume-profit analysis is sometimes referred to simply as break-even analysis.

2. Assumptions for CVP Analysis

i. A linear revenue function and a linear cost function.
ii. Selling price, total fixed costs, and unit variable costs can be accurately identified and remain
constant over the relevant range.
iii. What is produced is sold, i.e. no inventories
iv. A single product or a constant sales mix.
v. The selling price and costs are assumed to be known with certainty.
vi. The analysis applies only to a short-term time horizon.

3. Uses of CVP Analysis

i. Budget planning. The volume of sales required to make a profit (breakeven point) and the
'safety margin' for profits in the budget can be measured.
ii. Pricing and sales volume decisions.
iii. Sales mix decisions, to determine in what proportions each product should be sold.
iv. Decisions that will affect the cost structure and production capacity of the company.

4. Graphical Representation of CVP Relationships

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A Profit Statement of a certain company

Total Per Unit

Sales (72,500 units) $2,900,000 $ 40

Less: Variable Cost 1,740,000 24

Contribution margin $1,160,000 16

Less: Fixed Cost 800,000

Operating Profit $ 360,000

N.B
i. Contribution margin is the difference between sales and variable cost of sales. It is the
amount available to cover fixed costs before a firm can realise profits or incur losses.
ii. Thus, any contribution above the break-even point will constitute a profit.

5. Break-Even analysis

Break-even analysis is of vital importance in determining the practical application of cost func-
tions. It is a function of three factors, i.e., sales volume, cost and profit. It aims at classifying the
dynamic relationship existing between total cost and sale volume of a company.

Hence it is also known as “cost-volume-profit analysis”. It helps to know the operating condition
that exists when a company ‘breaks-even’, that is when sales reach a point equal to all expenses
incurred in attaining that level of sales.

The break-even analysis is based on the following set of assumptions:

(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.

(ii) The cost and revenue functions remain linear.

(iii) The price of the product is assumed to be constant.

(iv) The volume of sales and volume of production are equal.

(v) The fixed costs remain constant over the volume under consideration.

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(vi) It assumes constant rate of increase in variable cost.

(vii) It assumes constant technology and no improvement in labour efficiency.

(viii) The price of the product is assumed to be constant.

(ix) The factor price remains unaltered.

(x) Changes in input prices are ruled out.

(xi) In the case of multi-product firm, the product mix is stable.

Functions of break Break-even analysis

Break-even analysis enables a business organization to:

1. Measure profit and losses at different levels of production and sales.

2. Predict the effect of changes in sales prices.
3. Analyze the relationship between fixed and variable costs.
4. Predict the effect of cost and efficiency changes on profitability.

Limitations of Break-Even Analysis:

1. In the break-even analysis, we keep everything constant. The selling price is assumed to be
constant and the cost function is linear. In practice, it will not be so.

2. In the break-even analysis since we keep the function constant, we project the future with the
help of past functions. This is not correct.

3. The assumption that the cost-revenue-output relationship is linear is true only over a small
range of output. It is not an effective tool for long-range use.

4. Profits are a function of not only output, but also of other factors like technological change,
improvement in the art of management, etc., which have been overlooked in this analysis.

5. When break-even analysis is based on accounting data, as it usually happens, it may suffer
from various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates
and inappropriate allocation of overheads. It can be sound and useful only if the firm in question
maintains a good accounting system.

6. Selling costs are specially difficult to handle break-even analysis. This is because changes in
selling costs are a cause and not a result of changes in output and sales.

7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate
income tax.

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8. It usually assumes that the price of the output is given . In other words, it assumes a horizontal
demand curve that is realistic under the conditions of perfect competition.

9. Matching cost with output imposes another limitation on break-even analysis. Cost in a
particular period need not be the result of the output in that period.

10. Because of so many restrictive assumptions underlying the technique, computation of a

breakeven point is considered an approximation rather than a reality.

Determining the Break-Even Point in Units

Two approaches:
i. Operating Income Approach
ii. Contribution Margin Approach
5.1 Operating Income Approach
This approach involves determining the level of income or sales revenue that will equate to the
total costs.
In the previous illustration, the break-even point can be calculated as follows:
0 = ($40 x Units) – ($24 x Units) – $800,000
0 = ($16 x Units) – $800,000
($16 x Units) = $800,000
Units = 50,000

Proof
Sales (50,000 units @ $40) $2,000,000
Less: Variable Costs 1,200,000
Contribution margin $ 800,000
Less: Fixed Costs 800,000
Operating income $ 0
N.B. Break-even point in sales is derived by multiplying BEP in units by the selling price.

5.2 Contribution Margin Approach

This involves dividing the fixed cost by the contribution per unit.
i.e. BEP (units) = Fixed Costs/Contribution per unit.
Number of units = $800,000 / ($40 - $24)
= $800,000 / $16 per unit = 50,000 units

Profit -Volume ratio: (Also know as contribution-sales ratio).

It is one of the most important ratios for studying the profitability of operations of a business and
it establishes the relationship between contribution and sales.
C/S (or P/V Ratio) = Contribution C
Sales S
Or FC + P

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S
Or S-VC
S
Or Change in contribution
Change in sales
N.B. The ratio can also be shown in the form of a percentage if the formula is multiplied by 100.
e.g. 15 – 10 = 5 = 1 or 1 X 100 = 331/3%
15 15 3 3
6. Margin of Safety
It is the difference between the Budgeted sales volume and the breakeven level of sales. Margin
of safety is simply a measurement of how far sales can fall short of the budget before the business
makes losses. A large margin of safety indicates a low risk of making a loss, whereas a small
margin of safety might indicate a high risk of a loss. It therefore indicates the vulnerability of a
business to a fall in demand.
It is usually expressed as a percentage of budgeted sales. The margin of safety may also be
expressed as a percentage of actual sales or of maximum capacity.
= Budgeted Sales/or Actual sales – Break even sales

Basing on the CVP graph on the left

side, if the firm budgeted for an
activity of 45 units of output, then the
margin of safety would be 25 units (45
– BEP of 20 units).
The margin of safety (MOS) can also
be expressed as a percentage as
follows:
25/45 *100 = 55.56%

7. General Formulae for C-V-P Analysis

i. Sales – variable costs = Contribution – Fixed Costs = Profit or Loss.
ii. C/S Ratio = FC where: BEP (Sales) = FC
BEP (Sales) C/S Ratio
C/S Ratio (P/V Ratio)
= Contribution to sales ratio (%)
= C X 100
S
OR = change in contribution
change in sales

iii. Breakeven point (in units) = Fixed cost

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Contribution per unit
Break-even point (Sales) = Fixed Cost
C/S Ratio
OR BEP (units) X selling price
iv. Fixed cost = (sales X C/S Ratio) – profit

v. Calculation of profit when sales are given = (Sales X C/S ratio) – FC

vi. Sales required to earn a given profit (before tax) = FC + Desired Profit
Unit contribution or C/S ratio
vii. Sales required to earn a given profit (after tax) FC + Desired Profit
(1-tax rate)
Unit contribution or C/S ratio
viii. Variable cost in a period = (1 – C/S ratio) X sales

ix. Margin of safety = Total sales – sales at BEP

= Or Profit
C/S Ratio
= Margin of sales in (shs.) x 100
Total sales
x. Operating leverage = Contribution
Net income

Example 1
A company makes a single product with the selling price of Shs.20,000 and unit variable cost of
Shs.12,000. Fixed costs incurred include production costs of Shs.40,000,000 and administration
costs amounting to Shs. 20,000,000.
Required:
i. Calculate the number of units to break-even
ii. Contribution sales ratio
iii. Sales at break-even point
Solution:
(a). Break-even point (Quantity) = Fc__
Sp – Vc
= 60,000,000 = 60,000,000 = 7,500 units
20,000 – 12,000 8,000

(b). Contribution ratio or profit volume ratio = Contribution x 100

Sales
= Unit Contribution x 100
Unit selling price
= 20,000 – 12,000 x 100
20,000
= 0.4 or 40%
(c). Sales at break-even = FC__

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CS/ratio
= 60,000,000 = 150,000,000=
0.4
Similarly, Break-even sales = Break-even quantity x Unit selling price
= 7,500 units x 20,000/= = 150,000,000
Activity 1
The total costs incurred at various output levels for a process operation in a factory was measured as
follows:
Output (in units) Total cost (£)
11,500 102,476
12,000 104,730
12,500 106,263
13,000 108,021
13,500 110,727
14,000 113,201
Required:
i. Using the high-low method, analyse the costs of the process operation into fixed and variable
components
ii. Calculate, and comment upon, the break-even output level of the process operation in (i) above,
based upon the fixed and variable costs identified and assuming a selling price of £10.60 per unit.
iii. The earlier the BEP of the firm the better in terms of profitability. Identify ways in which a firm
can lower its BEP in order to start making profits earlier.

Example 2:
UMU Ltd produces and sells a single product to its customers. The following data was extracted
in the books of company covering the month of December 2008.
Annual fixed costs 10,000,000=
Expected selling price per unit 20,000=
Variable cost per unit:
Production cost 9,000=
Selling & distribution 7,000=

The company wishes to earn a total profit of Shs. 2,000,000 per month before tax.

Required:
i. How many units should be produced and sold in order to make the plan possible?
ii. Determine the amount of sales that can be made to get the profit above.

Solution
Unit selling price = 20,000=
Unit variable cost (9,000 + 7,000) = 16,000=
i). Required sales, Q (in units) = FC + Planned profit
Unit contribution
Q = 10,000,000 +2,000,000

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20,000 – 16,000
Q = 12,000,000 = 3,000 Units
4,000
ii) Sales that can be made are calculated as under:
Sales value: = FC + Planned Profit
C/S ratio
Where, contribution to sales(c/s) ratio = 20,000 -16,000 X 100 = 20%
20,000
Therefore, sales = 10,000,000 + 2,000,000 = Shs. 60,000,000
0.2
Alternatively, Sales (amount)= sales (units)* selling price

= 3,000 units * 20,000 = Shs. 60,000,000

In Class Activity
A company sold fans at Shs 200,000 each. Variable cost Shs. 120,000 each and fixed cost Shs.
6,000,000.

Calculate:
a. Calculate break even sales in Shs.
b. Break even sales in units.
c. Sales in units to earn a profit of Shs. 2,000,000.
d. Prepare a profit statement showing profit earned in (c ) above.

Example 3
A company expects to sale 10,000 units. The variable cost per unit is 1,000/= and annual fixed
costs of 20, 000,000/=.
i. What price would be charged in order to break-even at a given level of activity?
ii. Using the price calculated in (i), determine the amount of units that should be sold in order
to yield a desired profit of Shs. 1,000,000.
iii. What is the profit that will result from 10% reduction in variable cost per unit and
Shs.5,000,000 decrease in fixed costs assuming that current sales in (i) above will be
maintained?

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Solution:
Let selling price = Px
(a) Break-Even quantity (Units) = FC = 20,000,000
Unit Contribution (Px – VC)
10,000 units = 20,000,000
(Px – 1,000)
10,000 (Px – 1,000) = 20,000,000
10,000 Px – 10,000,000 = 20,000,000
10,000Px = 30,000,000
Px = Shs 3, 000
(b) Units to provide desired profit = FC + Planned Profit
Unit Contribution
= 20,000,000 + 1,000,000
3,000 – 1,000
= 21,000,000 = 10,500 Units
2,000
(c) Selling price = 3,000
Variable cost per unit = 900= (90% x 1,000)
Fixed Cost = 15,000,000
But Q = FC + Profit
SP – VC
10,000 = 15,000,000 + Profit
3,000 – 900

10,000 x 2,100 = 15,000,000 + Profit = 10,000 x 2,100 – 15,000,000 = Profit

21,000,000 – 15,000,000 = Profit = 6,000,000

8. Target profit after taxation

The profit goal or desired profit may be stated in terms of profit after taxes. In such scenario the
following formula applies.
Amount of units that can be produced and sold = Fixed cost + Desired profit
1- Tax rate
Unit selling price – unit variable cost
Sales value (to earn desired amount of profit after tax) = Fixed cost + Desired profit
1- Tax rate
Contribution ratio (c/s ratio)
Example 4
The company plans to earn an after tax profit of 1,200,000= and that the income tax rate is 30%.
The unit selling price and variable cost amount to 10,000= and 6,000= respectively. The fixed
costs will amount to shs.20,000,000. The amount of units and sales value to make the profit can
be calculated as under.
i) Units to be produced (Q) = Fixed cost + Desired profit
1- Tax rate
Unit selling price – unit variable cost
Q = 20,000,000 + 1,200,000
1 - 0.3

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10,000 – 6,000

Q = 20,000,000 + 1,714,286 = 5,429 units

4,000

ii). Sales volume (S) = Fixed cost + Desired profit

1- Tax rate
Contribution ratio (c/s ratio)
= 20,000,000 + 1,200,000
1 – 0.3
0.4
= 20,000,000 +1,714,286 = 54,285,715=
0.4
In Class Activity 2:
Norvik Enterprises operate in the leisure and entertainment industry and one of its activities is to
promote concerts at locations throughout Europe. The company is examining the viability of a
concert in Stockholm. Estimated fixed costs are £60,000. These include the fees paid to
performers, the hire of the venue and advertising costs. Variable costs consist of the cost of a pre-
packet buffet which will be provided by a firm of caterers at a price, which is currently being
negotiated, but it is likely to be in the region of £10 per ticket sold. The proposed price for the sale
ticket is £20. The management of Norvic have requested the following information:
i. The number of tickets that must be sold to break even.
ii. How many tickets must be sold to earn £30,000 target profit before tax?
iii. Assuming, the tax rate is 25%, how many tickets must be sold in order to make a profit of
£30,000 after tax?
iv. What profit would result if 8,000 tickets were sold?
v. What selling price would have to be charged to give a profit of £30,000 on sales of 8,000
tickets, fixed costs of £60,000 and variable cost of £10 per ticket?
vi. How many additional tickets must be sold to cover the extra cost of television advertising
of £8,000? (assuming the selling price per unit remains £20 and variable cost per unit is
£10).

9. CVP analysis with multiple products

The previous CVP analysis was based on the situation where a firm produces and sells a single
product. However, a firm can produce and sell more than one product. A CVP analysis can still be
made if a firm maintains a constant sales mix. The sales mix or product mix represents the relative
proportion of the sales of each product. If the firm’s fixed costs are common to all the products
produced and sold, then to determine the firm’s break-even point, the multi-product firm’s c/s ratio
will first be determined. The total fixed costs will be divided by the calculated c/s ratio to determine
the break-even point. The multi-product’s c/s ratio is the weighted average of the c/s ratios for all
products, the weights being the relative proportion of each product’s sale.
The contribution ratio(c/s ratio) for multi-product firm can also be calculated by dividing the total
contribution from all products by the total sales.

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Example 5:
UGA Ltd produces and sells three products namely A, B and C. The following data was obtained
for a year
Products A B C

Sales units 600 2,500 2,000

Unit selling price 2,500 1,000 3,000

Unit variable cost 1,000 400 2,200

UGA Ltd incurs total fixed costs given below:

Production costs Shs. 1,200,000
Selling and administration costs Shs. 1,800,000

Required:
a) Determine multi-product firm’s c/s ratio
b) Compute the firm’s break-even point in shillings
c) Determine each product’s break-even point in shillings and units.

Solution:
Product A B C Total

Sales mix 15% 25% 60% 100%

Total sales (Shs) 1,500,000 2,500,000 6,000,000 10,000,000

Less: Total variable costs 600,000 1,000,000 4,400,000 6,000,000
Total contribution 900,000 1,500,000 1,600,000 4,000,000
Contribution to sales ratio(C/S 60% 60% 26.667% 40%
ratio)

Note: C/S ratio = Total contribution x 100 =

Total sales
Sales mix = Individual product sales x 100
Multi-product total sales

a). Multi-product firm’s c/s ratio (4,000,000) x 100 = 40%

10,000,000
b). The firm’s break-even point in shillings is calculated as follows:
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Break-even point (Shs) = Total fixed costs = 3,000,000 = Shs. 7,500,000
C/S ratio 0.4
Alternatively, the break-even point can also be determined as follows.
Product A B C Total

Sales mix (1) 15% 25% 60%

C/s ratio (2) 60% 60% 26.667%
Weighted C/s 9% 15% 16% 40%
ratio(1x2)

Break-even point in shillings = 3,000,000 = Shs. 7,500,000

0.4
The company is currently operating above the break-even point by Shs. 2,500,000 (Margin of
safety).
c). Each product’s break-even sales = Sales mix ratio x Total break-even sales.
Products Break-even sales Break-even
(Shs) quantity (units)
A 15% x 7,500,000 1,125,000 450
B 25% x 7,500,000 1,875,000 1,875
C 60% x 7,500,000 4,500,000 1,500
Total 7,500,000
Note: Break-even units are computed by dividing break-even sales by each product’s unit selling
price.
10. Limitations of Breakeven Analysis
a) Break-even analysis assumes a static situation that cannot exist for long period of time e.g.
constant process, capacity, technology methods, managerial policies etc.
b) It assumes that the costs can be separated unto their fixed and variable components.
However, in many cases costs may not be easily categorised as either fixed or variable.
c) Assumes that sales mix will remain constant, which is unrealistic.
d) This analysis presupposes that selling price does not change but in actual practice, it
changes due to many factors.
e) Break-even analysis completely ignores the consideration of capital employed in the
product and therefore presents only one fact of profit planning.

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CVP Analysis Question

Question 1
ABC
Income Statement
For the year ended 30th June 2017
Sales (60,000 units) 3,000,000
Variable Costs (60,000 units) 1,200,000
Contribution 1,800,000
Fixed Costs 1,500,000
Operating Profit 300,000

Required
i. Compute the company’s C/S ratio.
ii. Compute the company’s break-even point (both in units and sales value).
iii. Calculate the company’s margin of safety in sales value.
iv. Assuming management would like a target profit of Shs. 1,500,000. How many units would
be sold to realise the target profit?
v. The Managing Director has got an idea of increasing marketing cost by Shs. 400,000 and
offering an extra Shs. 2 per unit as commission, the number of units sold would increase by
20,000 units. Evaluate and comment on the idea.
vi. According to the available market research, there is high likelihood of stiff competition and
that the company would counteract it by reducing its selling price by 10%. Management
would like to maintain operating income of Shs. 300,000. Assuming all other costs remain
constant, how many units would be sold to meet management’s goal?
vii. What is the company’s degree of operating leverage? If sales increase by 5%, how much
would the net income increase by?

Question 2
A company produces and sells vending machines for outdoor events. The company’s three models
are: Basic, Premium and Supervend. Details about them are indicated below:

Basic Premium Supervend

Units sold 420 175 105
Selling price per unit 600,000 850,000 1,325,000
Variable cost per unit 425,000 650,000 825,000

The company has fixed costs of 138,000,000.

a) Determine the sales mix for the three products.
b) Determine the weighted-average contribution-margin.
c) How many units of each model must the company produce and sell in order to break-even?

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SHORT TERM DECISION MAKING
One of the main functions of management is decision-making. Many of the decisions are of a
short-term nature. Only rarely is a manager faced with a decision which has a long term impact
e.g. buying a new machine, expanding the factory, take-over of another company. Since most of
the decisions have a short-term impact it can be assumed that the capacity of the factory will not
change. Therefore, fixed or periodic costs are not affected by tactical short-run decisions. The only
costs which are affected are variable costs i.e. those costs which vary directly with the level of
activity of the factory. These would include direct materials, direct labour and variable overheads.

Short-term decisions are decisions, which maximise the use of the existing infrastructure. In most
cases, the firm would not need to alter its capital investments. Rather, the actions of the firm would
be directed towards optimising the existing infrastructure within the relevant range, based on
relevant costs and benefits. Such decisions include special price orders, product selection, dropping
a product, make or buy decisions, sales mix, etc.

Relevant Information for Decision Making

(a) Future costs and revenue
These are important to a decision-maker. Current decisions will affect future costs and revenues
rather than the past. Past costs (sunk costs) and revenue only provide guidelines to the future but
are not relevant for future decision making. Sunk costs cannot be changed by any decision. They
are not differential costs and should be ignored when making decisions. Also all the decisions
comprise a choice between alternative courses of action. Therefore, past costs can have no
relevance for future decisions. Past costs can consist of sunk costs or committed costs

Example: You bought a car that cost 10,000,000 two years ago. The 10,000,000 cost is sunk
because whether you drive it, park it, trade it, or sell it, you cannot change the 10,000,000 cost.

(b) Opportunity Cost

This is the cost of the best alternative forgone. Although opportunity costs are not recorded in the
accounts of the organisation because they do not involve actual cash outlays, they represent
economic benefits that are foregone as a consequence of undertaking a given course of action.
Example: If you were not attending this course, you could be saving 5,000,000 per year. Your
opportunity cost of attending this course is therefore 5,000,000.

(c) Differential Costs and Revenues

These are costs and revenue that would change as a result of undertaking a given course of action.
These are the ones that are relevant for decision-making. In the short run, fixed costs are
considered constant, thus not relevant for decision making. Instead marginal costs and
contribution are the relevant factors for decision making.
Example: You have a job paying 1,500,000 per month in your hometown. You have a job offer
in an upcountry town that pays 2,000,000 per month. The commuting cost to the town is 300,000
per month.
• Differential revenue is: 2,000,000 – 1,500,000 = 500,000
• Differential cost is: 300,000

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Relevant Costs for Decision Making

Key Terms and Concepts

Relevance:
a) Relevant costs and benefits are those that differ among alternatives
b) Total approach vs. differential approach and why relevant costs must be isolated.
c) Difference between costs that are avoidable and those that are not avoidable.
d) Avoidable costs are those that can be eliminated (in whole or in part) by choosing one
alternative over another in a decision.
e) Sunk costs, costs that has already been incurred and that cannot be changed by any decision
made now or in the future, are never relevant.
f) Future revenues and costs that will not change by choosing one alternative over another in
a decision are never relevant.
g) How and why some fixed costs (common fixed costs) need to be allocated, and the
problems inherit in the allocation process.

Constraints:
These are limitations under which a company must operate, such as limited available machine time
or raw materials, which restricts the company’s ability to satisfy demand. Constraints or
bottlenecks limit a company’s ability to grow and limit the total output of the entire system.

Opportunity Costs:
Opportunity costs are not recorded in the general ledger.
Opportunity costs are factors in the decision-making process because they differ among
alternatives.

Companies make many decisions which require relevant information on a timely basis.

Some of these decisions include:

a) Accepting or not accepting a special order, a one-time sales order that is not considered
part of the company’s normal ongoing business.
b) Dropping or retaining a product line or other business segment
c) Make or buy decisions, concerning whether an item should be produced internally or
purchased from an outside supplier.
d) The most profitable use of a constrained resource to maximize the company’s total
contribution margin

Relevant Costs
A number of costs are listed below that may be relevant in a decision faced by the management of
Birmingham Company. Birmingham normally runs at capacity and the old Model CY1000
machine is the company’s constraint. Management is considering purchasing a new machine,
Model CZ4000 and the old one, CY1000 will be sold. The new machine is more efficient and can
produce 20% more units than the old one. Demand for Birmingham’s product is greater than what
they can supply. If the new machine is purchased, there should be a reduction in maintenance

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costs however the new machine is very costly and the company will need to borrow money in
order to make the purchase. The increase in volume will be large enough to require increases in
fixed selling expense, but general administrative expenses will remain unchanged.

Required: For each cost listed determine whether the cost is relevant or irrelevant to the decision
to replace the CY1000.
a) Sales Revenue
b) Direct materials
c) Direct labor
d) Variable manufacturing overhead
e) Rent on the factory building
f) Janitorial salaries
g) President’s salary
h) Book Value of CY1000
i) Cost of CY1000
j) Cost of CZ4000
k) Interest on money borrowed to make purchase.
l) Shipping costs
m) Market value of old machine CY1000
n) Insurance on factory building
o) Salaries paid to personnel in sales office

(d) Procedures for Short Term Decision Making

(i) Check whether fixed costs will remain constant.
(ii) Where possible, separate fixed costs from variable costs.
(iii)Compute revenue, marginal costs and contribution of each alternative.
(iv) Where a limiting factor exists, calculate the contribution per unit of a limiting factor.
(v) Finally choose the alternative that maximises the contribution per unit of a limiting factor.

N.B.: Limiting factor or key factor or principal budget factor is a binding constraint upon the
organisation. in other words, the factor which prevents indefinite expansion or unlimited profits,
e.g. sales, skilled labour, finance, lack of space, etc.

Examples of Short Term Decisions

1. Acceptance of a Special Order
Example 1:
X Ltd. makes a product which sells for 1,500. The output for the period is 80,000 units of product
which represents 80% capacity. Total costs are 90,000,000 and of these it is estimated that
26,000,000 are fixed costs. A potential customer offers to buy 20,000 units at Shs. 1,100 and this
will use up the company’s spare capacity.

Should management accept this special order?

Special order:
Shs.
Sales (20,000 units @ Shs.1,100) 22,000,000

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Less Variable costs (20,000 @ 800) 16,000,000
Extra contribution 6,000,000

Decision:
The special order should be accepted on grounds that it will make a contribution of 6,000,000 to
the company towards profit since no extra fixed costs are to be incurred. Profits can be increased
by an additional Shs 6,000,000 since fixed costs are already covered. However management must
consider other relevant factors in arriving at the final decision.

However, other factors should be considered:

❑ Whether the reduction in price will not make other customers demand for reduced prices.
❑ Whether there are no more profitable ventures of utilising the spare facility.
❑ Whether the special order will not spoil the chance for the business to make better uses of the
spare facility.
❑ Whether fixed costs will remain unchanged.

Examples where a company may reduce on its selling price to utilise its idle capacity:
❑ Cheaper weekend or holiday rates - in hotels
❑ Railways and airlines - cheaper rates to students or off-peak periods
❑ Telephones - cheaper rates during off-peak periods, e.g MTN Zone, Pakalast for Airtel
❑ Stadia for students' fares or uncompetitive matches
❑ Theatres - for week days for students, or during rehersals.

Class Activity 1
A company produces and selling sports bicycles at a standard price of Shs.250,000@. The cost
per bicycle is as follows:
Direct materials 86,000
Direct labour 45,000
Manufacturing overhead 51,000
Production cost per bicycle 182,000

The variable portion of the above manufacturing over is 6,000 per bicycle.
The company has received a special order from a sports club to supply them with 100 specially
modified sports bikes at a price of Shs. 180,000. The order would have no effect on the company’s
total fixed manufacturing overhead costs. The modifications to the bikes consist of welded
brackets to hold radios, handcuffs and other gear. These modifications would require addition Shs.
17,000@ bike in incremental variable costs. In addition, the company would have to pay a graphic
design studio Shs. 1,200,000= to design and cut stencils that would be used for putting the logo of
the club and other identifying marks on the bikes.

The order should have no effect on the company’s other sales. The production manager says that
she can handle the special order without disrupting any of the regular scheduled production.

Required:
Should the company accept the special order?

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2. Dropping a Product/ Shut-down decisions
If a company has products that seem not to be profitable, it may consider dropping them. Before
a decision is made about which product is to be dropped, careful consideration needs to be made
about the contribution (if any) of the unprofitable products.

Example: 2
Product A B C Total
Shs, 000 Shs 000 Shs 000 Shs 000
Sales 20,000 50,000 25,000 95,000
Less:
Direct materials 1,000 15,000 10,000 26,000
Direct labour 3,000 16,000 14,000 33,000
Fixed overheads 2,000 7,000 9,000 18,000
Total Costs 6,000 38,000 33,000 77,000
Profit/(Loss) 14,000 12,000 (8,000) 18,000
With product C making a loss management might consider discontinuing this product. However,
using marginal costing principles, with fixed costs treated as irrelevant for short-run decision-
making the income statement can be reformatted.

Product A B C Total
£ £ £ £
Sales 20,000 50,000 25,000 95,000
Less
Variable costs 4,000 31,000 24,000 59,000
Contribution 16,000 19,000 1,000 36,000
Fixed costs 18,000
Net profit 18,000

Decision
Since product C makes a contribution it may be inadvisable to close it down. If Product C is
closed down the company will lose Shs 1,000,000 contribution and the overall effect would be to
reduce profits to Shs 17,000,000.

Other factors to be considered:

a) The contribution from Product C is very low. More lucrative ventures or markets need
to be searched.
b) If the elimination of Product C necessitates the reduction of fixed costs, then it may be
worthwhile to drop Product C.

3. Make or Buy Decisions

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Frequently management are faced with decision whether to make a particular product or
component or whether to buy it. Apart from overriding technical reasons, the decision is usually
based on an analysis of the cost implications.

In general the relevant cost comparison is between is between the marginal cost of manufacture
and the buying in price. However, when manufacturing the component displaces existing
production, the lost contribution must be added to the marginal cost of production of the
component before comparison with the buying in price. The two situations are illustrated below:

Example: 3
A company makes product P. A component Q used in the manufacture of P can be purchased
from a supplier for Shs 8,000. The costs to make the component are as follows:
Shs
Direct materials 2,000
Direct wages 3,000
Variable overheads 2,000
Variable cost of production 7,000
Assume spare capacity and the fixed costs remain unchanged.
Obviously it is cheaper to make than to buy.
However, if the firm is working at full capacity and to make component Q involves moving some
of the capacity from product P then the decision is a little more involved.
The following data applies to product P.
Shs
Selling price 16,000
Direct materials 6,000
Direct labour 4,000
Variable overhead 2,000
Contribution 4,000

The production rate for product P is 5 units per hour and for component Q is 10.
The effective cost of making a unit of component Q is:

Shs
Marginal cost of production 7,000
Plus Opportunity cost of 2,000
The effective cost is 9,000

By switching capacity from product P to component Q there is £2 contribution lost. This is an

opportunity cost ie. it is the benefit foregone by choosing one course of action over the other.

Example 4
A firm is considering whether to manufacture or purchase a particular component 2543. This
would be in batches of 10,000 and the buying in price would be Sh.6,500. The variable cost of
manufacturing Component 2543 is Sh.4,750 per unit and the component would have to be made
on a machine which was currently working at full capacity. If the component was manufactured,

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it is estimated that the sales of finished product FP97 would be reduced by 1000 units. FP97 has
a variable cost of Shs. 60,000 per unit and sells for Shs. 80,000 per unit.

Required: Should the firm manufacture or purchase component 2543 from outside suppliers?

Solution
A quick look, based on the preceding example is that, because the marginal cost of manufacture is
substantially below the buying in price, the component should not be bought in and thus further
analysis is unnecessary. However, such an approach is insufficient for this decision. Consideration
must be given to the loss of contribution from the displaced product.

Cost Analysis - Component 2543 in batches of 10,000

£
Variable cost of manufacture
= Sh.4,750 per unit x 10,000 47,500,000
+ Lost contribution for FP97
= Sh.20,000 per unit x 1000 units displaced 20,000,000
67,500,000
Buying in price
= Shs. 65,000 per unit x 10,000 65,000,000

There is a saving of Sh.2,500,000= per 10,000 batch by buying in rather than manufacture.
Note: Shs. 20,000,000 is an example of an Opportunity Cost. This is defined as the value of a
benefit sacrificed in favour of an alternative course of action. This is a highly important concept
and examples frequently occur in practice. Whenever there are scarce resources, there are
alternative uses that must be foregone and the benefit sacrificed is the opportunity cost. Where
there is also no alternative use for the resources, the opportunity cost is zero and it can thus be
ignored.

Class Activity 2
A company produces a certain component needed for its major product. The company’s
management accounting department reports the following costs of producing the component
internally.

Per Unit (in Shs) 8,000 units (in Shs)

Direct materials 6,000 48,000,000
Direct labour 4,000 32,000,000
Variable overhead 1,000 8,000,000
Supervisor’s salary 3,000 24,000,000
Depreciation of special equipment 2,000 16,000,000
Allocated general overhead 5,000 40,000,000
Total Cost 21,000 168,000,000

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A company received an offer from outside supplier for the component at Shs.19,000=@ for all the
8,000 units of components needed.

Required:
(i) Advise the company on the decision to make.
(ii) Assuming by deciding to buy the component from an outside supplier, the company would
free up production space which would be utilised to produce more products to generate
Shs. 60,000,000 per annum, what would be the company’s new decision?

Make or Buy Analysis (template)

Production Per unit differential Total differential cost –
Cost per unit cost 8000 units
Make Buy Make Buy
Direct materials
Direct labour
Variable overhead
Supervisor’s salary
Depr of special equipment

Allocated gen. Overhead

Outside purchase price
Total cost

4. Sell or Process Further Decisions

A firm may produce intermediary products which may require further processing in order to be
final product for the consumption of the end users, or reprocess the by-/joint products or to add
value to the product. Decisions have to be made whether a firm can sell intermediary products to
other firms for them to complete the processing or incur further processing costs in order to boost
their sales values. For instance, a firm may realise by-products from its main production line. This
by product (or even waste or scrap) can be sold as it is or reprocessed to add value. In addition, a
firm may decide not to carry out all the processes required to complete a product. Rather, it can
decide to sell it as an intermediary product to other firms. Whatever the case, the decision of the
firm would be influenced by which course of action generates the best value to the firm based on
the relevant costs.

The joint product costs or costs incurred up to the decision to stop processing are irrelevant in
decision-making regarding what to do with a product from the split-off point forward or further
processing. The joint products or costs already incurred would be sunk costs at the point of split-
off, thus would not be relevant whether a by-or joint product is sold as it is or further processed to
gain better sales value.

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In Class Activity 3
A company located on the Gulf of Mexico is a producer of soap products. Its six main soap product
lines are produced from common inputs. Joint product costs up to the split-off point constitute the
bulk of the production costs for all six product lines. These joint costs are allocated to the six
product lines on the basis of the relative sales value of each line at the split-off point.
The company has a waste product that results from the production of the six main product lines.
Until a few years ago, the company loaded the waste onto barges and dumped it into the Gulf of
Mexico, since the waste was thought to have no commercial value. The dumping was stopped,
however, when the company’s research division discovered that with some further processing the
waste could be made commercially saleable as a fertiliser ingredient. The further processing was
initiated at a cost of $175,000 per year. The waste was then sold to fertiliser manufacturers at a
total price of $300,000 per year.
The accountants responsible for allocating manufacturing costs included the sales value of the
waste product along with the sales value of the six main product lines in their allocation of the
joint product costs at the split-off point. This allocation resulted in the waste product being
allocated $150,000 in joint product cost. This $150,000 allocation, when added to the further
processing of $175,000 for the waste, caused the waste product to show the net loss as shown
below:
Sales value of the waste product after further processing $300,000
Less: cost assignable to the waste product ($150,000+$175,000) $325,000
Net loss 25,000
The company’s management decided that further processing of the waste was not desirable after
all. The company went back to dumping the waste in the Gulf. In addition to being unwise from
an economic viewpoint, this dumping also raises questions regarding the company’s social
responsibility and the environmental impact of its actions.

Required:
Advise management, especially with regard to the allocation of joint costs. Hint: Determine
whether there is any contribution margin generated by processing further the waste.

5. Determining Sales Mix Where Limiting Factors Exist

This is the situation where a firm has a choice between various types of products which it could
manufacture and where there is a single, binding constraint.

a. Where a single factor exists at a time

Often a company finds that there is a limiting factor or constraint which inhibits its capacity to
meet the desired production level. The limiting factor may be any resource eg. materials, labour or
machine hours. Management has to decide the best way to allocate the scarce resource among the
product range in the most effective way so that profits are maximised.

Example 5:

Product X Y Z

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Desired production (units) 1,000 2,000 500
Shs Shs Shs
Selling price per unit 35,000 25,000 15,000
Variable cost per unit 15,000 10,000 5,000
Contribution per unit 20,000 15,000 10,000
A special machine is used to manufacture the three products and there are only 15,000 machine
hours available.
Product X uses 20 machine hours per unit.
Product Y uses 5 machine hours per unit.
Product Z uses 2 machine hours per unit

Ranking of products according to contribution per unit of limiting factor

X Y Z
Contribution per unit 20,000 15,000 10,000
No. of machine hrs. 20 5 2
Contribution per machine hr. 1,000 3,000 5,000
Ranking (3) (2) (1)

Desired production level

Product Z 500 units x 2 hrs. 1,000 hrs

Product Y 2,000 x 5 hrs 10,000 hrs
Product X 200 x 20 4,000 hrs

Product Z earns 500 units x Shs 10,000 = Shs. 5,000,000 contribution

Product Y earns 2,000 units x Shs 15,000 = Shs 30,000,000 contribution
Product X earns 200 units xSh 20,000 = Shs 4,000,000 contribution
Shs 39,000,000 contribution

In Class Activity 4
A company is able to produce four products and is planning its production mix for the next period.
Estimated cost, sales and promotion data follow:
Product W X Y Z
£ £ £ £
Selling Price/Unit 20 30 40 36
£ £ £ £
Labour (@ £2/hr) 6 4 14 10
Materials (@£1 kg) 6 12 18 22 10 24 12 22
Contribution £8 £8 £16 £14
Resources/Unit
Labour (hours) 3 2 7 5
Materials (Kgs) 6 18 10 12
Maximum demand (units) 5000 5000 5000 5000

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Based on the above data, which is the most appropriate mix under the two following assumptions?
(a) If labour hours are limited to 50,000 in a period or
(b) If a material is limited to 110,000 Kgs. in a period.
b. Where several constraints exist at the same time: (Requiring the use of linear
programming)
Example 8
A manufacturing company produces two products X and Y. The selling prices and costs of each
of the products are shown below:
Product X Product Y
Selling Price 110 118
Less:
Materials (8 units @£4) 32 (4 units@£4) 16
Labour (6 hours @£10) 60 (8 hours @£10) 80
V/Ohd. (4 mach hours @£1) 4 96 (6 mach hours @ £1) 6 102
Contribution 14 16
During the next production period, the availability of resources is expected to be subject to the
following constraints:
Materials 3,440 units
Labour 2,880 hours
Machine capacity 2,760 hours
The marketing manager estimates that the maximum sales potential for Product X is limited to
420 units.

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BUDGETING AND BUDGETARY CONTROL
1. The Basic Framework of Budgeting
i. A Budget is . . .
 A quantitative expression of a plan of action.
 A detailed plan for acquiring and using financial and other resources over a specified
time period.

ii. Short-Run Vs. Long-Run Budgets

a) Short-run Budgets (1 year or less): These involve planning for things like:
• Quantities to produce.
• Quantities to sell.
• Supplies acquisition

b) Long-run Budgets (more than one year): These involve planning for things like:
• Forecasts of large asset acquisitions.
• Financing plans.
• Research and development plans

iii. Imposed Vs. Participatory Budgets

a) Best Time to Use Imposed Budgets

• In start-up organizations
• In extremely small businesses
• In times of economic crises
• When operating managers lack budgetary skills or perspective.

i. Advantages of Imposed Budgets

• Requires less time.
• Utilise top management’s knowledge of overall resource availability.
• Increase probability that the firm’s strategic plans are incorporated.

ii. Disadvantages of Imposed Budgets

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• Reduce feeling of teamwork.
• Dissatisfaction and low morale.
• Limited acceptance of stated goals and objectives.
• May stifle initiative of lower level managers.

b) Best Time to Use Participatory Budgets

• In well-established organizations.
• In extremely large businesses.
• In times of economic affluence.
• When operating managers have strong budgetary skills and perspectives.

i. Advantages of Participatory Budgets

• Obtain information from those persons most familiar with the needs and
constraints of the organizational units.
• Leads to better morale and higher motivation.
• Integrates knowledge that is diffused among various levels of management.
• Provides a means to develop fiscal responsibility and budgetary skills of
employees.
• Develop a high degree of acceptance of and commitment to organizational goals
and objectives by operating management.
• Are generally more realistic.

ii. Disadvantages of Participatory Budgets

• Require significantly more time.
• May motivate managers to introduce “slack” into the budget.
• May support “empire building” by subordinates.

Class Activity 1
What are other challenges of participatory budgeting process?

2. Benefits of Budgeting
i. Requires all levels of management to plan ahead.
ii. Provides definite objectives for evaluating performance at each level of
responsibility.
iii. Creates an early warning system for potential problems.
iv. Facilities coordination of activities within the organization.
v. Results in greater management awareness of entity’s overall operation.
vi. Motivates personnel throughout the organization to meet planned objectives.
3. Budget Committee
i. Is responsible for coordinating the preparation of the budget.
ii. Serves as review board where managers can defend their budget goals and
request.

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iii. Differences are reviewed, modified if necessary and reconciled.

4. Principal Budget Factor or Limiting Factor

This is the factor, which, at any given time, effectively limits the activities of an organisation. This
may be demand (or sales), production capacity, limited supply of skilled labour, materials, space,
or finance. The effects of the principal budget factor on the budgeting process need to be identified
and considered carefully during the budget formulation process. For instance, if the principal
budget factor is sales, then the sales budget needs to be formulated first and will thus affect other
operating budgets. A principal budget factor can change over time. However, when one constraint
is removed other limitations may occur, affecting the organisation from expanding up to infinity.

5. Master Budget
This is set of interrelated budgets that constitute a plan of action for a specific time period.

6. Operating Budgets
These are individual budgets that result in a budgeted income statement.

7. Financial Budgets
These are individual budgets that indicate the cash resources needed for expected operations and
planned capital expenditures.

8. Components of Master Budget

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9. Preparation of a Budget
i. Identify objectives
ii. Gather data about alternatives
iii. Select alternative courses of action
iv. Discuss the plans/activities and allocate the budget.
v. Establish monitoring mechanisms.
vi. Respond to problems encountered in the previous budget.

10. Approaches to Budgeting

a) Incremental (or Line-Item) Budgeting
This is the conventional or traditional approach to budgeting for which indirect costs and support
activities of the previous year’s budget are used as a starting point for the new budget, and a
number of adjustments or allowances are made to the old budget to cater for anticipated changes.
The changes may include inflationary increases, salary increases, and overall market growth
increases, production mix volumes, prices) which are anticipated in the subsequent budget period.
For instance, if the previous budgeted expenses for selling and administration were Shs.
10,000,000=, an allowance of 10% may be made in the following year’s budget to cater for any
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expected increases in costs. Thus, the budget for selling and administration expenses for the
subsequent budget period would be Shs.11,000,000= (110%x10,000,000).

Advantage of Incremental Budgeting

i. This budget approach is relatively simple to operate, especially with computerised systems,
and easy to understand.
Limitations of Incremental Budgeting
i. It has an inherent assumption that the current methodology and cost structure is the best way,
and should be built upon.
ii. It encourages people to have expectations of inflationary increases in salary and business,
for doing the same role in a changing market.
iii. It assumes that existing customers will grow in line with market growth, without accurately
reflecting the incremental costs of winning new customers.
iv. It encourages departments to spend their entire allocated budget to ensure that there is an
increase the following year.
v. There may be budgetary slack built into the budget, which is never reviewed-managers might
have overestimated their requirements in the past in order to obtain a budget which is easier
to work to, and which will allow them to achieve favourable results.
b) Activity Based Budgeting (ABB)
ABB aims to ensure effective management of resources in an organisation. Only the resources,
which are needed to perform activities required to meet the expected production and sales volume,
are allocated. The budgeted output is used to determine the necessary activities, which are
subsequently used to estimate the resources that are required for the budget period.

Stages involved in ABB

i. Estimate the production and sales volumes for each individual product or service.
ii. Estimate the demand for organisational activities.
iii. Determine the resources that are required to perform organisational activities.
iv. Estimate for each resource the quantity that must be supplied to meet the demand
v. Take action to adjust the capacity of resources to match the projected supply by comparing
the estimates of the quantity of resources to be supplied for each resource with the quantity
of resources that are currently committed. Additional spending would be required if the
estimated demand for a resource exceeds the current capacity. For instance, if the projected
sales and production requirements are 100,000 units, with each unit requiring 4 direct labour
hours. Assuming the existing quantity of labour hours amount to 200,000 hours, then an
organisation should authorise further expenditure on labour hours to match with the current
sales and production requirements.
Advantages of ABB
i. ABB provides a framework for understanding the amount of resources that are required to
achieve the budgeted level of activity.
ii. ABB is assumed to lead to better utilisation of resources.
Limitations of ABB
i. It is a laborious exercise to analyse all activities involved in producing a given output.
ii. It takes long time to come up with the annual budget.
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c) Zero Base Budgeting (ZBB)
ZBB is also known as priority-based budgeting. ZBB emerged in the late 60’s as a way of
mitigating the limitations of incremental budgets. ZBB requires that all activities are justified and
prioritised before decisions are taken on the extent of resources that are allocated to each activity.
It focuses on the programmes or activities rather than functional departments as it is the case with
incremental or line-item budgets.

ZBB is based on an idea that the projected or budgeted expenditure for the existing programmes
should start from base zero. The people involved in the budgeting process are required to formulate
and present their budget proposals based on cost-benefit analyses. This is meant to ensure that
value for money prevails in the projected expenditure. ZBB is best suited for discretionary costs
and support activities. Management usually has discretion on the amount of resources spent on
discretionary costs and support activities. Discretionary costs include advertising, research and
development, and training costs. There may not have a direct relationship between inputs
(discretionary costs) and outputs (revenues, efficiency or cost savings).

ZBB is mostly used in municipal and government organisations where discretionary costs are
likely to exist. For instance, the construction of a road is likely to be at the discretion of the officials
possessing power.

ZBB involves the following stages

i. A description of each organisational activities in a decision package
ii. Evaluation and ranking of decision packages in order of priority
iii. Allocation of resources based on order of priority up to the spending cut-off level

Advantages of ZBB
i. ZBB mitigates the limitations of the incremental budgeting approach by allocating resources
based on value for money or cost-benefit analyses.
ii. It emphasises questioning the current status quo in order to get the best value for money of
the proposed expenditure.
iii. It pays attention on the expected outputs in respect to value for money rather than inputs.

Limitations of ZBB
i. It requires huge effort required to prepare cost/benefit analyses
ii. The focus on money-driven decisions can lead to short-term thinking rather than long-term
strategic thinking.
iii. There is a tendency to assume that since the budget approves all spending, that all business
decisions will somehow lie within the confinement of the budget.

d) Policy or Development-Led Budgeting

This is where the annual budgets are formulated based on approved development plans. This
approach to budgeting is usually used in municipal and government organisations. Development
planning relates to the identification of investment projects to be pursued by local governments,

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mainly targeting the reduction of poverty over the medium term. The formulation of the medium
term development plan mitigates the limitations of the traditional planning approach in the public
sector, which is characterised by short-termism (Osborne and Gaebler, 1992, Preston, 1995). The
annual budget is derived from the detailed costed work plans found in the development plan with
adjustments to take into account the new developments emerging, and what could not be achieved
previously due to various operating constraints, including shortage of funds.

Example of development plan for an education sector of a municipal council

2009/10 2010/2011 2011/2012

Construction of School Premises (Shs) 1,600,000,000 2,000,000,000 1,400,000,000

Purchase of School Equipment 600,000,000 400,000,000 200,000,000

Staff Salaries 1,000,000,000 1,100,000,000 1,210,000,000

Therefore, the annual budget for 2010/2011 will be based on the costs appearing the development
plan with some adjustments to cater for emerging development issues and expected resource
envelope.

In order to ensure a strategic management approach, the development plan usually includes the
following: situation analysis; planning objectives and strategies; review of previous financial
performance; design of the development plan; and detailed costed work plans.

Figure 1: Strategic Development Planning Process

Target/
Goals and Strategies Specific
Objectives Projects Outputs

Source: Adapted from KCC- DDP 2007/08- 2010/11

In essence, the formulation of the development plan is expected to take into account the strategic
management approach of linking objectives of planning to strategies and priorities or activities to
be pursued and outputs expected from the planned activities to achieve the planning objectives
(MoLG, 2003).

Secondly, it forecasts the revenue envelope and its allocation to the planned activities in the
medium-term, usually 3-year period. This is meant to alleviate the traditional planning and
budgeting in local governments, which was exclusively on short-term basis, mainly annual basis.

The medium-term planning is believed to contribute towards the optimal allocation and utilisation
of resources over a medium-term. Besides, the development plan sets out the anticipated outputs

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of the investment, assumed to improve the traditional planning systems in the public sector, which
lacks quantifiable outputs of planning.

Table 1: Summary of the Contents of the Local Government Development Plan

Content Purpose

Situation Analysis To identify development gaps in local government sectors

Planning Objectives and To set the objectives of the planning process and
Strategies implementation strategies

Review of Previous To link future planning to the lessons learnt from the
Financial Performance previous experience to achieve informed decision-making

Design of the To formulate of the development plan based on situation

Development Plan analysis objectives, strategies and review of previous
financial performance

Detailed Work Plans To decompose the development plan into costed activities
with performance indicators and implementation plan

Source: Adapted from Kampala District Development Plan 2007-8 to 2009-2010

Advantages of Development-Led Budgets

i. Resources are prioritised and allocated over a medium term, which is expected to lead to
efficient utilisation of scarce resources.
ii. Resources are utilised on development needs and priorities.

Limitations of Development-Led Budgets

i. Usually sticking to the development plan may be difficult, especially with political
organisations such as municipal and government organisations where priorities changes within
a short period.
ii. Preparing a well-costed development plan is costly both in terms of financial and human
resources.

e) Output/Outcome-Oriented Budgeting (OOB)

OOB ensures that budget allocations are taken as inputs to finance activities that generate outputs,
which in turn lead to the realisation of the intended outcomes. OOB seeks to address the challenges
of the traditional incremental budgeting systems that characterised public sectors, particularly local
governments (Osborne and Gaebler, 1992). One of the major shortcomings of the traditional
incremental budgeting is that it makes no link between the inputs (budget allocations) and the
outputs (Preston, 1995).

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Figure 2: Output-Oriented Budget Cycle
The above figure shows that that annual budgeting cycle has to take into account the four elements
of the OBB: inputs, activities, output and outcome. For instance, the budget allocation to the Works
sector has to be broken down into activities that may include road construction. The road
construction activity has to specify the intended outputs, for example, improved means of
transport, which may lead to the desired outcomes, such reduction in transport costs and poverty.

Key Performance Indicators for a Works and Physical Planning Department of a Local
Government in Kampala District
Key Performance Indicator Financial Years
2007/08 2008/09 2009/10
Total length of motorable road network (in km) 130 150 160
% road network in good motorable condition (50kph) 67% 67% 70%
% road network in fair motorable condition (30- 30% 35% 38%
% road network in poor motorable condition (<30kph)
50kph) 6% 3% 2%
Source: Official Records of Kampala District, 2007

Work Plan
SCHOOL OF MANAGEMENT AND ENTREPRENEURSHIP
WORK PLAN FOR FINANCIAL YEAR 2017-18
Source of
Vote Function
Timeframe Inputs Est Costs
Annual Outputs Planned Activities Activity Indicator funding
output
Q1 Q2 Q3 Q4
Teaching and 5,000 students trained and Teaching 5,000 students 5,000 students trained X X X X 80 Lecturers (allowances) 1,200,000,000 NTR
Learning examined
Conducting tutorials for 2,000 students 1,920 tutorials conducted X X X X Tutorial allowances 44,800,000 NTR
1,600 research students Research supervision and marking 1,600 research students supervised X X X X Lecturers to supervise and mark 100,000,000 NTR
and marked (including external research
examiners for Masters programmes)

Programme Budgeting???

f) Beyond Budgeting
Authors, such as Ekholm and Wallin (2000), Dugdale and Lyne (2006), Kasumba (2009) have
identified the following limitations of annual budgeting process:

i. It encourages rigid planning and incremental thinking

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ii. Time consuming
iii. Produces inadequate variance reports, usually leaving the “how” and “why” questions
answered
iv. Ignores key drivers of shareholder value by focusing too much attention on short-term
financial numbers
v. It is usually considered as a yearly rigid ritual, in some cases not translated into expenditure
and performance. Normally, two different operating worlds exist: the world of budgeting and
world of spending.
vi. At times budgets formulated merely to fulfil a statutory requirement but not to influence
spending decisions.
vii. Tying the company to a 12-month, commitment which is risky since it is based on uncertain
and unrealistic assumptions.
viii. Meeting only the lowest targets and not attempting to beat the targets
ix. Spending what is in the budget even if this is not necessary (in terms of value for money) in
order to guard against the following year’s budget being reduced.
x. It may involve achieving the budget even if this results into undesirable actions.

Basing on the above limitations of annual budgeting, authors such as Fraser and Hope (2003) have
advocated for beyond budgeting. Rolling forecasts, produced on a monthly or quarterly basis, are
suggested as important alternatives to the annual budget. The rolling forecasts are flexible in nature
and are not based on outdated information. However, the extant accounting literature suggests that
very few organisations are willing to abandon the annual budgets.

11. Preparation of a Master Budget for a Manufacturing Organization

N.B Manufacturing, retail, and service organisations differ in their preparation.

a) Manufacturing Organisations
• The operating budgets for a manufacturing organisation include budgets for:
o Sales
o Production
o Direct materials purchases.
o Direct labour
o Manufacturing overhead
o Cost of goods manufactured
o Selling and administrative expenses

b) Retail Organisations
• Managers of retail organizations must know:
o What products to sell.
o Estimated quantities to be sold
o The selling price for each
• The operating budgets for retail organizations include the:
o Sales budget
o Purchases budget
o Cost of goods sold budget

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o Selling and administrative budget

c) Service Organisations
• Managers of service organizations must know the types and amounts of:
o Services to perform
o Labour hours required
o Level of expertise of employees
o Labour rates
• The operating budgets for service organizations include:
o Service revenue
o Labour
o Services overhead
o Selling and administrative budget
12. Preparation of Operating Budgets
• Detailed operating budgets include the:
o Sales budget (in units and sales value)
o Production budget (in units)
o Direct materials purchases budget (in units and value)
o Direct labour budget (in hours and value)
o Manufacturing overhead budget
o Selling and administrative expense budget
o Cost of Goods Manufactured budget

a) Sales Budget
This budget is based on the sales forecast, influenced by:
External factors
• The state of the local and national economies
• The state of the industry’s economy
• The nature of the competition

Internal factors
• Number of units sold in prior periods
• Credit policies and collection policies
• Pricing policies
• New product plans
• Manufacturing capacity

b) Production Budget
• The production budget is formulated basing on sales and inventory needs.
• It is used to plan for technical and human resources needed.
Total Production Units (Production Budget) =
▪ Budgeted Sales in Units
▪ Plus Desired Units of Ending Finished Goods Inventory
▪ Minus Available Units of Beginning Finished Goods Inventory

c) Direct Materials Purchases Budget

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• This budget is formulated based on production and inventory needs
• It is used to plan direct material purchases and to estimate cash payments to suppliers
Total Units of Direct Materials Purchases=
Total Production Needs in Units of Direct Materials
Plus Desired Units of Ending Direct Materials Inventory
Minus Available Units of Beginning Direct Materials Inventory

d) Direct Labour Budget

• This budget is based on production needs, labor pay rates, staffing levels, and productivity
projections.
• It is used to schedule (and hire) employees and to estimate cash payments to workers.

• Total Budgeted Direct Labor Cost =

Estimated Total Direct Labour Hours x Estimated Direct Labor Cost per Hour
e) Manufacturing Overhead Budget
• It provides details manufacturing costs, other than direct materials and labour.
• It is used to integrate overhead cost budgets and to calculate manufacturing overhead rates.
• The budget is categorised by variable and fixed overhead costs.
• Frequently, the manufacturing overhead budget can be broken down by each cost pool.

f) Selling and Administrative Budget

• This budget provides details of operating expenses, other than production costs, needed to
support sales and overall operations
• It is used to estimate cash payments for non-production-related products and services
• It is frequently broken into variable and fixed cost groups

g) Cost of Goods Manufactured Budget

• This budget summarises production costs, using Direct Materials, Direct Labour and
Manufacturing Overhead Budgets

Cost of Goods Manufactured =

Cost of Direct Materials Used (from Direct Material Purchases Budget)
Plus Direct Labour Costs (from Direct Labour Cost Budget)
Plus Manufacturing Overhead Costs (from Manufacturing Overhead Cost Budget)
Plus Cost of Beginning Work in Progress Inventory
Minus Cost of Ending Work in Progress Inventory

h) Budgeted Income Statement

• This statement/budget is prepared after all of the operating budgets
• It projects net income based on estimated revenues and expenses

i) Capital Expenditure Budget

• This budget outlines amount and timing of anticipated capital expenditure to be incurred.
• Examples:
o Buying equipment

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o Building a new store
o Purchasing and installing a materials handling system

j) Cash Budget
• A cash budget is a projection over a period of time of:
o Beginning cash
o Cash receipts
o Cash payments
o Ending cash
• Elements of a Cash Budget

• It excludes planned non-cash transactions and expenses.

• Examples:
o Depreciation
o Gains and losses on sales of assets

Preparing a Cash Budget

• Estimated Ending Cash Balance =
Total Estimated Cash Receipts
Minus Total Estimated Cash Payments
Plus Estimated Beginning Cash Balance

• Supporting schedules may include:

o Schedule of Estimated Cash Collections
o Schedule of Estimated Cash Disbursements for Materials, Labour and Overhead

Budgeted Statement of Financial Position

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• Information from all other elements of a master budget is used to prepare a budgeted
balance sheet.
• A budgeted balance sheet projects the financial position of an organisation at the end of a
future period.

Example 1

ABC plc produces and sells a standard product. The following information relates to the budgeting
process for the forthcoming budget period ending 200X.

i. Budgeted sales (in units): Quarter 1: 10,000 units; Quarter 2: 30,000 units; Quarter 3: 40,000
units; and Quarter 4: 20,000 units
ii. Budgeted selling price per unit is Shs. 2,000=
iii. 70% of sales are collected in the quarter of sale and the balance in the following quarter.
iv. Debtors at the beginning of Quarter 1 amount to Shs. 9,000,000= to be collected in Quarter 1.
v. The company has a policy of maintaining closing inventories of finished products and raw
materials of 20% and 10% respectively.
vi. Closing inventories for finished products for Quarter 4 are expected to be 3,000 units and for
raw materials are anticipated to be 22,500 kilos.
vii. Raw material requirements are 15 kilos for each unit of product bought at Shs. 20@.
viii. Cash payments for purchases are as follows:
a. 50% is paid for in the quarter of purchase and the remainder in the following quarter.
ix. Direct labour time per unit is 0.8 hours@ Shs. 750.
x. Manufacturing overhead is analysed as follows:
a. Variable element Shs. 200@unit
b. Fixed element Shs. 6,060,000 (this includes depreciation of Shs. 1,500,000)
xi. Selling and administration expenses are analysed as follows:
a. Variable element Shs. 180 per unit sold
b. Fixed element include:
i. Advertising Shs. 2,000,000 per quarter
ii. Executive salaries Shs. 5,500,000 per quarter
iii. Insurance Shs. 190,000 payable in quarter 2 and Shs. 3,775,000
payable in quarter 3
iv. Property taxes Shs. 1,815,000 payable in quarter 4
v. Depreciation Shs. 1,000,000 per quarter
xii. Equipment purchases are made as follows:
a. Quarter 1 Shs. 5,000,000
b. Quarter 2 Shs. 4,000,000
c. Quarter 3 Shs. 2,000,000
d. Quarter 4 Shs. 2,000,000
xiii. Dividend payments of Shs. 800,000 are made per quarter
xiv. The following is the statement of financial position of ABC plc as on 1st January 200X is as
follows:
ABC plc
Statement of financial position
As on 1st January 201X
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Assets
Current Assets
Cash 4,250,000
Accounts Receivables 9,000,000
Raw materials inventory (21,000 kilos) 420,000
Finished goods inventory (2,000 units) 2,680,000
Total Current Assets 16,350,000

Non-Current Assets
Land 8,000,000
Building and equipment 70,000,000
Accumulated depreciation (29,200,000)
Net Non-Current Assets 48,800,000
Total Assets 65,150,000

Liabilities and Shareholders’ Equity

Current liabilities:
Accounts Payables (raw materials) 2,580,000
Shareholders’ equity:
Share capital 17,500,000
Retained earnings 45,070,000
Total shareholders’ equity 62,570,000
Total liabilities and shareholders’ equity 65,150,000

Required: Prepare for year ending 201X

i. Sales budget, including a schedule of the expected cash collections
ii. Production budget
iii. Direct materials budget, including a schedule of expected cash disbursements for
materials.
iv. Direct labour budget
v. Manufacturing overhead budget, including cash disbursement for manufacturing
overhead
vi. Closing goods inventory budget
vii. Selling and administration expenses budget, including cash disbursement for selling and
expenses budget
viii. Cash budget
ix. Budgeted income statement
x. Budgeted statement of financial position

In Class Activity 2: Budgeting in a Service Sector

The following information relates to the budget data of a Management School of a certain
University:

1. Budgeted student enrolment per programme:

a. Degree 1,200 students
b. Diploma 600 students
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c. Certificate 400 students
2. Tuition fees (based on programme):
a. Degree Shs. 1,000,000 per semester
b. Diploma Shs. 700,000 per semester
c. Certificate Shs. 400,000 per semester
3. The semester runs from January to May 2014
4. Tuition fees collections (of the total fees budget) are anticipated to be as follows:
a. January 20%
b. February 20%
c. March 10%
d. April 10%
e. May 40%
5. Staff wages are paid based on contact hours worked, each paid at a rate of Shs.30,000 and in a
month in arrears
6. Budgeted contact hours are 600 hours each week
7. There are 15 weeks in a semester are analysed as follows:
a. January 2 weeks
b. February 4 weeks
c. March 4 weeks
d. April 4 weeks
e. May 1 week
8. Administration overheads are budgeted at a rate of Shs. 12,000,000, payable in the same month
9. The School pays for central university overheads at a rate of 30% of the fees collected in each
month, payable in the following month
10. The procurement plan for the school indicates the following acquisitions:
a. Equipment: 100 Computers@ Shs. 1,500,000, to be bought in March and paid for a
month later
b. Furniture (to be bought and paid for in February):
i. 100 computer chairs@ Shs. 100,000
ii. 50 computer tables@ Shs. 200,000
11. Research and publications expenses are budgeted to be Shs. 20,000,000 for the semester,
payable at the end of the semester.
12. Staff development expenses of Shs. 100,000,000 is anticipated to be incurred, payable as
follows:
a. 60% in February
b. 40% in April

Required: Prepare the following budgets

a. Fees Budget, including the fees receipt schedule analysed on a monthly basis
b. Staff Wages Budget, including the monthly cash payments
c. Central University Overheads Budget
d. Administration Overheads Budget
e. Equipment and Furniture Acquisition Budget
f. Cash Budget

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g. Consolidated Revenue and Expenditure Budget, indicating revenue surplus for the
semester

Group Activity 1:
Group Assignment:
You are assigned specific sum of money to prepare a plan/budget. The following are required in
the plan:
i. Situation analysis
ii. Planning objectives and strategies
iii. Specific projects to be undertaken to meet the planned objectives
iv. Specific targets/milestone or outputs
v. Performance indicators
vi. Outcomes
vii. Budgeted activities, costs
viii. Anticipated revenues (if any).

Below are the groups, specific projects and funds allocated to them:

Group Project Funds Allocated Time Frame

1 Youth Project 10,000,000 2 months
2 Poverty Alleviation 100,000,000 1 year
3 Poverty Alleviation 5,000,000 6 months
4 Community Development Project 10,000,000 3 months
5 Day Care Centre 2,000,000 2 months

All members of each group will be required to make a presentation of their project for a
maximum of 15 minutes.

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Budgetary Control Process
• This is the establishment of a budget relating the responsibilities of executive management
to the requirement of a policy and continuous comparison of actual and budgeted results.
• Control should ensure that actions are accordance with the objective of the policy in
question
• It also provides a basis for its revision

Elements of Budgetary Control

• Setting up budgets i.e. planned targets on revenue, expenses, assets and liabilities relating
to the activities concerned.
• Measuring actual results against the budgets on a continuous basis
• Identifying and analyzing deviations from budgets and modifying both actual operations
and subsequent budgets.

Aims of Budgetary Control

• To establish the degree of progress to the achievement of short term plans
• To allow delegation to occur without losing overall control
• To provide a measure for allowing flexibility in operations
• To establish short term plans and aid the organization’s planning process

Types of Budgets
i. Fixed Budgets: These are budgets for which the estimates (revenue and expenditure)
remain unchanged for the entire budget period regardless of the changes in the operating
environment. These budgets are easier to prepare and are well suited for organisations
operating in a stable environment. The variances can be explained by changes in
operations. However, if there are major changes in the operating environment, then the
fixed budgets are unusable.

ii. Flexible Budgets: These are budgets designed to vary with the level of activity or volume.
These budgets enable the organisation to hold its employees accountable for the budget
outcomes even if volume reduces, and allow for increased expenditure when the level of
activity expands.

Examples of Fixed and Flexible Budgets

Example 1
Assuming a company sells ice cream in cones with only four types of expenses: wages, ice cream,
cones and rent. The company expects to sell 10,000 ice cream cones in a month with the following
fixed budget:

Wages 2,000,000
Ice Cream 1,000,000
Cones 200,000
Rent 1,000,000
Total 4,200,000
As long as the company sells 10,000 ice cream cones, variances from the budget can be explained
by other reasons other than the volume of output. For instance, rent may increase or the price per

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cone may reduce. However, the fixed budget would be inappropriate for implementation if sales
activity dropped from the 10,000 ice cream cones. This situation would be resolved by preparing
a flexible budget. For instance, the company would set the flexible budget as follows:

Wages Shs. 1,000,000= fixed plus Shs. 100 per cone sold.
Ice Cream Shs. 100 per cone
Cones Shs. 20 per cone
Rent Shs, 1,000,000=
If the company sells 10,000 ice cream cones, the flexible budget will be equal to the fixed budget.
Verify

However, if the sales activity dropped to 80%, the flexible budget would be:

Wages

Ice Cream

Cones

Rent

Class Activity 4
A manufacturing firm prepared flexible budgets based on three levels of anticipated activity as
follows:

Activity Levels

60% 70% 80%

Direct Materials 36,000,000 42,000,000 48,000,000
Direct Labour 24,000,000 28,000,000 32,000,000
Production Overhead 10,500,000 11,000,000 11,500,000
Administration Overhead 20,000,000 20,000,000 20,000,000
Total 90,500,000 101,000,000 111,500,000

According to the market survey carried out recently, it was ascertained that the firm’s sales demand
equates to 75% activity level.

Required:
Prepare a flexible budget at 75% level of activity
Flexible Budget at 75% level of activity

Cost Budget
Direct Materials
Direct Labour

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Production Overhead
Administration Overhead
Total

b) Budgetary Control Systems

As a way of enhancing the monitoring and controlling policy implementation in organisations,
several control systems were established to ensure that council’s policies, including financial
expenditure, are within the approved estimates. The following subsections provide evidence of the
control systems adopted to ensure compliance with the approved budget.

Vote Control Systems (VCS)

After the approval of the budget, the Chief Executive or the Chief Finance Officer causes the vote
books to be opened up for each of the sector/department. In addition, the Chief Executive or the
Chief Finance Officer communicates, in writing, to all heads of department, who are vote
controllers about the approved expenditure on each vote. It is the responsibility of the vote
controllers to manage their expenditure within the approved limits. The budget officer, other than
providing primary data to enhance the planning and budgeting processes, monitors the
implementation of the budget. The vote control mechanisms to ensure that all expenditures fall
within the approved budget.

Commitment Control Systems (CCS)

The vote control system is enhanced by the Commitment Control System, which is intended to
eliminate domestic arrears. This is mostly used in the public sector. For instance, in Uganda
government, the adoption and implementation of CCS was one of the conditionalities from IMF
for continued access to development funding by ensuring enhanced accountability and fiscal
discipline in the utilisation of public financial resources. CCS provides that before any financial
commitment is made, there are sufficient funds in the approved budget.

CCS requires that:

i. All payments must be settled within a period of 30 days after the invoice date;
ii. No national debt is allowed. All committed expenditure must be paid from the revenue
relating to the period in which the expenditure is incurred.

CCS is supposed to bestow responsibility to the vote controllers to exercise authority over the
approval of the commitments to ensure transparency and accountability. The role of the Executive
Officer and Finance Officer, in this respect, is to ensure that systems are in place to honour the
financial commitment when they are due.

Integrated Financial Management System (IFMS)

In order to enhance the vote control systems and commitment control system, an Integrated
Financial Management System (IFMS) is used. An IFMS is defined as a fiscal and financial

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management information system that bundles all financial management functions into one suite of
applications. It is an IT-based budgeting and accounting system that will assist entities to initiate,
spend and monitor their budgets, initiate and process their payments, manage and report on their
financial activities. IFMS is presumed to ensure that the resources are utilised effectively based on
the budget allocations and available funds. For instance, it maintains all records and approval
mechanism from the initiation of a transaction (like an LPO) through to the payment of services.
For instance, the IFMS cannot permit processing expenditure for which there is no sufficient funds
on the vote; if it was not approved in the first instance; and the where the LPO was not raised and
entered in the system.

Electronic Funds Transfer System (EFTS)

EFTS is intended to enhance transparency in the utilisation and accountability of public resources,
especially in the public sector. Envisaged benefits of EFTS include:

a) Faster and secure means of effecting payments in government agencies and department;
b) Effective monitoring of payments by stakeholders as well as minimising fraud;
c) Reducing the cost of printing and handling of physical cheques;
d) Improved cash forecasting owing to the elimination of the cheque float; and
e) Elimination of stale cheques

How EFTS works in Uganda

EFTS is applied on all payments of a government entity exceeding 20 million shillings. An
electronic copy is then submitted to Ministry of Finance, Planning and Economic Development
(MoFPED) to process the payments. The MoFPED, then issues EFTS instructions to the central
bank (Bank of Uganda) to credit the respective beneficiaries’ commercial banks accounts.

c) Budgetary Control/Performance Statements

These statements are prepared to compare the budget with the actual budget outturn to ascertain
the extent to which the performance meets the desired targets. The control/performance statements
can be based on both fixed and flexible budgets. Management uses such statements to make the
employees account for their performance and to determine the extent of interventions required to
hit the set targets.

Example

Assuming a firm prepared the following budget based on 60% level of activity:

Direct Materials 36,000,000

Direct Labour 24,000,000
Production Overhead 10,500,000
Administration Overhead 20,000,000
Total 90,500,000

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The following is the actual expenditure incurred:

Direct Materials 42,500,000

Direct Labour 27,500,000
Production Overhead 12,900,000
Administration Overhead 20,000,000
Total 102,900,000
Required:
Prepare: Budgetary Control Statements, based on:
i. Fixed Budget
ii. Flexible Budget, assuming the actual expenditure is based on 70% level of activity. Fixed
production overheads amount to Shs. 7,500,000=

Solutions
Fixed Budget Control Statement
For the Budget Period ended xxxx
Cost Fixed Budget Actual Variance
Direct Materials 36,000,000 42,500,000 6,500,000 Adverse
Direct Labour 24,000,000 27,500,000 3,500,000 Adverse
Production Overhead 12,000,000 12,900,000 900,000 Adverse
Administration Overhead 20,000,000 20,000,000 -
Total 92,000,000 102,900,000 10,400,000
Adverse
Required: Comment on the fixed budgetary control statement
Flexible Budget Control Statement
For the Budget Period ended xxxx
Cost Flexible Actual Variance
Budget at 70%
Direct Materials 42,000,000 42,500,000 500,000 Adverse
Direct Labour 28,000,000 27,500,000 500,000 Favourable
Production Overhead 11,000,000 12,900,000 1,900,000 Adverse
Administration Overhead 20,000,000 20,000,000 -
Total 101,000,000 102,900,000 1,900,000 Adverse

Required: Comment on the flexible budgetary control statement

d) Challenges to the Budgetary Control Systems
i. Uncertainties in financial flows
ii. Interferences or interventions from power-wielding stakeholders
iii. Tensions and conflicts between actors supposed to implement the budget
iv. Corruption and rent-seeking tendencies
v. Poor records system
vi. Insufficient budgetary control skills

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Budget Revision Processes
The annual budget is an estimate of the expected revenue and anticipated expenditure. Traditional
budgeting, especially in the public sector, did not provide any opportunity for budget revisions.
The budget had to be implemented based on the initial estimates, even though various assumptions
on which it was based had changed. However, the contemporary budgeting systems sought to
improve the budget implementation process by providing procedures through which the annual
budget of an organisation could be revised to bring it in line with the current operational realities.
The following procedures are usually used to cater for the flexibility in the budget implementation:
i. Virement of Resources
Virement involves the transfer of approved funds between expenditure votes under the same sub-
programme temporarily. This requires explicit approvals from relevant authorities, in most cases,
the Chief Executive Officer. However, virement cannot be applied for to create new positions or
changing the salary structure. In addition, virement cannot be approved on creating a new policy
altogether than significantly alters the approved estimates. The need for virement may arise where
actual funds on an approved vote are not available but the expenditure needs to be incurred at that
time. In such a circumstance the vote controller, who is the Head of Department applies for
virement to the Chief Executive. However, funds must be returned to the original vote when they
are available.

ii. Reallocation of Resources

Reallocation may apply where it necessitates transfer of approved funds between “employee costs
and “Other charges” and between items of different programmes and sub programmes. The
rationale for reallocation procedures is to cater for uncertainties in the operating environment. The
vote controller has to indicate the amounts to be transferred from one sub-programme to another
and the votes affected. Reallocations may involve significant departure from the original estimates,
thus to ensure optimal decision-making and to avoid tensions and conflicts between various parties
of the organisation, the decisions to reallocate funds are usually taken by the governing councils
or bodies, such the board of directors, local councils, board of governors or the Parliament.

iii. Supplementary Budgets

In some cases, it may be necessary to increase or reduce the amount for recurrent or capital
expenditure that cannot be provided for by virement and reallocation. In such a circumstance,
supplementary estimates would be applied for by the vote controller to the Chief Executive. The
application for the supplementary budget has to specify where the additional funding can be
derived from or where it is necessary to reduce on expenditure if the revenue anticipated for is not
forthcoming. For instance, additional funding may come from savings from other votes or
additional revenue that can be or has been generated; or from anticipated external funds. This is to
ensure flexibility in decision-making. Since the supplementary budgets introduce new ideas and
projects that may not have been initially approved, but considered beneficial to the organisation,
or to reduce on expenditure because revenue expected is not received, the final decision on
supplementary budgets has to be approved by the supreme governing bodies. These include boards
of directors, local councils, board of governors or the Parliament.

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STANDARD COSTING AND VARIANCE ANALYSIS
Definition of Standard cost:
These are realistic estimates of cost based on analyses of both past and projected operating costs
and conditions.

Types of Standards

The following are the most important types of standards:

a) Basic Standards:
These are long-term standards, which would remain unchanged over the years, their sole
use is to slow trends over time for such items as material prices, labour rats and efficiency
and effect of changing methods.

b) Ideal Standards:
These are based on the best possible operating conditions i.e. no breakdowns, no material
wastage, no stoppages or idle time, in short, perfect efficiency. Ideal standards if used
would be revised periodically to reflect improvements in methods, material and
technology.

c) Attainable standards:
This is the most frequently encountered standard. It is based on efficient (but not perfect)
operating conditions the standards would include allowances for normal materials losses,
realistic allowances for fatigue, machine breakdown etc.

Uses of standard costing

• Value stocks and determine the cost of production
• Act as a control device by establishing standards (expected costs) and comparing actual costs
with the expected costs, thus highlighting performance gaps
• Assist in setting budgets
• Enable the principle of management by exception to be practised
• Provide a prediction of future costs to be used in decision-making situations
• To motivate staff and management by the provision of challenging targets
• To provide guidance on possible ways of improving efficiency

Deriving standards
The responsibility of deriving standards should be shared between managers able to provide the
necessary information about levels of expected efficiency, prices and overhead.

a. Direct materials costs will be estimated by the purchasing department from their knowledge
of: purchase contracts already agreed; pricing discussions with regular suppliers, forecast
movement of prices in the market, availability of bulk purchases, and quality of material

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required by the production departments. Provisions have to be made for bulk purchases and
inflation.
b. Labour costs – direct labour rates per hour will be set by reference to the payroll and to any
agreements on pay rises. A separate rate will be set for each grade of employees.
c. Overhead costs – when standard costs are fully absorbed costs, the absorption rate of fixed
production overheads will be predetermined and based on budgeted fixed production overhead
and planned production volume. Production volume will depend on two factors – production
capacity and efficiency of working. Capacity levels include, full capacity, practical capacity,
budgeted capacity, and idle capacity.
The three components of standard costing

– Standard costs, which provide a standard, or predetermined, performance level

– A measure of actual performance
– A measure of the variance between standard and actual performance

How standard costing differs from actual costing and normal costing.

– Standard costing uses estimated costs exclusively to compute all three elements of product
costs: direct materials, direct labor, and overhead.

How managers use standard costs for planning and control in the management process:

i. Planning—For budget development; product costing, pricing, and distribution

ii. Performing—For measurement of expenditures and control of costs as they occur
iii. Evaluating—For variance analysis
iv. Communicating—For variance reports

N.B.

i. The primary difference between standard costing in a service organization and standard
costing in a manufacturing organization is that a service organization has no direct
materials costs.
ii. In a standard costing system, costs are entered into the Materials, Work in Process, and
Finished Goods Inventory accounts and the Cost of Goods Sold account at standard
cost; actual costs are recorded separately

The following elements are used in determining a standard cost per unit:

a. Direct materials price standard

b. Direct materials quantity standard
c. Direct labor rate standard
d. Direct labor time standard
e. Standard variable overhead rate
f. Standard fixed overhead rate

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How standards are developed:

i. The direct materials price standard is based on a careful estimate of all possible price
increases, changes in available quantities, and new sources of supply in the next accounting
period.
ii. The direct materials quantity standard is based on product engineering specifications, the
quality of direct materials, the age and productivity of machines, and the quality and
experience of the work force.
iii. The direct labor rate standard is defined by labor union contracts and company personnel
policies.
iv. The direct labor time standard is based on current time and motion studies of workers and
machines and records of their past performance.
v. The standard variable overhead rate and standard fixed overhead rate are found by dividing
total budgeted variable and fixed overhead costs by an appropriate application base.

• Standard direct materials cost is the product of the direct materials price standard and the
direct materials quantity standard.
• Standard direct labor cost is the product of the direct labor rate standard and the direct labor
time standard.
• Standard overhead cost is the sum of the standard variable overhead rate and standard fixed
overhead rate.

• A product’s standard unit cost is the sum of the following:

o Standard direct materials cost
o Standard direct labor cost
o Standard overhead cost

Standards should be reviewed to reflect technical and current factors

Potential problems with using standard costs

• Outdated reports – standard cost variance reports are usually prepared on a monthly basis
and are released long after the end of the month
• Reports being using for punitive action instead of being used as a motivational tool
• Emphasis on simply meeting standards and not going a step further
• Setting labour standards emphasis is usually on the speed at which people work without
considering the efficiency of the machines and tools the workers will use
• The perception that favourable variances are always good which is not always the case

Class Activity

Compute the standard unit cost of a product whose standard costs are as follows:
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• Direct material quantity 5 kilos per unit
• Direct material price 1,000 per kilo
• Direct labour time 10 minutes per unit
• Direct labour rate 24,000=@ direct labour hour
• Variable overhead rate 18,000=@ direct labour hour
• Fixed overhead rate 9,000=@ direct labour hour

Variance Analysis
Variance analysis is the process of computing the differences between standard costs and actual
costs and identifying the causes of those differences.
Once a budget has been prepared, actual results are compiled on the same basis to enable budgeted
figures to be compared with actual results. Such comparison will reveal where there are
differences that are usually referred to as variances. Where it is deemed appropriate such
variances should be investigated to find out what actually happened to give raise to them. The
investigation may therefore result in a corrective action being taken or in improved planning in
subsequent budget preparations.

Reasons for variances

VARIANCE FAVOURABLE UNFAVOURABLE

Material price Unforeseen discounts Price increase
Material usage Higher quality material used Defective materials
Greater care in purchasing Careless purchasing
Labour rate Better bargaining Wage rate increase
More effective use of materials Excessive wastage
Labour efficiency • Output
Change producedstandard
in material more quickly than •Change
Lost time in excess
in material of standard
standard
expected due to motivation • Output lower than standard
Errors in quality
• better allocating material&materials
equipment to jobs Pilferage
due to lack of training
• Errors in allocating time to jobs • Sub standard material
•Stricter
Errorsquality control time to
in allocating
jobs
Overhead Savings in costs incurred Increase in cost of services
Overhead volume Level of activity greater than expected Level of activity less than
expenditure More economical use of services Excessive use of services
Selling price Unplanned price increase Unplanned
expected price reduction
Sales volume Additional demand Unexpected fallof
Change in type inservices
demand used

Variance analysis has four steps:

– Compute the amount of the variance.

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– Determine the cause of any significant variance.
– Identify performance measures that will track those activities, analyze the results of the
tracking, and determine what is needed to correct the problem.
– Take corrective action.

1. DIRECT MATERIAL VARIANCES

i. Direct Material Cost Variance (DMCV)
This is the difference between the standard material costs of the output produced and the actual
direct material cost incurred on all production attained.
DMCV = Standard cost of material (SC) – Actual cost of material used (AC)

DMCV is analysed into:

o Direct material price variance (DMPV)
o Direct material usage variance (DMUV), which can also be further analysed into:
❖ Direct material mix variance (DMMV)
❖ Direct material yield variance (DMYV).

Thus: DMCV can also be derived by: DMPV + DMUV

Or DMPV + DMMV + DMYV
ii. Direct Materials Price Variance (DMPV)
This is the difference between the standard price and actual price of all materials used in
production.
That is: DMPV = (Standard Price (SP) – Actual Price (AP))* Actual materials used in
production
iii. Direct Materials Usage Variance (DMUV)
This variance measures efficiency in the usage of direct materials, and it is derived by comparing
the standard and actual quantity of materials used in production valued at the standard price.
That is: DMUV = (Standard Quantity (SQ) – Actual Quantity (AQ))* Standard Price
OR (SQ-AQ)*SP
Example 1
The standard quantity of producing one unit of product X is 50kgs at a standard price of Shs.
2,500=@kg. During a given period, a company produced 150 units of product X using 7,450 kgs
all costing Shs.19,370,000.
Required: Compute the following variances:
i. Direct material price variance (DMPV)
ii. Direct material usage variance (DMUV)
iii. Direct material cost variance (DMCV)

Solution
i. Direct material price variance (DMPV)
Formula: (SP-AP)AQ
Where SP = Shs. 2,500; AP= (19,370,000/7,450kg) = Shs. 2,600; and AQ= 7,450kg
 (2,500-2,600)* 7,450kg = 745,000A
ii. Direct material usage variance (DMUV)

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Formula: (SQ-AQ)SP
Where SQ = (150 units * 50kgs) = 7,500 kgs.
 (7,500-7,450)*2500 = 125,000F
iii. Direct material cost variance (DMCV)
Formula: (SC-AC)
Where SC = Standard Price * Standard Quantity
= 2,500 * 7,500 = 18,750,000
AC = = 19,370,000
 620,000A
OR DMCV = DMPV +DMUV
 745,000A + 125,000F = 620,000A

Class Activity 1
The following details were extracted from the standard cost card of a component:
Direct materials 2.82kgs@ Shs. 4,800
During the period, the actual production of the component was 1,100 units consuming 3,200kgs
all costing Shs. 15,100,000.
Required: Compute the:
i. Direct material price variance (DMPV)
ii. Direct material usage variance (DMUV)
iii. Direct material cost variance (DMCV)

In a production setting, it is possible to vary the mix of input materials and affect the yield. Usually
a standard mix is established for production activities. Mix and yield variances can be computed
to indicate the cost of deviating from the standard mix.

Class Activity 2
A manufacturing firm formulated its standard mix for producing 18kg of product Q as follows:
10kg of material A @ 5,000 = 50,000
6kg of material B @ 4,000 = 24,000
4kg of material C @ 4,000 = 16,000
20kg 90,000

A standard normal loss of 10% of input is expected to arise. The actual input for a certain period
was:
92,600kg of material A @ 5,400
53,800kg of material B @ 3,800
33,600kg of material C @ 4,000
The actual output for the period was 163,800kg of product Q.
Required: compute the:
i. Direct material mix variance

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ii. Direct material yield variance
iii. Direct material usage variance
iv. Direct material price variance
v. Direct material cost variance

2. DIRECT LABOUR VARIANCES

i. Direct Labour Cost Variance (DLCV)
This is the difference between the standard direct labour cost and the actual direct labour cost
incurred for the production achieved.
Formula: DLCV = SC-AC
ii. Direct Labour Rate Variance
This is the difference between the standard and actual direct labour rate per hour for the total hours
worked on all production.
Formula: DLRV = (SR-AR)AH
iii. Direct Labour Efficiency Variance
This is the difference between the standard hours for the actual production achieved and the actual
hours worked, valued at the standard labour rate.
Formula: DLEV = (SH-AH)SR
Example 3
The standard hours of producing one unit of product X are 14 hours@ at a standard rate of Shs.
2,750. During a certain period, 150 units of product X were produced using 2,020 labour hours all
paid at Shs. 5,858,000=.

Required: Compute the following

i. Direct labour rate variance

ii. Direct labour efficiency variance
iii. Direct labour cost variance

Solution
i. Direct labour rate variance (DLRV)
Formula: DLRV = (SR-AR)AH
(2,750- 2900)* 2,020 hours = 303,000A
ii. Direct labour efficiency variance (DLEV)
Formula: DLEV = (SH-AH)SR
SH = 14 hours x 150 units = 2,100 hours
(2,100 – 2020)*2,750 = 220,000F
iii. Direct labour cost variance
Formula: DLCV = SC-AC
SC = SHxSR = 2,100 hours x 2,750 = 5,775,000
AC 5,858,000
83,000A
OR DLCV= DLRV +DLEV = 303,000A +220,000F = 83,000A
Class Activity 3

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The standard hours of producing one unit of product Q are 2 hours@ at a standard rate of 5,000=.
During a certain period, 1150 units of product Q were produced using 2,200 labour hours all paid
at Shs. 2,530,000.
Required: Compute the following
i. Direct labour rate variance
ii. Direct labour efficiency variance
iii. Direct labour cost variance

3. VARIABLE OVERHEAD VARIANCES

i. Variable Overhead Cost Variance (VOCV)
This is the difference between the standard variable overhead absorbed in production and the actual
variable overhead incurred.
Formula: VOCV = SC-AC
ii. Variable Overhead Expenditure Variance (VOExV)
This is the difference between the standard variable overhead absorption rate and the actual
variable overhead rate of the actual activity (either in hours or in units of output) performed.
Formula: VOExV = (SR-AR)AH
iii. Variable Overhead Efficiency Variance (VOEfV)
This is the difference between the standard hours of the actual production achieved and the actual
hours worked, valued at the standard variable overhead absorption rate.
Formula: VOEfV = (SH-AH)SR

Example 4
A company budgeted for variable overhead at Shs. 13,120,000 for a period and the standard labour
hours for the period were 3,280 hours. During the said period, the actual variable overheads
incurred were shs. 13,930,000; the actual labour hours worked were 3,150 and the standard hours
of production achieved were 3,230.
Required: Compute the
i. Variable overhead expenditure variance
ii. Variable overhead efficiency variance
iii. Variable overhead cost variance

Solution
i. Variable overhead expenditure variance (VOExV)
Formula: VOExV = (SR-AR)AH
SVOAR (SR) = Budgeted variable overhead
Budgeted labour hours
= 13,120,000 = Shs. 4,000@ labour hour
3,280 labour hours
SRxAH 4,000 x 3,150 12,600,000
ARxAH 13,930,000
1,330,000A
ii. Variable overhead efficiency variance
Formula: VOEfV = (SH-AH)SR
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(3,230 – 3,150)* 4000 320,000F
iii. Variable overhead cost variance
Formula: VOCV = SC-AC
SC = SH x SVOAR= 3,230 x 4,000= 12,920,000
AC 13,930,000
1,010,000A

OR VOCV = VOExV + VOEfV = 1,330,000A + 320,000F 1,010,000A

4. FIXED OVERHEAD VARIANCES

i. Fixed Overhead Cost Variance (FOCV)
This is the difference between the standard cost of fixed overheads absorbed in the production
achieved and the fixed overhead incurred during the period.
Formula: FOCV = SC-AC
ii. Fixed Overhead Expenditure Variance (FOExV)
This is the difference between the budgeted cost allowance for production for a specified period
and the actual fixed expenditure incurred during the period.
Formula: FOExV = (BFO-AFO)
iii. Fixed Overhead Volume Variance (FOVV)
This is the difference between the budgeted activity (e.g. directly labour hours) and the standard
activity (hours), valued at the standard cost absorbed in the production.
Formula: FOVV = (BH-SH) FOAR
iv. Fixed Overhead Efficiency Variance (FOEfV)
This is the difference between the standard activity (e.g. directly labour hours) and the actual
activity attained during the period, valued at the standard cost absorbed in the production.
Formula: FOVV = (SH-AH) FOAR

v. Fixed Overhead Capacity Variance (FOCapV)

This is the difference between the budgeted activity (e.g. directly labour hours) and the actual
activity attained during the period, valued at the standard cost absorbed in the production.
Formula: FOCapV = (BH-AH) FOAR
Example 5
A company budgeted for fixed overheads at Shs. 11,480,000 based on the budgeted direct labour
hours of 3,280 hours. During the period, actual fixed overheads incurred amounted to Shs.
12,100,000; actual direct labour hours worked were 3,150 hours. The standard hours of production
were 3,230 hours.

Required: compute the following:

i. Fixed overhead expenditure variance (FOExV)
ii. Fixed overhead volume variance (FOVV)
iii. Fixed overhead efficiency variance (FOEfV)
iv. Fixed overhead capacity variance (FOCapV)
v. Fixed overhead cost variance (FOCV)

Solution
i. Fixed overhead expenditure variance (FOExV)
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Formula: FOExV = (BFO-AFO)
(11,480,000 – 12,100,000) = 620,000A

ii. Fixed overhead volume variance (FOVV)

Formula: FOVV = (BH-SH) FOAR
FOAR = Budgeted fixed overheads = 11,480,000 = 3,500 per hour
Budgeted direct labour hours 3,280 hours

(3,280- 3,230)* 3,500 175,000A

iii. Fixed overhead efficiency variance (FOEfV)
Formula: FOEfV = (SH-AH) FOAR
(3,230 – 3,150)* 3,500 280,000F
iv. Fixed overhead capacity variance (FOCapV)
Formula: FOCapV = (BH-AH) FOAR
(3,280- 3,150)*3,500 455,000A
Cross check
FOVV = FOEfV + FOCapV
280,000F + 455,000A = 175,000A
v. Fixed overhead cost variance (FOCV)
Formula: FOCV = SC-AC
SC = SH x FOAR = 3,230 x 3,500 = 11,305,000
AC 12,100,000
795,000A
Cross check
FOCV = FOExV + FOVV
620,000A + 175,000A = 795,000A

Class Activity 4
A company’s budgeted overheads were as follows:
Variable overheads Shs 10,000,000=
Fixed overheads Shs 8,000,000=
The budgeted direct labour hours for the period were 10,000 hours. During the period, the actual
overheads were as follows:
Variable overheads Shs 9,880,000=
Fixed overheads Shs 8,120,000=
The standard direct labour hours for the production attained were 10,650 hours.

Required: compute the following:

i. Variable overhead expenditure variance
ii. Variable overhead efficiency variance
iii. Variable overhead cost variance
iv. Fixed overhead expenditure variance
v. Fixed overhead volume variance
vi. Fixed overhead efficiency variance
vii. Fixed overhead capacity variance
viii. Fixed overhead cost variance

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ix. Total overhead cost variance

Summary of the formulae for the computation of the variances

1. Material Variances
a. Direct material price variance = (SP-AP)*AQ
b.Direct material usage variance = (SQ-AQ)*SP
c. Direct material mix variance = (AQ in standard mix proportions – AQ used)*SP
d.Direct material yield variance = (Standard Yield – Actual Yield)*Standard cost per mix
e. Direct material cost variance = SC –AC
2. Labour Variances
a. Direct labour rate variance = (SR – AR)*AH worked
b.Direct labour efficiency variance = (SH – AH)*SR
c. Direct labour cost variance = (SC – AC)
3. Variable Overhead Variances
a. Variable overhead expenditure variance = (SVOAR – AVOAR)*AH
b.Variable overhead efficiency variance = (SH – AH)* SVOAR
c. Variable overhead cost variance = (SC – AC)
4. Fixed Overhead Variances
a. Fixed overhead expenditure variance = (BFO – AFO)
b.Fixed overhead volume variance = (BH – AH)*SFOAR
c. Fixed overhead efficiency variance = (SH – AH)*SFOAR
d.Fixed overhead capacity variance = (BH – SH)*SFOAR
e. Fixed overhead cost variance = (SC-AC)

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Revision Exercises on Variance Analysis
The budget figures for DX Ltd for the year ending 31/12/2008 were as follows:
Production 10,000 units
Standard cost card: per unit
Direct materials 20,000
Direct labour 4,000
Variable production overhead 3,000
Fixed production overhead 10,000
37,000
Notes: Direct material budgeted at Shs. 10,000 per ton
Direct labour budgeted at Shs. 8,000 per hour

Actual results for the period were as follows:

Production 10,560 units
Direct materials 21,000 tons costing Shs. 225,400,000
Direct labour 5,200 hours costing Shs. 44,000,000
Variable production overhead Shs. 33,210,000
Fixed production overhead Shs. 100,900,000
There were no stocks of direct materials at the beginning or end of the period.

Required:
Compute all the relevant variances for the period.
1.Slammer plc uses a standard costing system and for the single product that the firm produces,
the following standard costs apply:
Direct materials 5kg at Shs. 2,000 per kg
Direct labour 4 hours at Shs. 3,000 per hour
Variable production overhead 4 hours at Shs. 1,000 per hour
Fixed production overhead 4 hours at Shs. 2,000 per hour
During a given period, the budgeted production was 5,000 units and the actual data for the period
was as follows:
a. Production 5,400 units
b. Actual materials consumed were 30,000kg cost Shs. 57,000,000
c. Actual labour hours worked were 23,300 costing Shs. 72,500,000
d. Actual variable overhead incurred was Shs. 24,800,000
e. Actual fixed overhead cost was Shs. 38,000,000.

Required:
Compute all the relevant variances for the period.

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DIVISIONALISED PERFORMANCE MEASUREMENTS AND TRANSFER
PRICING
Learning Objectives
1. Explain how and why firms choose to decentralize.
2. Compute and explain return on investment.
3. Compute and explain residual income and economic value added.
4. Explain the role of transfer pricing in a decentralized firm and at international level.

A. Decentralization and Responsibility Centers

In general, a company is organized along lines of responsibility. Today, most companies use a
more flattened hierarchy that emphasizes teams. Firms with multiple responsibility centers usually
choose one of two decision-making approaches to manage their diverse and complex activities:
centralized or decentralized.
In centralized decision making, decisions are made at the very top level, and lower level managers
are charged with implementing these decisions.

Decentralized decision making allows managers at lower levels to make and implement key
decisions pertaining to their areas of responsibility. The practice of delegating decision-making
authority to the lower levels of management in a company is called decentralization.

a) Centralization and Decentralization

b) Reasons for Decentralization

Firms decide to decentralize for several reasons, including the following:
• ease of gathering and using local information
• focusing of central management
• training and motivating of segment managers
• enhanced competition, exposing segments to market forces

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c) Divisions in the Decentralized Firm
Decentralization involves a cost-benefit trade-off. As a firm becomes more decentralized, it passes
more decision authority down the managerial hierarchy.

Decentralization usually is achieved by creating units called divisions. Divisions can be

differentiated a number of different ways, including the following:
• types of goods or services
• geographic lines
• responsibility centers

i. Types of Goods or Services

Divisions may be created based on different products and services offered by a firm. For instance,
Mukwano Industries may create divisions based on products like beverages, plastics, detergents,
cosmetics, cooking oils. etc.

ii. Geographic Lines

Divisions may also be created along geographic lines. The presence of divisions spanning one or
more regions creates the need for performance evaluation that can take into account differences in
divisional environments.

iii. Responsibility Centers

A third way divisions differ is by the type of responsibility given to the divisional manager. A
responsibility center is a segment of the business whose manager is accountable for specified sets
of activities. The four major types of responsibility centers are as follows:
• Cost center: Manager is responsible only for costs.
• Revenue center: Manager is responsible only for sales, or revenue.
• Profit center: Manager is responsible for both revenues and costs.
• Investment center: Manager is responsible for revenues, costs, and investments.

d) Responsibility Centers and Accounting Information Used to Measure Performance

Investment centers represent the greatest degree of decentralization (followed by profit centers and
finally by cost and revenue centers) because their managers have the freedom to make the greatest
variety of decisions.

i. Responsibility Center Interdependencies

It is important to realize that while the responsibility center manager has responsibility only for
the activities of that center, decisions made by that manager can affect other responsibility centers.

Organizing divisions as responsibility centers creates the opportunity to control the divisions
through the use of responsibility accounting.

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ii. Decentralised Organisations
This is an organisation in which decision-making is not confined to a few top executives, but rather
is spread throughout the organisation. Responsibility accounting systems function most effectively
in an organisation that is decentralised.

Benefits from decentralisation

a. Top management is relieved of much day-to-day problem solving and is left free to concentrate
on long-range planning and coordinating efforts.
b. Greater decision-making opportunity provides valuable training for managers as they rise in
an organisation.
c. Added responsibility and decision-making authority often result in increased job satisfaction
and provide greater incentive for the manager.
d. Decisions are best made at the level in the organisation where a problem or an opportunity
arises; the local manager typically has more information upon which to base a decision.
e. Decentralisation provides a more effective basis for measuring a manager's performance.

Disadvantages of decentralisation
Particularly in large organisations, the benefits of decentralisation usually outweigh the
disadvantages. Nevertheless, it is important to be aware of the potential problems with
decentralisation.
a. Lower level managers may not understand the "big picture," leading to decisions that are
inconsistent with the company’s strategy.
b. Decentralised decision-making may lead to a lack of coordination among business segments
and may lead to duplication of effort.
c. Lower level managers may have different objectives than top managers and may pursue their
own objectives to the detriment of the objectives of the overall organisation (suboptimal
decisions). (It should be pointed out as well that top managers might have different objectives
than the owners.) This is the classical "agency theory" problem.
d. If decentralised segments are really independent-minded and autonomous, there may be little
communication and cooperation among the segments. Innovative ideas may spread more
slowly through a highly decentralised organisation than an organisation in which top managers
feel free to impose innovation.

B. Measuring Managerial Performance

i. Return on Investment
Typically, investment centers are evaluated on the basis of return on investment (ROI). ROI is the
profit earned per dollar of investment. ROI is the most common measure of performance for an
investment center and is computed by dividing operating income by average operating assets.

Operating income refers to earnings before interest and taxes. Operating assets are all assets
acquired to generate operating income, including cash, receivables, inventories, land, buildings,
and equipment.

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Average operating assets is computed as: (Beginning assets + Ending assets) ÷ 2.

ii. Margin and Turnover

A second way to calculate ROI is to separate the formula (Operating income/Average operating
assets) into margin and turnover. Margin is the ratio of operating income to sales. It tells how many
cents of operating income result from each dollar of sales; it expresses the portion of sales that is
available for interest, taxes, and profit. Turnover is a different measure; it is found by dividing
sales by average operating assets. Turnover tells how many dollars of sales result from every dollar
invested in operating assets.

The equation that yields ROI from the Margin and Turnover is as follows:
Margin Turnover
ROI = Operating Income X Sales
Sales Average Operating Assets

Notice that ‘‘Sales’’ can be cancelled out to yield the original ROI formula of Operating income
divided by Average operating assets.

iii. Calculating Average Operating Assets, Margin, Turnover, and Return on

Investment

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Notice while both approaches yield the same ROI, the calculation of margin and turnover gives
manager valuable information. Computing the margin and turnover ratios for each division gives
a better picture of what caused the change in rates. As with variance analysis, understanding the
causes of managerial accounting measures (i.e., variances, margins, turnover, etc.) helps managers
take actions to improve the division.

Advantages of Return on Investment

✓ It encourages managers to focus on the relationship among sales, expenses, and investment, as
should be the case for a manager of an investment center.
✓ It encourages managers to focus on cost efficiency.
✓ It encourages managers to focus on operating asset efficiency.

Disadvantages of the Return on Investment Measure

Overemphasis on ROI can produce myopic behavior. There are a number of criticisms of the use
of ROI in evaluating managerial performance.
✓ ROI tends to emphasise short-run rather than long-term performance. Managers can often
improve short-term profitability by taking actions that hurt the company in the long-term.
Prominent examples include neglecting maintenance and training, slashing prices at the end of
the fiscal year to induce customers to make unusually large purchases in advance of their needs,
purchasing lower quality inputs, and compromising on quality of output.
✓ A manager who takes over an investment centre typically inherits many committed costs over
which the manager has little control. These committed costs may be relevant for assessing how
well the investment centre has performed as an investment, but are less relevant for assessing
how well the current manager is performing.
✓ A division whose ROI is larger than the ROI for the entire company may reject an alternative
that would lower its own ROI even though it would increase the ROI for the entire company.

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iv. Strategies of Improving the ROI
✓ Increase sales
Ordinarily, an increase in sales will increase margin and turnover because of the presence of fixed
costs. Since the fixed costs do not increase with sales, net operating income should increase faster
than sales, and the margin should go up.

✓ Reduce expenses
A decrease in expenses will increase margins through an increase in net operating income. In hard
times, managers often turn to cost cutting as the first line of defence. Conventional wisdom holds
that "fat" can creep into an organisation during good times and that such fat can be cut away
without a great deal of pain when necessary. Some business critics claim that there has been too
much reliance on cost cutting. Instead of just cutting away fat, managers may cut the muscles and
bones. Moreover, organisational morale suffers during and after periodic cost cutting binges. It is
now generally acknowledged that it is best always to be "lean and mean" and to avoid the effects
caused by cost cutting campaigns.

✓ Reduce operating assets

The third approach to improving ROI is to reduce operating assets. This has been a focus of the
JIT movement.

v. Effects of increasing sales on the ROI

Assuming in the previous example, the firm decided to increase sales from 100,000,000 to
110,000,000. In addition, assuming the net operating profit increases from 10,000,000 to
12,000,000, and the operating assets remain constant. The new ROI would be:

ROI = Net operating profit = 12,000,000 = 0.24 or 24%

Average operating assets 50,000,000

vi. Effects of reducing expenses on the ROI

Assuming the manager of the division is able to reduce expenses by 1,000,000, so that the
operating profit increases from 10,000,000 to 11,000,000; and both sales and operating assets
remain constant. The new ROI would be:
ROI = Net operating profit = 11,000,000 = 0.22 or 22%

Average operating assets 50,000,000

vii. Effects of reducing operating assets on the ROI

Assuming the manager of the division was able to reduce the operating assets from 50,000,000 to
40,000,000. Sales and net operating profit remain constant. The new ROI would be:

ROI = Net operating profit = 10,000,000 = 0.25 or 25%

Average operating assets 40,000,000

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Class Activity 1

Snack Foods Appliance

Division Division

Sales 30,000,000 117,000,000

Net operating income 1,800,000 3,510,000
Average operating assets 10,000,000 19,500,000

Required: Compute the ROI for the two divisions.

viii.The problem of allocated expenses and assets

In practice, corporate headquarters expenses and other common costs are often allocated to
divisions.

✓ Only those allocations that reflect the costs of actual services provided by central
headquarters that the divisions would otherwise have had to provide for themselves should be
included in ROI computations.
✓ Arbitrary allocations of other headquarters expenses should be avoided in ROI
computations. They undermine the credibility of the measure of performance, generate arguments
among managers, and serve no apparent useful purpose.

ix. Residual Income

To compensate for the tendency of ROI to discourage investments that are profitable for a company
but that lower a division’s ROI, some companies have adopted alternative performance measures
such as residual income. Residual income is the difference between operating income and the
minimum dollar return required on a company’s operating assets. In other words, residual income
is the net income that an investment centre is able to earn above the minimum required rate of
return on its operating assets. Ideally, the minimum required rate of return should be the firm’s
cost of capital or opportunity cost of funds. When residual income is used to measure performance,
the goal is to maximize the total amount of residual income generated for a period.

Residual income equals Operating income minus (Minimum rate of return times Average
operating assets)

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Calculating Residue Income

The minimum rate of return is set by the company and is the same as the hurdle rate. If residual
income is greater than zero, then the division is earning more than the minimum required rate of
return (or hurdle rate). If residual income is less than zero, then the division is earning less than
the minimum required rate of return. Finally, if residual income equals zero, then the division is
earning precisely the minimum required rate of return.

Advantage of Residual Income

The advantage of using residual income is that its use encourages managers to accept any project
that earns a return that is above the minimum rate.
This prevents the fallacy of using ROI that may reject a profitable project that reduces divisional
ROI.

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Disadvantages of Residual Income
Unfortunately, residual income, like ROI, can encourage a short-run orientation. Another problem
with residual income is that, unlike ROI, it is an absolute measure of profitability. Thus, direct
comparison of the performance of two different investment centers becomes difficult, as the level
of investment may differ. One possible way to correct this disadvantage is to compute both ROI
and residual income and to use both measures for performance evaluation. ROI could then be used
for interdivisional comparisons.

Class Activity
The following data relate to the business activity of a firm:
Average operating assets 100,000,000
Net operating profits 20,000,000
Minimum required rate of return 15%

Required
Compute the residual income

Economic Value Added (EVA)

Another financial performance measure that is similar to residual income is economic value added.
Economic value added (EVA) is after tax operating income minus the dollar cost of capital
employed. The dollar cost of capital employed is the actual percentage cost of capital multiplied
by the total capital employed.

EVA is expressed as follows:

Calculating Economic Value-Added

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Basically, EVA is residual income with the minimum rate of return equal to the actual cost of
capital for the firm (as opposed to some minimum rate of return desired by the company for other
reasons). If EVA is positive, then the company has increased its wealth during the period. If EVA
is negative, then the company has decreased its wealth during the period.

Behavioral Aspects of Economic Value Added

✓ The key feature of EVA is its emphasis on after-tax operating profit and the actual cost of
capital.
✓ Investors like EVA because it relates profit to the amount of resources needed to achieve it.
✓ A number of companies have discovered that EVA helps to encourage the right kind of
behavior from their divisions in a way that emphasis on operating income alone cannot. The
underlying reason is EVA’s reliance on the true cost of capital.
✓ In some companies, the responsibility for investment decisions rests with corporate
management. As a result, the cost of capital is considered a corporate expense rather than an
expense attributable to particular divisions.
✓ Without an EVA analysis, the result of investments do not show up as reducing divisional
operating income and may seem free to divisions who want more.

C. Transfer Pricing
In many decentralized organizations, the output of one division is used as the input of another. As
a result, the value of the transferred good is revenue to the selling division and cost to the buying
division. This value, or internal price, is called the transfer price. In other words, a transfer price
is the price charged for a component by the selling division to the buying division of the same
company.

i. Impact of Transfer Pricing on Divisions and the Firm as a Whole

When one division of a company sells to another division, both divisions as well as the company
as a whole are affected. The price charged for the transferred good affects both:
✓ the costs of the buying division
✓ the revenues of the selling division

Thus, the profits of both divisions, as well as the evaluation and compensation of their managers,
are affected by the transfer price.

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Since profit-based performance measures of the two divisions are affected, transfer pricing often
can be an emotionally charged issue. The above exhibit illustrates the effect of the transfer price
on two divisions of a company. Division A wants the transfer price to be as high as possible while
Division C prefers it to be as low as possible.

ii. Setting Transfer Prices

i. The ideal transfer price allows each division manager to make decisions that maximise the
company’s profit, while attempting to maximise his/her own division’s profit.
ii. Conflicts may arise between the company’s interests and an individual manager’s interests
when transfer-price-based performance measures are used.
iii. Conflicts may be resolved by . . .
a. Direct intervention by top management
b. Centrally established transfer price policies.
c. Negotiated transfer prices
iv. Top management may become swamped with pricing disputes causing division managers to
lose autonomy.

iii. General-Transfer-Pricing Rule

Transfer price = Additional outlay cost per unit incurred because goods are transferred +
Opportunity cost per unit to the organisation because of the transfer

Scenario I: Where No Excess Capacity Exists

The Battery Division makes a standard 12-volt battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
The Battery division is currently selling 300,000 batteries to outsiders at $40.
The Auto Division can use 100,000 of these batteries in its X-7 model.

What is the appropriate transfer price?

Solution
Transfer price = $18 variable cost per battery + $22 Contribution lost if outside sales given up
= $ 40 per battery

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General Rule
When the selling division is operating at capacity, the transfer price should be
set at the market price.

Scenario II: Where Excess Capacity Exists

The Battery Division makes a standard 12-volt battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
The Battery division is currently selling 150,000 batteries to outsiders at $40.
The Auto Division can use 100,000 of these batteries in its X-7 model.
It can purchase them for $38 from an outside supplier.

What is the appropriate transfer price?

Solution
Transfer price = Additional outlay cost per unit incurred because goods are transferred +
Opportunity cost per unit to the organisation because of the transfer
$18 variable cost per battery + $0 = $18 per battery

General Rule
When the selling division is operating below capacity, the minimum transfer price is the variable
cost per unit.
Therefore, the transfer price will be no lower than $18, and no higher than $38.

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iv. Transfer Pricing Policies
Several transfer pricing policies are used in practice, including:
✓ market price
✓ cost-based transfer prices
✓ negotiated transfer prices

v. Transfer Pricing Policies: Market Price

✓ If there is a competitive outside market for the transferred product, then the best transfer
price is the market price.
✓ In such a case, divisional managers’ actions will simultaneously optimize divisional profits
and firm-wide profits.
✓ Furthermore, no division can benefit at the expense of another. In this setting, top
management will not be tempted to intervene.
✓ The market price, if available, is the best approach to transfer pricing.

vi. Transfer Pricing Policies: Cost-Based Transfer Prices

✓ Frequently, there is no good outside market price.
✓ The lack of a market price might occur because the transferred product uses patented
designs owned by the parent company.
✓ Then, a company might use a cost-based transfer pricing approach.
✓ Since a transfer price at cost does not allow for any profit for the selling division, top
management may define cost as ‘‘cost plus, ’’ which allows a certain percentage to be
tacked onto the cost.

vii. Negotiated Transfer Prices: Bargaining Range

When using negotiated transfer prices, a bargaining range exists.
✓ Minimum Transfer Price (Floor): The transfer price that would leave the selling division
no worse off if the good were sold to an internal division than if the good were sold to an
external party. This is sometimes referred to as the ‘‘floor’’ of the bargaining range.
✓ Maximum Transfer Price (Ceiling): The transfer price that would leave the buying division
no worse off if an input were purchased from an internal division than if the same good
were purchased externally. This is sometimes referred to as the ‘‘ceiling’’ of the bargaining
range.

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Calculating Transfer Price

viii. Transfer Pricing: An International Perspective

Since tax rates and import duties are different in different countries, companies have incentives
to set transfer prices that will:

i. Increase revenues in low-tax countries.

ii. Increase costs in high-tax countries.
iii. Reduce cost of goods transferred to high-import-duty countries.

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