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UN
P A U L ’

I VE R S I TY
.
S T
SE R TY
VANT
S OF GO D AND HUMANI

ST. PAUL’S UNIVERSITY

[NELSON KARANJA]

SPU Distance Learning Course Handbook

BAC 200: MANAGEMENT ACCOUNTING

[MARGARET WAITHERA FLORENCE]

SPU Distance & E - Learning Program
© 2016
COURSE OUTLINE
Contact hours:
Pre-requisites:
Purpose: Learners should understand the rationale behind decision making environments,
and various management accounting computations
Expected Learning Outcomes of the Course
By the end of the course unit the learners should be able to:-
i) Describe concepts and methods in management accounting
ii) Explain various elements of costs
iii) Explain the difference between marginal and absorption costing
iv) Explain types of budgets and CVP analysis

Course Content
Introduction to management accounting,
Cost classification and estimation,
Cost forecasting,
Material Costing,
Labour Costing,
Overheads
Budgetary planning and Control
Information for decision making

Teaching / Learning Methodologies: Lectures and tutorials; group discussion;

demonstration;
Individual assignment; Case studies
Instructional Materials and Equipment: Projector; test books; design catalogues; computer
laboratory; design software; simulators
Course Assessment
Examination - 70%; Continuous Assessment Test (CATS) - 20%; Assignments - 10%; Total -
100%
Recommended Text Books:
i) Musgrave R.A and P.B Musgrave (2005), Costing, New York
McGraw Hill
ii) Hyman (2007), management accounting, Cengage Learning ( Thompson )
ACKNOWLEDGEMENT

I sincerely acknowledge permission to illustrate from ACCA and KASNEB papers. I would also
like to thank my family for their valuable contribution, which were an integral section in the
writing of this module.
iv

INSTRUCTION FOR LEARNERS

This module is expected to help distant learners in their independent learning. In addition to that
it is only for the personal use of registered students only, kindly check the copyright clause. This
study pack is divided into various lessons.

At the end of every lesson there is a comprehensive exercise which will equip the learners with
enough skills to handle other questions during the exam period. The student may there after
submit the assignment to the facilitator for review and other necessary recommendations.

SUBMISSION PROCEDURE

1. After you have completed a comprehensive assignment clearly identify each question and
number your pages.

2. If you do not understand a portion of the course content or an assignment question indicate
this in your answer so that your marker can respond to your problem areas. Be as specific
as possible.

3. Arrange the order of your pages by question number and fix them securely to the data
sheet provided. Adequate postage must be affixed to the envelope.

4. While waiting for your assignment to be marked and returned to you, continue to work
through the next two lessons and the corresponding reinforcement problems and
comprehensive assignment
CONTENTS
ACKNOWLEDGMENT .............................................................. Error! Bookmark not defined.
INSTRUCTIONS FOR STUDENTS........................................... Error! Bookmark not defined.
Management Accounting Course Description ............................ Error! Bookmark not defined.
LESSON ONE ............................................................................... Error! Bookmark not defined.
Introduction to management accounting …………………………...…7
LESSON TWO .............................................................................................................................
Cost classification and estimation …………………………………....15
LESSON THREE.............................................................................
Cost estimation and forecasting .............................................................................22
LESSON FOUR.................................................................................
Material Costing ……………………………………………………...28
LESSON FIVE..................................................................................
Labour costing……………………………………………………….38
LESSON SIX...................................................................................
Overhead Costs……………………………………………………..46
LESSON SEVEN …………………………………………………...
Budgetary planning and control……………………………………...67
LESSON EIGHT.............................................................................
Information for decision making……………………………………..71
CONTENTS

MANAGEMENT ACCOUNTING

This module includes a range of topics which are needed to equip the distant learners to
understand the concepts of management accounting in depth.

This requires the devotion of the students prime time to his studies for without this commitment,
the benefit of this material will not be realized. The learners also need to understand the
relevance in cost accounting and management accounting

Distant learners mainly find difficulty because of time given for preparation, and lack of
material, this course overcomes the second cause. It is the responsibility of each individual
learner to overcome the problem.

RECOMMENDED TEXT

Management and Cost Accounting by Colin Drury and N.A. SALEEMI

INTRODUCTION TO MANAGEMENT ACCOUNTING

LESSON ONE

OBJECTIVES
After you have studied this lesson you should be able to:
1. Define and introduce the subject Management Accounting

2. Explain the process of decision making

CONTENTS
1.1 Key definitions
1.2 Attributes of good information
1.3 Role of the Management Accountant in the Management Process
1.4 Decision Making Process
1.5 Decision Making Environment

1.1 Key Definitions

Definition of accounting
Accounting is the process of identifying measuring and communicating economic
information to permit informed judgments and decisions by users of information.
It is therefore concerned with providing information that will help decision makers make
good decisions.

To understand accounting one must understand:

 The attributes of good information

 Process of measuring and communicating information
 The decision making process
 Users of information
 The above points are briefly discussed below:

Users of information
The users of information can be divided into two:

 Internal users who are parties within the organization e.g. the management and the
employees.
 External users who on the other hand, are parties outside the organization e.g. the
shareholder, creditors, government, customers, etc

From the users point of view accounting can be divided into two:
Management Accounting
 This is concerned with provision of information to people within the organization to
help them make better decisions. Management accounting is concerned with the
provision and interpretation of the information required by management at all levels
for the following purposes:
 Formulating the policies of the organization
 Planning the activities of the organization in the long-term, medium-term and short-
term (Strategic to operational planning)
 Controlling the activities of the organization
 Decision-making
 Performance appraisal
 Management accounting can also be said to be concerned with data gathering (both
from internal and external sources), analyzing, processing, interpreting and
communicating the resulting information for use within the organization, so that
management can more effectively plan, make decisions and control operations.

Financial Accounting
This is concerned with the provision of information to external parties outside the
organization. It‘s the process of measuring, classifying, summarizing and reporting financial
information used in making economic decisions. It‘s concerned with the preparation of
financial statements to be used by the firm‘s external stakeholders.

The key differences between Management Accounting (MA) and Financial Accounting (FA)
can be summarized as follows:

MA FA

Users Internal External

Nature Future Historical
Details More detailed Summarized
Legality Not legal Legal
Format Not standard standard

It is important to define cost accounting at this point.

Cost accounting
It‘s the process of cost ascertainment and cost control. It is a formal system of accounting by
means of which cost of product and services are ascertained and controlled.

1.2 Attributes of good information

 Information is anything that is communicated and is sometimes said to be processed
data. It is data processed in such a way as to be of meaning to the person receiving it.
Good information should have the following attribute:
 It should be relevant to a user‘s needs. For the communicator this requires the
following:
 Identifying the user: Information must be suited and sent to the right person i.e. the
person who requires it to do his job.
 Getting the purpose right: It is effective only when it helps the user to make decisions.
 Getting the volume right: Information must be complete for its purpose and should
not omit any necessary item. It should be no greater in volume than the users would
find helpful or be able to take in.
 It should be accurate within the user‘s needs i.e. should be correct and error free.
 It should inspire the user‘s confidence i.e. information should not give the user any
reason to mistrust it, disbelieve it or ignore it by making sure the information is
neutral.
 It should be timely: The information must be readily available within the time period
which makes it useful. It must be at the right place at the right time.
 It must be appropriately communicated: Information will lose its value if it is not
clearly communicated to the users in a suitable format and through a suitable medium.
 It should be cost effective: Good information should not cost more than its worth.
Gathering, storing, retrieving and communicating an item of information may require
expenses in form of time, energy and resources. If the expense is greater than the
potential value of the item, then it should not be communicated.

1.3 Role of the Management Accountant in the Management Process

The management process involves planning, organizing, controlling, directing,
communicating and motivating. We will explain each of these functions:

Planning
Planning is the basic function of the management by means of which the managers decide:
 What goals are to be accomplished
 How they will be accomplished
 Planning gives the manager a warning of possible future crisis and therefore they
avoid the need to make unplanned decisions.
 The management accountant helps to formulate future plans by providing information
to assist in deciding what product to sell, in what market and at what prices and in
evaluating proposals for capital expenditure.
 In the budgeting process the management accountant provides data on past
performance, establishes budget procedures and budget time tables.

Control
 Control involves a comparison of actual performance with the plan so that deviation
from the plan can be identified and corrective action taken.
 It can be defined as the process of compelling events to conform to a plan. The
management accountant aids the control process by providing performance reports
that compare the actual performance with the planned outcome for each responsibility
centre.
 A responsibility centre may be defined as a segment (e.g. a division) of an
organization where an individual manager holds delegated authority and is
responsible for the segments performance.
 The management accountant also draws a manager‘s attention to those specific
activities that do not conform to a plan. This aids the process of Management By
Exception

Organizing
 It is the establishment of the framework within which the required activities are to be
performed and the designation of who should perform these activities. It involves the
establishment of decision units such as departments, sections, branches, etc.
 The management accountant will provide information on the performance of each of
these segments.

Motivation
Motivation involves influencing human behavior so that the participants identify with the
objectives of the organization and makes decisions that are in harmony with these objectives.
Budgets and performance reports produced by management accountants motivate the firm‘s
employees. To be motivating however, targets should be challenging but achievable.

Communication
To communicate means to make known, impart or transmit the information. The
management accountant aids the communication process by installing and maintaining an
effective communication system such as the Management Accounting Information System
(MAIS). An example of a MAIS is the budgetary system.
1.4 Decision Making Process
Decision making is the process of choosing among alternatives. There are 7 steps that should
be followed as shown in figure 1 below:

Figure 1 The decision-making, planning and control process

Figure 1 above represents a diagram of a decision-making model. The first five stages
represent the decision-making of the planning process. Planning involves making choices
between alternatives and is primarily a decision-making activity. The final two stages
represent the control process, which is the process of measuring and correcting actual
performance to ensure that the alternatives that are chosen and the plans for implementing
them are carried out. Let us now consider each of the elements of the decision-making and
control process.
Identifying Objectives
Before good decisions can be made there must be some guiding aim or direction that will
enable the decision-makers to assess the desirability of favouring one course of action over
another. Hence the first stage in the decision-making process should be to specify the
objectives of the organisation.

The Search for Alternative Courses of Action

The second stage of the decision-making model is a search for a range of possible courses of
action (or strategies) that might enable the objectives to be achieved. If the management of a
company concentrates entirely on its present product range and markets, and market shares
and cash flows are allowed to decline, there is a danger that the company will be unable to
generate sufficient cash flows to survive in the future. To maximise future cash flows, it is
essential that management identifies potential opportunities and threats in its current
environment and takes any developments which may occur in the future. In particular, the
company should consider one or more of the following courses of action:

1. Developing new products for sale in existing markets;

2. Developing new products for new markets;
3. Developing new markets for existing products.

The search for alternative courses of action involves the acquisition of information
concerning future opportunities and environments. It is the most difficult and important
stage of the decision-making process. Ideally, firms should consider all alternative courses of
action, but, firms will in practice consider only a few alternatives, with the search process
being localised initially. If this type of routine search activity fails to produce satisfactory
solutions, the search will become more widespread.

Gather Data about Alternatives

When potential areas of activity are identified, management should assess the potential
growth rate of the activities, the ability of the company to establish adequate market shares,
and the cash flows for each alternative activity for various states of nature. Because decision
problems exist in an uncertain environment, it is necessary to consider certain factors that are
outside the decision-maker's control, which may occur for each alternative course of action.
These uncontrollable factors are called states of nature. Some examples of possible states of
nature are economic boom, high inflation, recession, the strength of competition, and so on.

The course of action selected by a firm using the information presented above will commit its
resources for a lengthy period of time, and the overall place of the firm will be affected
within its environment—that is, the products it makes, the markets it operates in and its
ability to meet future changes. Such decisions dictate the firm's long-run possibilities and
hence the type of decisions it can make in the future. These decisions are normally referred
to as long-run possibilities and hence the type of decisions it can make in the future. These
decisions are normally referred to as long-run or strategic decisions. Strategic decisions have
a profound effect on the firm's future position, and it is therefore essential that adequate data
is gathered about the firm's capabilities and the environment in which it operates. Because of
their importance, strategic decisions should be the concern of top management.
Besides strategic or long-term decisions, management must also make decisions that do not
commit the firm's resources for a lengthy period of time. Such decisions are known as short-
term or operating decisions and are normally the concern of lower-level managers. Short-
term decisions are based on the environment of today, the physical, human and financial
resources presently available to the firm.

These are, to a considerable extent, determined by the quality of the firm's long-term
decisions. Examples of short-term decisions include the following:

1. What selling prices should be set for the firm's products?

2. How many units should be produced of each product?
3. What media shall we use for advertising the firm's product?
4. What level of service shall we offer customers in terms of the number of days
required to deliver an order and the after-sales service?

Data must also be gathered for short-term decisions; for example, data on the selling prices of
competitor's products, estimated demand at alternative selling prices, and predicted costs for
different activity levels must be assembled for pricing and output decisions. When the data
has been gathered, management must decide which course of action to take.

Select Appropriate Alternative Courses of Action

In practice, decision-making involves choosing between competing alternative courses of
action and selecting the alternative that best satisfies the objectives of an organization.
Assuming that our objective is to maximize future net cash inflows, the alternative selected
should be based on a comparison of the differences between the cash flows. Consequently,
an incremental analysis of the net cash benefits for each alternative should be applied. The
alternatives are ranked in terms of net cash benefits, and those showing the greatest benefits
are chosen subject to taking into account any qualitative factors. We shall discuss how
incremental cash flows are measured for short-term and long-term decisions and the impact
of qualitative factors.

Implementation of the Decisions

Once alternative courses of action have been selected, they should be implemented as part of
the budgeting process. The budget is a financial plan for implementing the various decisions
that management has made. The budgets for all the various decisions are expressed in terms
of cash inflows and outflows, and sales revenues and expenses. The budgets are merged
together into a single unifying statement of the organization‘s expectations for future periods.
The statement is known as a master budget. The master budget consists of a budgeted profit
and loss account, cash flow statement and balance sheet. The budgeting process
communicates to everyone in the organization the part they are expected to play in
implementing management's decisions.

Comparing Actual and Planned Outcomes and Responding To Divergences from Plan
The final stages in the process outlined in Figure 1 of comparing actual and planned
outcomes and responding to divergences from plan represent the firm's control process. The
managerial function of control consists of the measurement, reporting and subsequent
correction of performance in an attempt to ensure that the firm's objectives and plans are
achieved. In other words, the objective of the control process is to ensure that the work is
done so as to fulfil the original intentions.

To monitor performance, the accountant produces performance reports and presents them to
the appropriate managers who are responsible for implementing the various decisions.
Performance reports consisting of a comparison of actual outcomes (actual costs and
revenues) and planned outcomes (budgeted costs and revenues) should be issued at regular
intervals. Performance reports provide feedback information by comparing planned and
actual outcomes. Such reports should highlight those activities that do not conform to plans,
so that managers can devote their scarce time to focusing on these items. This process
represents the application of management by exception. Effective control requires that
corrective action is taken so that actual outcomes conform to planned outcomes.

1.5 Decision Making Environment

There a four main environment within which decisions can be made. These are:
 Certainty
 Risk
 Fundamental uncertainty
 Competition

 Certainty environment

In this environment complete information is available as to which states of nature will occur.
The decision making process just involves picking the best alternative.

Risk
Risk involves situations or events which may or may not occur but whose probability of
occurrence can be predicted from past records. In this environment, the states of nature are
not certain but probability distribution can be assigned.

Fundamental uncertainty
Uncertain events are those whose outcome cannot be predicted with statistical confidence. In
this environment the states of nature are not known nor are their probability distribution. The
decision making process depends on the risk attitude of the decision maker.

Competition
In this environment the decisions made by the firm are affected by decisions made by other
firms with opposing interests.

Decision Making Under Risk and Uncertainty

Before looking at the various methods of making decisions under risk, we shall look at the
three main risk attitudes that distinguish different decision makers. These are:

Risk seeking

A risk seeker is a decision maker who is interested in the best possible outcome no matter
how small the chance that they may occur i.e. he takes high risks in anticipation of high
profitability. For such a decision maker, the marginal utility for wealth is positive and
increasing.

2. Risk neutral

A decision maker is risk neutral if he is concerned with what will be the most likely outcome
i.e. he is indifferent to risk. For such a decision maker the marginal utility of wealth is
positive and constant.

3. Risk Averse

A decision maker is risk averse, if he acts on the assumption that the worst possible outcome
will occur, and chooses the decision with the least risk possible.
For such a decision maker, the marginal utility of wealth is positive but decreasing.

These risk attitudes can be illustrated by the diagrams below:

i. Risk neutral ii. Risk averse iii. Risk

seeking

utils utils utils

sh sh
sh

REVISION QUESTIONS
1. Define the following terms
a) Cost Accounting
b) Financial Accounting
c) Management accounting

2. Briefly describe the purpose of Cost Accounting.

3. Compare and contrast Cost Accounting and financial Accounting
COST CLASSFICATION AND ESTIMATION

LESSON TWO
OBJECTIVES
After you have studied this lesson you should be able to:
 Explain and discuss basis of Cost classification
 Explain and discuss methods of cost estimation
 Perform computations

CONTENT
2.0 Definition of cost classification and estimation
2.1 Cost classification bases
2.2 The purpose of cost classification
2.3.1Manufacturing and non manufacturing cost
2.3.2 Behavioral classification of costs
2.3.3 Functional Classification of costs:

2 Cost Classifications and Estimation

2.0 Introduction
Cost classification may be defined as ‗the arrangement of cost items in a logical sequence
having regard to their nature and purpose to be fulfilled‘. The term cost must be qualified
when in use in order that its precise meaning is established in a particular situation;
however, cost refers to the amount of resources that have been diverted from other uses or
sacrificed so as to achieve the desired objective. But the term is used to refer to various
aspects of cost, depending on the base of argument that one is approaching the issue from.
Different bases are used in classifying costs, thus giving us several types of costs. We
look at these bases in the following sections.
2.1 Cost Classification bases
Costs can be classified on either one or more of the following bases:
a) Are the costs dependent on the level of output (variable) or are the costs the same
irrespective of the level of output (fixed)?
b) Have the costs already been incurred (sunk) or are they going to be incurred in the
future depending on what we decide (incremental) ?
c) Are they already incurred (sunk/historical) or are the costs due to a benefit
foregone for not taking a certain option (opportunity cost)?
d) Are we in a position to decide not to incur the costs (avoidable) or are we bound
to incur them by authorities we are subject to such as higher managers and the
government (unavoidable)?
e) Are the costs actually incurred (actual) or are they the expected as per the
expenditure guidelines set by the management (standard)?
f) Can we be able to control the costs , for example , by varying the level of output
or by making appropriate decisions (controllable costs) , or are the costs beyond
us because they are fixed or the decisions are made by higher authorities
(uncontrollable)?
g) Can we trace the exact costs incurred to the final product (direct costs) or can we
not, may be only estimate such costs (indirect costs)?
h) What is the function that makes the costs to be incurred in the organization, is it
production, administration or selling and distribution?
i) Is the cost incurred for manufacturing reasons (production cost) or for
manufacturing support reasons (non-manufacturing cost)?
j) How does the cost behave with respect to changes in the output level,
 Does it remain fixed through-out irrespective of the output level
(fixed cost),
 Does it change proportionately with the change in output level
(variable cost),
 Does it remain fixed when output is zero but increases as output
increases from that point onwards (semi-variable); or
 Does the cost remain fixed within certain production bands but change
immediately to another fixed level once the output band changes (a
stepped cost)?

These different bases of cost classification are summarized in the diagram below:
Manufacturing/ Non-manufacturing

Fixed/Variable incremental/sunk

Direct/indirect historic/opportunity

Cost Behaviour
Functional
Classification

Avoidable/unavoidable
Controllable/
Uncontrollable

Standard/actual

In our course, we will always refer to either of these terminologies every now and
then, in different cost accounting situations. You will also meet them extensively in
Management Accounting in the advanced stages of your course, where you will
utilize their distinction to make appropriate profit maximizing management decisions
as well as budgetary planning and control.

Remember, a cost is simply a quantification or measurement of the economic sacrifice

made to achieve a given objective. It is therefore a measurement of the amount of
resources sacrificed in attaining a specified goal.
2.2 purpose of cost classification
Analysis of cost behavior is important to all organizations for effective management.
This is because many organizations have a unique cost structure. For example, fixed
costs account for 60 – 80% of all hospital costs. However, unlike many organizations
of this type, labour costs largely comprise the hospital‘s fixed costs.
Labour costs unlike depreciation require a cash outflow. This is characteristic of
labour intensive organizations. Capital-intensive organizations, on the other hand,
have low labour costs, e.g. computerized manufacturing organizations.
Some organizations e.g. hospitals allocate 10 –15% of their space for standby
emergency events giving them built in idle capacity. This prevents them from
enjoying advantages of higher profits that a capital-intensive organization realizes at
higher volumes beyond the break-even volume. Thus the cost structure of healthcare
institutions presents challenges to accountants because of their labour intensive and
capital-intensive characteristics

2.3.1 Manufacturing vs. Non- Manufacturing costs:

Elements of manufacturing costs:
Manufacturing costs are the costs incurred to produce a product. Remember that a product refers
to both goods and services.
The elements of manufacturing costs are :
 Material costs,
 Labour costs; and
 Overhead costs.
These elements make up the total cost of a product, as shown below:
Total product cost = Material cost + Labour Cost + overhead cost
These costs are discussed further in the following sections.
a) Material costs;
Material refers to all the physical inputs into the production process. They include the
following:
- Raw material refers to bought in material which is used in the manufacture of
the product. According to the organization raw material may further be
classified as steel, timber e.t.c.
- Components and subassemblies i.e. bought in components and
subassemblies which are incorporated in the product
- Work in progress i.e. partly completed assemblies and products incorporating
raw
-
- materials and or subassemblies
- Consumable materials i.e. materials used in the operation of the factory and
during production but do not appear in the product e.g. detergents
- Maintenance materials i.e. materials of all types used in maintaining
machinery, buildings and vehicles e.g. spare parts, lubricating oil and grease
- Office materials; materials used in operation of the office e.g. stationery

 Elements of Non Manufacturing costs

Non-Manufacturing costs are costs incurred by all activities that support the production of
goods and services. They are administration costs, selling costs and distribution costs.
These are explained as follows:
a) Administrative costs: Is the sum of costs associated with the overall management
of the enterprise which cannot be readily identified with one of the major
functional areas e.g. salary of the factory manager would be seen as a production
cost but the salary of the personnel officer will be viewed as administrative cost
since the personnel function does work for all other functions of the enterprise.
b) Selling Costs: Is the sum of costs associated with the securing of orders from
customers? Included in this area will be items such as the salaries paid to the
salesmen and expenditure on advertising.
c) Distribution costs: Is the sum of costs associated with warehousing the products
and their delivery to customer? The cost of wooden pallets on which products are
stacked for delivery to customers and the cost of delivery whether using the
company‘s own vehicles or outside haulage firm are examples of distribution
costs.
d) Finance Costs: These are costs incurred to secure funds to finance the
organization‘s activities. These include interests on loans and overdrafts,
dividends to shareholders, interests on debentures etc
e) Research and development Costs: These are costs that are incurred to invent
new products or to modify the existing ones, as well as costs incurred to acquire
more information on such products.
2.3.2 Behavioral classification of costs

Definition
Cost behavior refers to the change in costs (increase or decrease) as the output level changes,
i.e. as we increase output, are the costs rising, dropping or remaining the same.
Cost Behaviour can be used to produce various classifications of costs such as:
Variable Costs Vs. Fixed Costs
1) Variable costs:
Are costs that increase or decrease proportionately with the level of activity , i.e. that
portion of the cost of an activity that changes with the level of output.

Costs
Variable Costs

0 Activity Level

Note that with variable costs, the cost level is zero when production is zero. The cost
increases in proportion to the increase in the activity level, thus the variable cost
function is represented by a straight line from the origin. The gradient of the function
indicates the variable cost per unit.
2) Semi variable costs
Are costs with both a fixed and variable cost component. The fixed component is that
portion which is constant irrespective of the level of activity. They are variable
within certain activity levels but are fixed within other activity levels, as shown
below:

Costs

Variable cost
Fixed
Cost
Activity Level

Fixed Costs
Are costs that do not change with of the level of output. It is also called autonomous
cost, as it remains the same irrespective of the activity level as shown below.

Costs

Fixed Cost

Activity Level

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

3) Semi Fixed Costs

Are costs with both a fixed and variable cost component. The fixed component is that
portion which is constant irrespective of the level of activity. They are variable within
certain activity levels but are fixed within other activity levels, as shown below:

Costs
Variable component
Semi
Variable cost
Fixed component

Activity Level
a) Direct Vs. Indirect costs
Recall that direct costs are costs that can be traced specifically to the end product of the
production process while indirect costs cannot be so traced.
- Direct costs consist of costs that can be directly attributed to a specific output,
product or level of activity. Direct costs include direct raw materials and direct
labour also called prime costs in aggregate.
PRIME COST = Direct Material Cost + Direct Labour Cost
- Indirect costs are costs that will not be directly attributable to a specific
product. They are regarded as overheads. Identification of overheads to
specific products is done through cost allocation and apportionment. They
include supervisors‘ salaries, rent, electricity, depreciation of building etc.

b) Controllable Vs. Non Controllable costs

Controllable costs can be influenced at the level of authority at which they are being
analysed while non-controllable costs cannot.
- Controllable cost; Refers to the cost which can be influenced by the actions
of a person in whom authority for such control is vested, for example control
of labour cost will be influenced by the method of remuneration and the
degree at management control which is exercised by a certain managers.
- Non controllable cost: is cost which cannot be influenced by a person in
whom authority for such control is vested for example if the trade union
demands an increase in wages the increment is non controllable cost.
Similarly, the depreciation of a building is a non-controllable cost to a
manager as he does not have authority over depreciation!
In decision making, only controllable costs are considered because they can be
changed by the decision maker. There is little or nothing that the decision maker can
do about the non-controllable costs thus they are irrelevant in decision making.
However, the facilities provided by the nun-controllable costs should be efficiently
used.

2.3.3 Functional Classification of costs:

Under this classification, costs are classified according to the function they perform in
an organization. Costs can functionally be classified as:

a) Production costs: Are all the costs incurred in production of units during a time
period e.g. raw material costs, direct labour costs and production overheads.
b) Administration costs: These are all costs incurred in ensuring the smooth running
of the organization so as to facilitate the production and sale of goods and services.
These include: salaries for the managers, salaries for support employees (such as
accountants, clerks and secretaries) etc
c) Selling and distribution costs: These are costs that are incurred to enable the
delivery of products and services to the actual markets and promote or complete a
sale. These costs include: salesmen commission, saleswoman salaries, advertising
costs, depreciation on motor vehicles used by salesmen, the cost of fuel used by
vehicles used for distribution purposes etc.

Test Your Understanding

QUESTION ONE
a) Explain the difference between the following terms
i. Product cost and period cost
ii. Sunk cost and relevant cost
iii. Incremental and sunk costs
iv. Fixed and variable cost
v. Avoidable and unavoidable costs
vi. Controllable and uncontrollable costs
vii. Direct and indirect costs
(14 marks)

b) What is the relevance of cost classification? Is it merely an activity for the

sake of it? Explain (6 marks)
(20 marks)
COST ESTIMATION AND FORECASTING
LESSON THREE
Objectives
After you have studied this lesson you should be able to:
 To understand how to estimate the costs
 To be able to forecast operation cost
Contents
3.0 introduction of cost estimation
3.1 Purpose of Estimation
3.2 Methods of cost estimation
3.3 Regression analysis

3.0 COST ESTIMATION

Introduction:
Cost estimation may be defined as ‗a study which attempts to predict the between costs and
the activity level or cost driver that causes those costs. In practice, managers frequently
encounter such cost drivers (what is a cost driver?) as machine hours, number of transaction,
work cells, labour hours, and units of output e.t.c.
The cost estimating function is
y = a + bx,
Where
Y - Represents Total cost
a - represents cost fixed component of the total cost
bx- represents the variable costs component of the total cost
b- Represents the unit variable cost (this is the gradient of the equation)
x - Represents output level
This is the usual straight line equation you have been encountering in elementary
mathematics.

3.1 Purpose of Estimation

It assists in estimating the future expenditure (cost prediction) as the expenditure will depend
on the cost of the respective activities
a) It assists in determining the net benefits anticipated in a specific activity based on the
relationship between projected costs and projected revenue.
Cost estimation is useful in business planning, cost control, performance evaluation and
decision making.
3.2 Methods of cost estimation
We will consider following cost estimation methods commonly utilized, namely:
a) High Low Activity method
b) Account Analysis
c) Engineering Analysis
d) Visual Fit (Scatter graph) method
e) Simple linear regression analysis
f) Learning curve Theory

a) High – Low method

Here, cost estimation is based on the relationship between past cost and past level of
activity. Variable cost is based on the relationship between costs at the highest level of
activity and the lowest level of activity. The difference in cost between high and low
activity level is taken to be the total variable cost from which the unit variable cost can
be computed by dividing it by the change in output level. This is indicated below:
Total Variable Cost = Cost at high activity level – Cost at low activity level
Therefore,
Unit Variable cost = Variable cost = Cost at high level activity – cost at low level
activity
Output Units Units at high activity level – units at low activity
level

The variable cost per unit so calculated forms the ‗b‘of the straight line equation
mentioned earlier. By substituting ‗ b‘ into the equation, we can obtain ‗a‘, the fixed
cost.

Illustration
Based on performance, you have been provided with the following information regarding
ABC Ltd for the year ended 31 December 2004 :
Labour hours Service cost (Shs)

Highest activity level 800 200,000

Lowest activity level 300 150,000

Required
Develop a total cost function based on the above data using the high-low method.
Solution
Unit Variable cost = Variable cost = Cost at high level activity – cost at low level
activity
Output Units Units at high activity level – units at low activity
level

Variable Cost Per Unit = Shs.200,000 – shs.150,000

800 hrs – 300 hrs

= Shs.50,000 = shs.100/hr
500 hrs
Therefore b = 100
To get the fixed cost a, substitute ‗b‘ into the straight line equation as follows:

When labour hours (x) = 800, service cost (total cost, y) = shs.200,000
Therefore from the Straight Line equation, y = a + b x
200,000 = a + (100) 800
200,000 = a + 80,000
a = 200,000 – 80,000
a = 120,000
Therefore fixed costs = shs.120,000

NB: Even if we used the 2nd set of labour hours and service costs, were would still get he
same answer i.e.

When labour hours (x) = 300, service cost (total cost, y) = Shs.150,000.
Therefore 150,000 = a + 100(300)
a =150,000 – 30,000 = Shs.120,000
Therefore the cost equation is:
y = 120,000 + 100x
This equation can be used to estimate or predict the total costs : for example, when the
activity level is say at 1000 labour hours, then the total cost would be
Y= 120,000 + 1000(100)
=120,000 + 100,000
= Shs.220,000.
b) Account Analysis (Inspection of Accounts)
Using account analysis, the accountant examines and classifies each ledger account as
variable, fixed or mixed. Mixed accounts are broken down into their variable and fixed
components. They base these classifications on experience, inspection of cost behaviour
for several past periods or intuitive feelings of the manager.
Example
Management has estimated Shs.1,090 variable costs, Shs.1,430 fixed costs to make 100 units
using 500 machine hours. Since machine hours drives variable costs in our example, the
variable cost stated as
Then we get the total cost equation as
Y = ,1430 +2.18 x
Where y = total cost
x = number of machine hours
For 550 machine hours
Total cost = Shs.1,430 + Shs. 2.18 (550) = 1,430 + 1,999 = Shs.2,629
This analysis should determine whether any factors apart from output machine hours are
influencing total cost.
A danger in using this method lies in the fact that many managers may assume a cost‘s
behaviour without further analysis. This is because the method is highly subjective.

c) Engineering method
This method is based on a detailed study of each operation where careful specification is
made for materials, labour and equipment necessary to produce a product. It involves
identifying the level of input required of an activity in form of raw material and labour
while total cost is based on the cost of each input. This approach is applicable where no
past data exists. The main setback of the approach is that it requires a complex analysis of
all the constituents of an activity and the requirements of an activity in terms of costs
detailed into materials, labour, overheads and time.
d) Visual fit (scatter graph method)
Cost estimation is based on past data regarding the dependent variable and the cost driver.
The past data on cost levels and the output levels) is plotted on a graph( called a scatter
graph )and a line of best fit is drawn as shown in the diagram . A line of best fit is a line
drawn so as to cover the most points possible on a scatter graph. Its intersection with the
vertical axis indicates the fixed cost while the gradient indicates the variable cost per unit.
Illustration:
Assume a firm has total costs of 8m, 4m and 1m respectively when the output units are
400,000, 200,000 and
respectively. Estimate its cost equation using the visual fit method.

10
9
Dependant 8 X
Variable 7 X X X
(Total Cost) 6 X X X
5 X X X X X
4 X
3 X X X X X
2 X X

1m X

X2 X3
0 200,000 400,000
Independent Variable
(Output Level)
 Fixed Cost  X 1
 0 m

Note :  Change in Y
 Gradient   Y3 - Y2  Variable Cost Per Unit
 Change in X X3 X2

Variable cost = Change in cost = 8m – 4m = 20

Per unit Change in activity level 400,000 – 200,000

 Total cost equation y = 1m + 20 x

On the basis of the existing data, fixed cost is Shs 1m and the variable cost per unit is 20. On
the basis of the developed model, estimates can be made regarding future cost. When the
activity level is 600,000 units, total cost will be estimated as:
TC = 1M + 20 (600,000) = 1M + 12M = 13 M
e) Regression analysis
It involves estimating the cost function using past data or the dependent and the
independent variables. The cost function is based on the regression of the relevant
variables. The cost function will depend on the relationship between the dependant
variable and the independent variable. The dependent variable will constitute the
relevant cost which may be service, variable cost, overhead cost e.t.c. The independent
variable will be the cost drivers where the cost drivers will be labour hours, units of
labour or raw materials, units of output e.t.c.
In regression analysis, a regression model of the form y= a + bx for a simple regression is
obtained. For a multiple regression, a regression model of the form Y = a + b1x1 +b2x2 +
bnxn is obtained
Where a is fixed cost, x1,x2,xn are cost drivers x1,x2,x3 upto xn.
b1,b2 bn are changes in cost with the change in value of cost driver i.e. variable cost per
unit of change in x1,x2,xn
y is the dependant variable (Total cost)
Note that a simple regression produces a cost function of the form y = a + bx so that we only
have only one variable cost per unit (b) and only one independent variable (cost driver) x..
However, a multiple regression produces a cost function of the form
y = a + b1,x1+ b2, x2 + bn,xn so that we have several variable costs per
unit (b1,b2,bn) and several independent variables (x1,x2,xn)

REVISION QUESTIONS
QUESTION ONE
b) Explain the difference between the following terms
i. Product cost and period cost
ii. Sunk cost and relevant cost
iii. Incremental and sunk costs
iv. Fixed and variable cost
v. Avoidable and unavoidable costs
vi. Controllable and uncontrollable costs
vii. Direct and indirect costs

QUESTION TWO
Discuss the behavioural classification of costs, explaining all the terms
used therein. (20 marks)

QUESTION THREE
Discuss in detail what constitutes manufacturing costs as production costs, administration
costs as well asselling and administration costs. (20
marks)
MATERIAL COSTING

LESSON FOUR
Objectives
After you have studied this lesson you should be able to:
 To understand types of material costs
 To be able to compute material issues costs
Contents
4.0 Ascertainment of material cost
4.1 Material cost control
4.2 Inventory Control and Management
4.3 Stock Level and its control
4.4 Valuation of inventory (Issues and closing stocks)

Introduction
4.0 Ascertainment of material cost
Materials refer to the tangible inputs into the process of producing useful output. They could
be direct materials or indirect materials (overheads) e.g. to produce tea, tealeaves is the
material (input).
Material cost classification
Material costs may be classified as:
a) Direct Material Cost: Refers to costs of materials that may readily be identified with
output units. The cost of timber used in the manufacture of a chair is an example of a
direct material.
b) Indirect Material cost: refers to items of raw materials for which it would be
difficult and or inefficient to attempt to charge directly to specific cost units. For
example the glue used to bind the joints in the assembly of a chair
Other examples of indirect materials include:
- Materials used by service departments e.g. spare parts used by maintenance
department in repairing and servicing plant and machinery
- Materials used by non production functions e.g. stationary used in accounting
department

4.1 Material cost control

Materials form a significant cost of output units and therefore should be controlled. Material
Control is more than simply recording the accounting transactions relating to material cost.
Control should be implemented to ensure that material is available
a) In appropriate quantities
b) In appropriate quality
c) In appropriate location
d) At an appropriate time
e) At the most economic cost

Control may be exercised at a number of points in the business cycle as follows

a) When the choice is made as to the type and quality of material to be used
b) Where the purchase order is being placed with the chosen supplier
c) On receipt of the material from supplier, check the appropriateness of quality and
quantity of materials received.
d) Where the material is held in store before use: It must be safe from theft and damage
e) Where the material is issued from the store: It must be issued to the correct
department
f) Where the material is being used for intended purposes e.g. the material must be
utilized to produce the desired output.

The material control system must attempt to ensure that the company does not incur costs in
excess of an agreed efficient level of expenditure. Lack of adequate control routines will
result in the incidence of costs in excess of an acceptable level, reduced profitability of
production and increased operational costs.
4.2 Inventory Control and Management
The objectives of inventory management are
 To ensure adequate stocks to allow for continuous operations/production, and
 To minimize the cost of having inventory.

Inventory management is important since in most organizations it represents the largest single
investment. The major types of inventory are:
 Raw materials
 Work in progress
 Finished goods

To achieve the above objectives of material cost costing , the manger has to make decisions
regarding the following:
a) How to determine commodities to stock
 Use Material Requirement Planning
From the Master Production Schedule, the manager has determined the products to be
produced. A Bill of Materials can then be prepared. This lists in descending order the
components required to make the final product. The information required includes
part name or description, part number, next higher level assembly, required quality
per end item, quantity per end item and quantity required for the next higher level
assembly.

Stores Ledger Account is also used to obtain information on what is currently

available. The file shows balance on hand as well as past data on how much is
usually ordered, lead-time, and safety stock.
From the above the manager can determine what need to be purchased.
b) How much quantity to stock
 Use The Economic Order Quantity Model
This is a simple model that helps the manager to determine the optimum quantity of
stock to order so as to keep total costs at a minimum. The main costs of inventory
are:
 Holding or carrying costs
 Ordering or set up costs
 Shortage costs
To determine the economic order quantity the following formula may be used:
2 DC O
EOQ 
Ch

Where D is the annual demand (knits)

Co is the cost of making one order
Ch is the holding cost per unit per annum

 Use Pareto Analysis

Items are classified into three classes as follows:
Class A: These are high cost, fast moving and high usage items. They are few
accounting for only 20 percent of the total number of items yet account for
80 percent of the total inventory budget.
Class B: These are medium moving goods. They account for 15 percent of the total
number of the budget
Class C: These are slow moving low value items. They are very many accounting
for 65 percent of the total number of items and only 5 percent of the total
inventory budget.
c) Determining When to stock
This will be influence by the inventory system in place as follows:
 Periodic order system.
The firm receives a new order of the amount specified by the order quantity at equal
intervals of time. The firm determines the maximum and minimum inventory, the
safety stock and the reorder level.
 Continuous Review System
The firm places orders at regular intervals but the order quantity varies according to
how much a firm requires bringing the level to some predetermined size or value.
 Just In Time Inventory System
This is a concept developed by the Japanese and advocates zero inventory and stockless
production. In addition, it calls for 100 per cent quality. Some of the major features of JIT
include:
a) Frequent and reliable deliveries to avoid inventory build up. Companies are also
setting delivery dates with penalties for not meeting them.
b) Closer location to suppliers and customers
c) Improved communication between companies and suppliers through the use of
computerized purchasing systems that allows for online ordering.
d) Single sourcing and building long-term relations with a few trusted suppliers.

e) Increased supplier involvement in the design aspects of a product to ensure that

they meet the company‘s quality requirements.
f) Maintenance of strict quality control by all parties.
Material Handling
The objective is to ensure that goods are delivered to the right places at the right time and in
aright manner to avoid delays, congestion and unnecessary handling. A big percentage of
production costs is taken up by material handling activities. A good material handling system
should minimize these costs.

The manger needs to determine the type of equipment to be used to handle the material. The
type of equipment that is most frequently used includes:
 Cranes
 Lifts
 Trucks
 Conveyors
 Towing
The factors that influence the type of equipment used includes:
 Type of materials being moved
 Volume
 Rate or frequency of movement
 Route of movement speed required
 Method of storage employed
 Safety or hazards involved.

Storage and Issue of Material

A number of factors are relevant in control of materials during storage and issue of materials.
They are:
a) Stores location and layout
b) Stock level and its control.
c) Stock control records and issue procedures
d) Stock taking procedures
e) Valuation of inventories (issues and closing stock)

Stores location and layout

The layout of stores should ensure
a) Ease of access for movement of material in and out of stores
b) The issue of perishable materials on a first in first out basis
c) The segregation of toxic and dangerous materials in a separate location
d) Security of materials by restriction of access to authorized personnel only

The location of stores should ensure

a) Nearness to point of use to minimize expenditure on handling costs
b) Specialist stores e.g. spare parts for machinery should be located close to the point of
use.

4.3 Stock Level and its control

Management must make decisions about the control of stock levels with a view to
minimizing the cost of the company while achieving more efficiency in the availability of
material to fulfill planned usage requirements. Consideration should be given to the following
control levels:
a) Minimum stock level
b) Maximum stock level
c) Re-order level
d) Re order quantity (Note the re-order quantity is not necessary the EOQ)

a) Minimum stock level

This is the level below which stock should not fall. It is essentially a base (buffer) stock
level. If stock falls below this point, there is a danger of stock out.
Minimum stock level = Reorder level – (Normal consumption x normal reorder period)
b) Maximum stock level
This is the upper limit above which stock should not be allowed to rise. Each material to
be kept in store must have a maximum level and stock should not be allowed to go
beyond this level
Maximum stock level = Re-order level +re-order Quantity - (Minimum consumption x
minimum re-order period)
c) Re-order level
Is a point that lies between minimum and maximum stock levels at which purchase orders
must be placed to ensure that goods ordered are received before the minimum stock level
is reached? It is the level of stocks at which replenishment must be made to avoid a stock-
out.
Re-order level = maximum consumption X maximum re-order period
d) Re-Order quantity
This is the quantity of stock ordered once the re-order point is reached. The quantity is
such as to minimize stock costs taking into consideration the cost of holding stocks and
making an order. This is also regarded as the Economic Order Quantity (EOQ). It is
computed as follows:
Where D is the annual demand (knits)
Co is the cost of making one order
Ch is the holding cost per unit per annum
2 DC O
EOQ 
Ch

Economic Order Quality (EOQ)

Define the EOQ model and the three methods of computing EOQ.
- Assumptions of the model.

Illustration

The following information was extracted from the books of Danex Holdings regarding its
stocks:
i. Reorder quantity 1,800
ii. Reorder period 4 weeks
iii. Maximum consumption 450 units/week
iv. Normal consumption 300 units/week
v. Minimum consumption 150 units/week
Vi Maximum reorder period 5 weeks
Vii Minimum reorder period 3 weeks

Required
Determine the following stock levels for Danex Holdings:
i. Re-order level
ii. Maximum stock level
iii. Minimum stock level
Solution
i) Re-order level = Maximum consumption X maximum reorder period
= 450 units X 5 weeks = 2,250 units
ii) Maximum stock level = reorder level + reorder quantity-

(Minimum consumption X minimum reorder period)

= 2250 + 1800 – (150 X3) = 4050 – 450 = 3600 units

iii) Minimum stock level = Reorder level – (Normal consumption X

Normal reorder period)

= 2,250 – (300 X 4) = 2250 – 1200 = 1050 units

Economic Order Quantity (EOQ):

It constitutes the quantity purchased of either stocks or raw materials that is considered most
optimum. This is the quantity that minimizes both holding costs and ordering costs, As the
quantity of purchase increases there is a reduction in ordering costs, but an increase in holding
costs as illustrated in the graph below:

Total cost
Ordering costs Total cost

Holding Costs Holding costs

Ordering costs

0 Qx Quantity of
Inventory
Qx represents the EOQ where the aggregate stock cost is lowest
Total cost = Total ordering costs + Total holding costs
Total ordering costs = cost per order X no of orders in a period
Total holding cost = average stock quantity X holding cost per unit
4.4 Valuation of inventory (Issues and closing stocks)
Valuation of inventory aims at attaching a monetary value in the stores or issued for
production. This is useful in producing. State costing the output and pricing
production, as well as decision making
Methods used in valuing inventory:
a) First In First Out
b) Last In Last Out
c) Weighted Average method
First in First out (FIFO)
This method is based on the assumption that stock purchased first is issued first. Prices of
stock purchased first are used to determine the cost or value of inventory issued. Closing
stocks are carried at the latest costs.
Advantages
1. It is a realistic system: oldest items are usually issued first out.
2. Unrealized profits or losses do not arise
3. It is easy to calculate if prices of materials don‘t fluctuate
4. Closing stocks values reflect the latest costs thus tend to reflect the current market values.
5. It is acceptable to many tax authorities and is also consistent with accounting practices
e.g. IAS/IFRS.
Disadvantages
1. It involves tedious calculations if the price of materials fluctuate from time to time
2. Product costs, based on the oldest material prices, lag behind current conditions especially
in inflationary markets.
3. Comparison of one job with another may be difficult if materials are issued at different
prices.

Last in first out (LIFO)

Is based on the assumption that the stock purchased last is issued first. Stock valuation
should therefore be based on the prices ruling on the acquisition of the last stocks.

Advantages
1. Product costs tend to be based on current market prices and is therefore realistic
2. A charge to production is as closely related to current price levels as possible
Disadvantages
1. Stocks are valued at the oldest prices.
2. It involves tedious calculations if the price of materials fluctuate from time to time
3. Comparison of one job with another may be unfair and difficult
Weighted average method
i. This method is a perpetual weighted average system where the issue price is recalculated
after each receipt of stocks taking into account both quantities and money vale of the
stocks received.
In this case stock used or unused is based on the average price per unit where the average
price per unit is calculated as follows:
= Total value of stocks = Average Price Per Unit
No. of units of stock

= (Money value of old stocks + Money Value of New Stocks)

(Quantity of old stocks + Quantity of New Stocks)

Illustration
Assume the following purchases were made in ABC Ltd
Date of purchase Units purchased Price/unit
1st January 500 100
2nd January 600 200
3rd January 800 400
Units used on 4th January are 900. Determine the value/cost of units used by using FIFO,
LIFO and weighted average.

Required:
Determine the cost of units used and the value of the closing stocks using FIFO, LIFO and
Weighted Average.

Solution
1. FIFO
Cost of units used
Date Units Unit price Total cost
Jan 1 500 100 50,000
Jan 2 400 200 80,000
900 Cost of units used 130,000

Closing stock is valued as

Jan 2 200 units x 200 shillings = 40,000
Jan 3 800 units x 400 shillings = 320,000
1,000 360,000

2. LIFO
Cost of units used
Date Units Unit price Total cost
Jan 3 800 400 320,000
Jan 2 100 200 20,000
900 Cost of units used 340,000

Closing stock is valued as

Date Units Unit price Total cost
Jan 2 500 200 100,000
Jan 1 500 100 50,000
1,000 Value of closing stocks 150,000

3. Weighted average
Date Units Unit price Total Cost of Issues

0 – 0 900 257.8 232,105.20

Closing Stock Valuation = (Goods Available – Goods Issued) x Unit Price =

500 (100)  600 (200)  800 (400) 490,000

Unit Price =   257.8
1 , 900 1,900

REVISION QUESTIONS
Question One
a) What is the Economic Order Quantity? (3 marks)
b) What are the assumptions of the EOQ Model? (5 marks)

2)A company uses 50,000 rings per annum, which cost Sh.100 each. The ordering and
handling costs are Sh.1,500 per order and carrying costs are 15% per annum of costs i.e. it
costs Sh.15 per annum (15% x 100) to carry a ring in stock.

Required
Determine the EOQ using the following methods.
a) Tabular method (4 marks)
b) Graphical method (4 marks)
c) Algebraic formula method (4 marks)
(Total: 20 marks)

Maajabu Limited wishes to achieve excellent stock management so as to achieve a

marvelous profit this year. Its management estimates the demand for its products to be
1000 units per annum, with a purchase price of shs.10 per unit, a holding cost of shs.0.75
per unit and ordering cot of shs.15 per order. The supplier of the stocks has presented
Maajabu Limited with the following range of prices of the stocks:

Quantity Price Per

Order size (in units) Discount Unit (Shs)
(%)
0 – 99 0 10
100 – 199 1 9.90
200 – 399 2 9.80
400 – 599 4 9.60
600 – 799 5 9.50
800 – 899 5 9.50
900 – 999 5.5 9.45

Due to its storage capacity, the company can only purchase an amount of up to 600 units.
Currently, the company is purchasing at optimum stock quantity to enable it achieve its
objectives. The management is considering whether to shift from the current stock purchase
policy to purchase the maximum stocks.
Required
a) Calculate the current EOQ in units. (4 marks)
b) Determine the total costs of stocks that arise due to the EOQ purchased (include the discount
opportunity costs). (6 marks)
c) Advise the company whether it should change its policy. (10 marks)
(Total: 20 marks)
LABOUR COSTING

LESSON FIVE
OBJECTIVES
After you have studied this lesson you should be able to:
 To be able to compute labour costs
 To be able explain various remuneration methods

Contents
5.0 Definition of labour costs
5.1 Classification of labour costs
5.2 Methods of labour remuneration
5.3 Wages department
5.4 Accounting for labour costs

LABOUR COSTS
5.0 DEFINITION
Labour costs refer to all the costs incurred in compensating the human resources
employed to provide a useful service in the production process. This compensation
usually comes in the form of:
 Basic salary
 Wages
 Overtime pay
 Bonus
 Allowances

5.1 CLASSIFICATION OF LABOUR COSTS

It can be classified into
a) Direct or indirect cost
b) Fixed or variable cost
c) Controllable and non controllable cost

a) Direct labour cost may be defined as the cost of remuneration for employee‘s efforts
and skills applied directly to a product or saleable service and which can be identified
separately in product costs.
Indirect labour cost may be defined as labour costs, which are not charged directly
to a product.
The analysis of labour costs into direct or indirect cost depends upon the
circumstances under review

Examples include-
The wage paid to a worker who assembles components for a product is a direct cost
while that paid to a worker who is moving components for a range of products from
one part of the factory to another is an indirect cost.
b) Fixed cost in relation to labour is where by an employee is paid a fixed weekly wage
irrespective of the output produced cost varies directly with level of activity, for
example where wages are paid at a rater per unit.
c) Variable Labour Cost varies directly with level of activity, for example where
wages are paid per unit.
d) Controllable labour cost is a cost, which can be influenced by the actions of a person
in whom authority for such control is vested. The control of labour costs will be
influenced by the method of remuneration and the degree of management control,
which is exercised.
Uncontrollable labour costs cannot be influenced by an officer in the organization, for
example, wage rise agitated by the trade union is an uncontrollable labour cost.
Time Keeping
A labour cost control routine should ensure that payments are paid only to employees
who have spent time at the work place and that payments are at agreed rates of pay
including overtime premium and shift premium payments where relevant.
Where an employee is paid a fixed sum for an agreed length of working week, it may be
decided by a check by the supervisor that the employee is at work is all that is necessary.
Where the employee is being paid at the rate per hour for the time spent at work together with
premium rates for overtime work, it is likely that a detailed record of time spent on the
premises is required. This is done by having the employee to register his arrival and departure
times.
Time analysis
This is usually achieved by having the employee complete a daily or weekly timesheet or by
having job cards or piecework tickets. Where time sheets are issued, the employee records the
time analysis stating how much time was spent on each job and recording idle time. This
sheet will then be authorized by the supervisor. Job cards move with a job as it passes from
one employee to another. There may be time clocks at each work center where the time spent
on the job is recorded. Where this routine is used, employees may also be required to clock
idle time on an idle time card, which will be analyzed to determine the cause of idle time.
Where payments are made in return for out put units, piecework tickets may be completed
which are signed by the supervisor certifying the number of units claimed. The analysis of
employee time will facilitate:
a) Correct charge of direct labour cost to each job
b) Correct charge of indirect labour cost to cost centers
c) Control of labour costs by job and cost center
d) Calculation of employee bonus
e) Measurement of efficiency

5.2 Methods of Labour Remuneration

Labour remuneration methods can be broadly classified into two:
i. Time rate (on the basis of the time spent in the factory)
ii. Piece Rate (On the basis of work done)
Most of the remuneration methods are a combination of or modification of these 2
systems

Time Rate System

May be a flat time rate or a high day rate
Under flat time rate, each worker is paid for the time spent without considering the volume of
production during that period
This may be paid daily, hourly or monthly basis as follows:
Total Pay = Hours worked X rater per hour
Under the high day rate system the workers time rate is fixed at a higher level than the usual
rate of payment if the output exceeds the expected (usually set) level. The objective of this
system is to provide an incentive to the workers while retaining the simplicity of the system.
It is most appropriate for easily measurable output to which groups of workers contribute e.g.
car assembly lines.
Piece Rate System
An employee is paid a fixed amount for each unit produced irrespective of time taken; the
wages payable are calculated as follows:
Wages = Number of units produced X Rate per unit
In this case, there is a flat rate per unit. However, a company may modify this and apply the
Taylor‘s differential price rate system where three piece rates are set for each job: the low,
normal higher piece rate. The low piece rate is applicable where a worker is not able to
achieve the standard (normal) output and the highest piece rate is for those above standard. If
it does not guarantee minimum wages on time basis, this may lead to high wage differential
in the company and consequently demotivation. For this reason, the differential price rate
system as well as many variations of the piece rate system contain a minimum (guaranteed)
pay.
Premium Bonus Schemes
Illustration 1
Under a premium bonus scheme, workers received a guaranteed basic hourly minimum rate of
pay plus a bonus of 50% of the time saved. No payment is paid beyond the time allowed but the
bonus which is paid at the basic hourly rate is applicable to the accepted output only. No penalty
is imposed on rejected output. The following details are available for the month of January 2003
Worker A B C
Time allowed per unit (hrs) ¼ 1/6 ½
Units produced 474 684 175
Units rejected 54 84 25
Time taken (hrs) 78 72 80
Basic Pay per hour (Kshs) 6 6 3

Required
From the above information calculate for each employee
a) Bonus hours and amount of bonus paid
b) Gross wages earned
c) Labour cost for each good unit sold

Solution
Worker A
Total time saved = Expected time – Time taken
= ¼ (474 – 54) – 78 = 1/4/ X 420 – 78
= 105 – 78 = 27 hours

Accepted time saved = 50/100 x 27 = 13.5 hrs

Therefore bonus hours = 13.5 hours
Bonus pay = 13.5 x 6 = Shs. 81

Worker B
= 1/8 (684 – 84) = Shs 100
Time saved = 100 – 72 = 28 hours
Bonus hours = 28/100 X 50 = 14 hours
Bonus pay = 14 x 6 = Shs 84

Worker C
= ½ (175 – 25) = 150/2 = 75 hours
Time saved = 75 – 80 = - 5
Bonus hours =0
Gross Wages = Regular wage by Bonus
A B C
Time allowed per unit ¼ 1/6 ½
Regular pay 78 x 6 72 x 6 75 x 3
= 468 = 432 = 225
Bonus pay
81 84 0
549 516 225
Good units
A B C
474 – 54 684 – 84 175 – 25
Good units = 420 = 600 = 150
Labour cost per unit of output 549 516 225
420 600 150
= 1.30 =0.86 =1.5

Illustration 2
Based on the data below you are required to calculate the remuneration of each employee as
determined by each of the following methods
i. Hourly rate
ii. Basic piece rate
iii. Individual bonus scheme where the employee receives the bonus in proportion of
the time saved to time allowed

Name of employee Salmon Roala Pike

Units produced 270 200 220
Time allowed in minutes per unit 10 15 12
Time taken (hours) 40 38 36
Rate per hour (Kshs) 125 105 120
Rater per unit (Kshs) 20 25 24

Solution
Salmon Roala Pike
i. Hourly rate 40 x 125 38 x 105 16 x 120
= 5000 = 3990 = 4320

ii. Piece rate Salmon Roala Pike

Gross wage 270 x 20 200 x 25 220 x 24
Therefore regular wage = 5,400 = 5,000 = 5,280
iii. Bonus scheme Salmon Roala Pike
Time saved
Time allowed (270x100)/60 (200x15)/60 (220 x12)/60
= 45 hours = 50 hours = 44 hours
Time taken 40 hours 37 hours 36 hours
5 hours 12 hours 8 hours

Bonus time = Time taken x total time saved

Time allowed

Salmon Roala Pike

40 38 36
x 5 x 12 x 8
45 50 44
= 4.4 = 9.12 = 6.55
► Bonus Pay 4.4x125 = 550 9.12x105 = 958 6.55x120= 786
► Total pay
= Gross pay + Bonus 5,000 + 550 3990 +958 4320 + 786
Using hourly rate = 5550 = 5958 = 6066

Group Bonus Plan

There are certain jobs or operations which require to be done collectively by a group of
workers, for example, continuous production work flows in a sequence or in assembly work
of computers, radio, televisions e.t.c A team of workers is engaged in various operations and
as such it becomes necessary to introduce bonus schemes for collective efficiency of the
group as a whole and the intention is to create a collective interest in the work. In this case,
the bonus is shared among the members. The proportionate share may depend on a number of
factors, for example, the level of employee in management structure, the department in which
the employee falls, his current salary e.t.c.
Benefits associated with group bonus schemes include
i. It encourages cooperation and teamwork among workers
ii. It reduces absenteeism since an absent worker is found to reduce the group
earnings and the group may dislike him
iii. The approach reduces supervision time and cost, thus it is administratively
much simpler.
iv. It greatly reduces the number of rates to be negotiated.
v. It may encourage flexible working arrangements within the group.

But it suffers the following setbacks

(i) It may not provide a strong incentive to the individual workers, as it is
group based.
(ii) Less hardworking group members are similarly rewarded as the very
hardworking ones: this may cause demotivation in the group.
(iii) It is hard to determine each group members‘ fair, have of the bonus.

Co-ownership incentive scheme (Profit Sharing Schemes)

The organization allows for ownership whereby the employees are allowed to own a
percentage of the shares in the firm and therefore, have in the company‘s profits. This
converts employees from mere salary seekers to individuals who are part of the
organization. They will be directly affected by the decisions taken in the firm in form of
changes in earnings per share and dividends per share. The company may offer financial
assistance in form of security, guarantees or loan if possible

REVISION QUESTIONS
Sannet Products Ltd who manufactures and retails products A, B and C employ sixty direct
workers who work under a group of bonus scheme. The company engages three grades of
workers who are paid a bonus of the excess of time allowed over time taken. The bonus paid is
75% of the workers‘ base rate and is shared by the workers in proportion to the time spent on the
work. The following production data has been extracted from the company‘s records for April
2000.

Product Units produced Time allowed per unit

A 320 63
A 640 120
C 1200 100

Grade of worker Number of Base rate per Hours worked

direct workers hour (sh) per worker
1 20 30 30
2 8 27 64
3 32 24 50

Required:
a) Percentage of hours saved to hours taken. (6 marks)
b) Bonus due to the group. (7 marks)
c) Gross earnings due to the group. (7 marks)
(Total: 20 marks)

OVERHEAD COSTS

Lesson six
Objectives
After you have studied this lesson you should be able to:
 Be able to compute overhead costs of an organization
 To be able to apportion overheads to various departments
Contents
6.0 Introduction of overheads
6.1 Overhead cost classification
6.2 Purposes of overhead cost analysis
6.3 Terms used in overheads costing
6.3.1 Terms used in overheads costing
6.3.2 Allocation and Apportionment of Overhead Costs
6.3.3 over and under absorption of production overhead costs
6.4 Activity Based Costing (ABC)
6.0 Introduction
Overhead costs may be defined as the total cost of indirect materials, indirect labour
and indirect expenses. They may occur or be charged to:
a) Production cost centers i.e. making, finishing and packing departments.
b) Service costs centers for example maintenance and power generation
c) Other non production cost centers for example administration, selling and
distribution
In this section, we will look at how these overhead costs are changed to production
and non-production departments so as to determine the total cost incurred by every
department in the organization.

6.1 Overhead cost classification and analysis

Overhead costs may be analyzed into
a) That which may be directly identifiable with a single cost center, for example,
wages paid to indirect workers who work solely in one cost center such as making
department.
b) That which is incurred as a single figure and is then shared amongst cost centers
which make use of it, for example, the rates payable to the local authority
c) The total cost of a service department, for example, maintenance department will
have various costs charged to it for material, labor and other expenses.

6.2 Purposes of overhead cost analysis

There are a number of situations in which the analysis of overhead costs will assist in the
satisfactory evaluation of the relevant cost data. These include:

a) The control of overhead expenditures

There must be a link between overhead cost and the manager responsible for its
control. This is best achieved by having the planned level of overhead costs for each
cost center compared to the actual cost incurred in order that any differences may be
investigated and corrective measures taken.
b) Charging of overheads to cost units
As products pass from one cost center to another in the production cycle, direct costs
for material and labour are charged to them. In addition, each product or job should
share a part of indirect costs of the business. This may be done by assessing the
benefits extracted from each cost center through which the product or job passes and
then choosing a suitable absorption basis
c) Valuation of work in progress
At any point in time, there may be partly completed goods in the production cycle.
Such work in progress must be valued at the end of an accounting period in order that
profit be calculated and a balance sheet arrived at. This may be achieved by the
absorption of production overheads in each cost center.
d) Valuation of abnormal losses
This is a similar procedure to that for work in progress. Such losses also need to be

charged to the departments that incur them for efficiency analysis purposes.

e) Profit measurement
The valuation of work in progress and finished goods stock will affect the profit
reported. The basis on which production overhead has been absorbed by cost units
will therefore have a direct influence on the level of profit reported during the period.
f) Decision making
It is vital that relevant costs are used in any decision making situation. Production
overhead costs may be allocated to a department (cost center) or apportioned to it
using some arbitrary apportionment basis. In addition overhead cost may be a fixed or
variable behaviour pattern as activity changes. The total costs associated with cost
centre and the organization as a whole affect the kind of decisions made by the
management. But such relevant costs need to be incremental (making a difference)
and future costs (not sunk costs) that are controllable (not uncontrollable) by
management.

Absorption Costing
The process described in this lesson by which total overheads are absorbed into production
naturally enough is known as absorption costing. The absorption of total overheads into
product costs has implications for performance measurement, cost control and stock valuation
and students should be aware that the process described is subject to criticism by some
managers and accountants.
The criticism arises from the fact that overheads contain items, known as fixed costs – which
do not change when the activity level changes and which would still have to be paid if there
was no activity, e.g. rates – and items, known as variable costs, which vary more or less
directly with activity, e.g. power consumption. To overcome some of the difficulties, an
alternative method of costing has been developed, known as marginal costing, which,
although using the process of absorption, excludes fixed costs from the absorption process.

6.3.1 Terms used in overheads costing

Stage 1. Cost Elements
The raw data relating to Labour, Materials, Expenses are gathered from Invoices,
Payroll, Goods Issued Notes and Requisitions.
Stage 2. Coding
All the raw cost data needs to be classified and then coded in respect of the type of
expense and location. This process is fundamental to all costing and management
accounting procedures.
Stage 3. Cost Analysis
Where discrete items of cost can be allotted to cost centers this is termed
allocation. Where the cost has to be spread or shared over several cost centers this
is known as apportionment.
Stage 4. Service Cost Centres
These are cost centers which provide a service to production cost centers.
Examples are Maintenance, Sores and Boiler House. Their costs are built up by
the usual process of allocation and primary apportionment and then their total
costs are apportioned (secondary apportionment) over the production cost centers,
thus forming part of production overheads which are absorbed into the cost units
produced. The problems of service cost centers are dealt with in more detail
below.
Stage 5. Production Cost Centres
These are the cost centers involved directly in the production process. Typical
examples are, the Assembly shop, Drilling machines, Centre lathes, Spray Shop.
Stage 6 Overhead Absorption
The overheads of each production cost centre are absorbed into the costs of the
units produced, usually in proportion to the time involved, i.e. by the Labour Hour
or Machine Hour Rate.

Service Cost Centres

Because no production cost units pass through the service cost centers, it is necessary to
apportion the service department costs, to the production cost centers so that all production
costs (including those for the servicing departments) are absorbed into production. Typical
basis for secondary apportionment, i.e. the apportionment of service costs to production
departments are given below:

Service Department Possible basis of Apportionment to

Production Cost Centres

Maintenance Maintenance Labour Hours

Maintenance Wages
Plant value

Stores Number of Requisitions

Weight of Materials issued

Inspection Number of production employees per cost

centre
Number of Inspection Tickets
Number of Jobs

Production Control No of Production Employees per cost centre

No of jobs

Power General Generation Metered Usage

Notional Capacity
Technical Estimate

Personnel Department No of Employees per Department

Note
s
The basis chosen should be one that is judged to be the most equitable way of sharing the
service department‗s costs over the departments which use the service. This may mean that a
particular and unique basis of apportionment may have to be derived. It must reflect the use
made of the services provided.
Wherever possible, service department costs should be charged directly, i.e. allocated. An
example
of this would be maintenance wages and materials. When a maintenance job is done for a
department, the wages and materials used would be charged directly to the department
concerned. In this way only unallocated service department costs need to be apportioned.

6.3.2 Allocation, and Apportionment of Overhead Costs

Allocation of overheads is the term used where the overhead cost item can be charged to
a specific cost center without the need for any estimation procedure. For example,
a) The salary of the sales manager will be allocated to the selling overhead cost center,
b) The salary of the engineer in charge of power generation will be charged to power
generating cost center.
Apportionment of overheads occurs where the total value of an overhead item is shared
between two or more cost centers that use the overheads. It is important that an
apportionment basis which reflects the benefit extracted by a cost center is used. For
example, the rates payable to the local authority may be apportioned on the basis of area
of occupancy of each cost center
Re-apportionment of overheads occurs when service department costs are charged to
user departments. For example, the maintenance department overhead costs are
summarized and then charged to the user department, which will probably include other
service or non-production departments.
Service departments do not participate directly in the manufacturing process but play a
supportive indirect role. Products do not pass through the support departments. It is for
this reason that service department costs have to be reapportioned to the production cost
centers or departments.
The re-apportionment of service department costs may be implemented in a number of
ways.
The Two extremes are
a) Where costs of each service department are only charged to production centers
administration; selling and distribution centers are not charged with the cost of the
service departments are they are they not production centres. This is referred to as the
Direct Method
Where the reciprocal nature of service costs is fully recognized; that is service
departments serve each other. This approach may be implemented using two methods.
i. The repeated distribution method
ii. Using an algebraic approach
b) A compromise method (elimination method) may be used where by the costs of each
service cost centers are re-apportioned in turn. The costs of the first service center will be
reapportioned to all user centers including other service centers. The first service center
however, is then eliminated from any further reapportionment. The cost of the second service
center including any costs already reapportioned from the first service center are then
reapportioned to all user centers other than the first service center. The process is continued
until all service centers are eliminated

Absorption of production overhead costs

What is overhead absorption?
Absorption of overheads refers to the sharing out of overhead costs to the various cost
centers that used the overheads. It is used when the overheads cannot be allocated or
attributed to a specified cost centre.
The aim is to establish the overhead cost per unit of output having allocated and or
apportioned overhead costs. The next stage should be to absorb them into the cost of
production.
What are the bases of overhead absorption and what factors are considered in
their selection?
The first stage in absorption is to establish the absorption rate
What is an overhead absorption rate and what types are there?
NB: Overheads incurred are normally absorbed on the basis of estimated or budgeted
figures. The following basis may be applied leading to the following types of rates.

i. Percentage of direct material cost = overhead cost x 100

Direct material cost

ii. Percentage of direct labour cost = overhead cost x 100

Direct labour cost

iii. Direct prime cost = overhead cost x 100

Prime cost
iv. Labour hours = overhead cost
Labour hours

V . Units of output = overhead cost

Units of output
Illustration 2
The budgeted production overheads and other budgeted data of calculata Ltd are as follows:

Budget
Overhead cost for the period = Kshs 36,000 Production department
Direct material cost Kshs 32000
Direct labour cost Kshs 40000
Machine hours Kshs 10000
Direct hours of labour Kshs 18000
Units of output Kshs 10000
Required
Determine the absorption rate of the overheads
Solution
Total overhead costs to be absorbed = Kshs 36000
Absorption rate Calculation
a) Direct material cost 36000 x 100 = 112.50%
32000
b) Direct labour 36000 x 100 = 90%
40000
c) Machine hours shs 36000 = Shs 3.6/machine hour
10000 hrs
d) Labour direct hours shs 36000 = Shs 2/direct hour
18000 hrs

e) Units of output 36000 = Shs 3.6/unit

10000 units
f) Prime cost = Direct labour + direct material cost
= 32000 + 40000
= Shs 72000

∴ Overhead absorption rate based on prime cost = 36000 x 100 = 50%

72000
The overhead cost will vary according to the absorption base. Assume that in the company an
individual production has a material cost of Shs 80, labour cost of shs 85, requires 36 labour
hours and 23 machine hours to complete. Determine
i. Overhead per individual production on the above different bases
ii. Individual production cost
Solution
a) Production overhead per each absorption rate
Direct Material cost 112.5 x 80 = Shs 90
100
Direct labour cost 90 x 80 = Shs 72
100

Prime cost 50 x (80+ 85)= Shs 82.50

100
Machine hours 23 x 36 = Shs 82.80

Labour hours 36 x 2 = Shs 72

b) Production cost per each absorption base = Prime cost + Overhead cost
Prime cost + Overhead cost = Product cost
Direct material cost 165 + 90.00 = 225.00
Direct labour cost 165 + 72.00 = 237.00
Prime cost 165 + 82.50 = 247.50
Machine hours 165 + 82.80 = 247.80
Labour hours 165 + 72.00 = 237.00

Illustration 3
The following is the budget of Superb Engineering Works for the year 2002
Factory overheads Kshs 62,000
Direct labour cost Kshs 98,000
Direct labour hours 155,000
Machine hours 50,000
Actual labour hours were 40,000
Actual machine hours were 30,000
Actual direct labour costs were Kshs 50,000
Actual direct material costs were Kshs
45,000

Required
a) Determine the overhead application rate on the basis of
i. Direct labour hours
ii. Direct labour cost
iii. Machine hours, and
iv. Overhead costs
v. Production cost
Solution
i. Direct labour hours method
62,000
Overhead application rate (OAR) = 15,500  Shs.0.4/la bour hour

ii. Direct labour cost method

62,000
OAR = 98,000 x 100  63.27%

iii. Machine hour method

62,000
OAR = 50,000 x 100  Shs.1.24/m achine hour

b) Overhead costs using

i. Direct labour hours = 0.4 x 40000 = Shs 16000
ii. Direct labour cost = 63.27% x 50000 = Shs 31630
iii. Machine hours = 30,000 x 1.24 = Shs 37200

c) Production cost using each of the methods

Prime cost Overheads Total cost ∴Cost/unit
i. Direct labour hours 95,000 16,000 111,000 111.00
ii. Direct labour cost 95,000 31,630 126,630 126.63
iii. Machine hours 95,000 37,200 132,200 132.20

6.3.3 Over and under absorption of production overhead costs

This may be analyzed under
a) Activity
Level of the business or cost center. Expenditure on some items of production
overhead costs will vary directly with activity whereas others will be fixed
irrespective of the changes in activity level. For example in a machine orientated cost
center, power cost will vary in proportion to machine hours whereas salary of the cost
center manager will be fixed.
b) Level of expenditure on production overhead
Expenditure level may change from the budgeted level because of a change in the
price of an overhead item or a change in the usage of the overhead item
c) Activity level and the absorption of production overhead cost
In the table below the variable overhead absorbed per machine hour is constant
(Shs.3) irrespective of the activity level. The fixed overhead cost per machine hour
depends on the activity level used as the base. If 100 machine hours are used, Shs.5
per machine hour must be charged in order to absorb the fixed overhead cost of
Shs.500. if 300 machine hours are used, Shs.1.67 per machine hour is a sufficient
charge in order to absorb the total fixed overhead cost.
Figure 5.0 Machining cost center
Activity Total fixed Total Total Average Overhea Cost
level variable overhea d per
Overhead Machine
Machine d cost
costs Overhead Hour
hrs costs

Shs. Shs. Shs. Shs. Shs. Shs. Shs.

100 500 300 800 5.00 3.00 8.00
150 500 450 950 3.33 3.00 6.33
200 500 600 1100 2.50 3.00 5.50
250 500 750 1250 2.00 3.00 5.00
300 500 900 1400 1.67 3.00 4.67

Production overheads will be absorbed by jobs or products at the pre-determined rater per
machine hour.
If the actual number of machine hours used differs from the number used in the calculation of
the overhead absorption rate, an over or under absorption will occur.
Note that this problem does not occur with variable overheads since the incidence of the cost
(such as power cost) varies with changes in activity.

Illustration 4
Using data from figure 5.0 assume that the production overhead absorption rate was
calculated where an activity of 200 machine hours was estimated. Prepare a summary
showing any over or under absorption of overhead cost where the actual machine hours
charged to jobs turns out to be
a) 150 hours
b) 250 hours
Solution
Absorption rate is Shs. 5.50 per machine hour. This may be analysed into fixed rate Shs.2.50 per
machine hour and variable rate; Shs. 3 per machine hour.

a) Where actual activity is 150 hours

Fixed Variable Total

Shs. Shs. Shs.
Overhead incurred 500 450 950
Variable overhead absorbed (450)
(150 x 3)
Fixed overhead absorbed (375)
(150 x 2.50)
Total Overhead absorbed (825)
(150 x 5.50) ____ ____ ___
Under absorption of overhead 125 NIL 125

b) Where actual activity is 250 hours

Fixed Shs. Variable Shs. Total Shs.
Overhead incurred 500 750 1250
Variable overhead absorbed (750)
(250 x 3)
Fixed overhead absorbed (625)
(250 x 2.50)
Total Overhead absorbed (1375)
(250 x 5.50) ___ ___ ___
Under absorption of overhead 125 NIL 125

c) Expenditure level and the absorption of production overhead cost

A charge in expenditure on an overhead cost item may occur because of a charge in the
price per unit and/or because of change in the number of units of the overhead commodity
which are required
Expenditure changes can affect the absorption of both fixed and variable overheads
Illustration 5
AB Ltd has a machine cost center for which the following information is available
a) Budget
i. Budgeted (expected) activity 3000 machine hours
ii. Variable production overhead cost per machine hour Shs. 2
iii. Fixed production overhead cost (total) Shs. 9000
b) Actual
i. Activity level 3000 machine hours
ii. Variable production overhead cost incurred Shs. 6400
iii. Fixed production overhead cost incurred Shs. 8800

Required
1. Calculate the over and under absorption of variable overhead and fixed overhead cost
2. Comment on possible causes of over or under absorption figures

Solution
Variable overhead cost
Actual cost incurred Shs.6400
- Overhead absorbed 3000 hrs x Shs. 2 Shs.6000
Shs. 400

Under absorption may have occurred through a combination of

a) Increased price per unit of variable cost e.g. a rise in price or electricity
b) An increase in the number of units of overhead cost item, e.g. machine efficiency has
fallen through lack of maintenance

Fixed overhead cost:

Actual cost incurred Shs. 8800
- Overhead absorbed 3000 hrs x Shs. 3 Shs. 9000
Over absorption of overhead cost Shs. 200

The fixed overhead absorption rate 9000/3000 machine hours = Shs. 3 per machine hour.
The actual activity level of 3000 machine hours is the same as that budgeted. The over
absorption of fixed overhead is therefore due to expenditure factors. It may have occurred
because of the combination of
a) A lower price of a fixed item e.g. salary may be lower than budgeted
b) A reduced usage of what was classified as a fixed cost item e.g. the quantity of oil
used to lubricate the machines.

Absorption of non production overheads in production cost

Product costs may be compiled for a range of purposes including
a) Stock valuation
b) Product pricing
c) Decision making
For stock valuation purposes International Accounting Standard No. 2 define cost being that
expenditure which has been incurred in the normal course of business in bringing the product
or service to its present location and condition. This expenditure should include in addition to
the cost of purchase such costs of conversion as are appropriate to that location and condition.
Costs of conversion include production overheads and other overheads attributable in the
particular circumstances of the business in bringing the product or service to its present
location and condition
For product pricing purposes, administration, selling and distribution overheads may be
absorbed in a number of ways including
a) As a percentage of selling price
b) As a percentage of full cost of production
c) As a percentage of conversion costs
d) As a rate per unit sold
For decision making purposes it is also relevant to know which part of administration selling
and distribution overhead costs are directly attributable to a particular product and which are
avoidable if that product is discontinued.
6.4 Activity Based Costing (ABC)
Absorption Costing appears to be relatively straightforward way of adding overhead costs to
units of production using, more often than not, a volume-related absorption basis (Such as
direct labour hours or direct machine hours). The assumption that all overheads are related
primarily to production volume is implied in this system. Absorption costing was developed
at a time when most organizations produced only a narrow range of products and when
overhead costs were only a very small fraction of total costs, direct labour and direct material
costs accounting for the largest proportion of the costs. Errors made in adding overheads to
products were therefore not too significant.

Nowadays, however, with the advent of advanced manufacturing technology, overheads

are likely to be far more important and in fact direct labour may account for as little as 5% of
a product‘s cost. Moreover, there has been an increase in the costs of non-volume related
support activities, such as setting-up, production scheduling, inspection and data processing,
which assist the efficient manufacture of a wide range of products. These overheads are not,
in general affected by changes in production volume. They tend to vary in the long term
according to the range and complexity of products manufactured rather than the volume of
output.

Because traditional absorption costing methods tend to allocate too great a proportion of
overheads to high-volume products (which cause relatively little diversity), and too small a
proportion of overheads to low-volume products (which cause greater diversity and therefore
use more support services), alternative methods of costing have been developed. Activity-
based costing (ABC) is one such development.

The major ideas behind activity-based costing are as follows:

 Activities cause costs; activities include ordering, materials handling, machining,
assembly, production scheduling and dispatching,
 Products create demand for the activities
 Costs are assigned to products on the basis of a product’s consumption of the
activities.

Absorption rates under ABC should therefore be more closely linked tot eh cause of overhead
costs and hence product costs should therefore be more realistic especially where support
overheads are high.

Outline of an ABC System

An ABC costing system operates as follows:
Step 1
Identify an organisation‘s major activities.
Step 2
Identify the factors which determine the size of the costs of an activity/cause of the costs of
an activity. These are known as cost drivers. Look at the following examples:

Activity Possible cost driver

Ordering Number of orders
Materials handling Number of production runs
Production scheduling Number of production runs
Dispatching Number of dispatches

For those costs that vary with production levels in the shorn term, ABC uses volume-related
cost drivers such as labour or machine hours. The cost of oil used a lubricant on the
machines would therefore be added to products on the basis of the number of machine hours
since oil would have to be used for each hour the machine ran.
Step 3
Collect the costs of each activity into what are known as cost pools (equivalent to cost centres
under more traditional costing methods).
Step 4
Charge support overheads to products on the basis of their usage of the activity. A product‘s
usage of an activity is measured by the number of the activity‘s cost driver it generates.

Suppose, for example, that the cost pool for the ordering activity totaled Ksh.100,000 and that
there were 10,000 orders (the cost driver). Each product would therefore be charged with
Ksh.10 for each order it required. A batch requiring five orders would therefore be charged
with Ksh.50 as its share of the ordering costs for the period.
Absorption costing and ABC are similar in many respects. In both systems, direct costs go
straight to the product and overheads are allocated to production cost centres/cost pools. The
difference lies in the manner in which overheads are absorbed into products.

Absorption costing most commonly uses two absorption bases (labour hours and /or machine
hours) to charge overheads to products

ABC uses many cost drivers as absorption bases (number of orders, number of dispatches and
so on).

This refers to the distribution or assignment of a group of costs to cost centers. Such costs
are assimilated in a similar and should be allocated on the same base. Allocation base is the
measure of activity used to allocate a cost pool to the cost centers.

Reasons for Cost Allocation

 To facilitate comparison with externally provided services: It assists in assessing
whether to continue the service or contact outsiders.
 To provide ideas on the efficiency of service departments: It helps to determine
whether a service department is operating efficiently and its size is optimal.
 To discourage unnecessary service by some managers as they know they‘ll be
charged.
 To provide opportunity for cost price-quality trade offs: Cost allocation helps to
eliminate friction between departments. This is because a user department that
demands higher quality knows that it will have to bear higher costs.

Allocation of Service Department Costs to Production departments

Service departments are those departments which provide support to production departments
but do not engage directly in the production of the products e.g. the accounting department,
maintenance department, and the legal department. Service departments provide services to
each other and at the same time to the production department. The methods of allocating
service costs include:

1. Direct Allocation Method

2. Step-wise Method
3. Reciprocal Method
Direct Method
The service costs are only allocated to the production department according to the usage of
the services provided.

Step-wise Method
Some of the costs of the reciprocal services will be recognized although only to some extent.
The steps followed include:
Choose one of the service departments and allocate its costs to all the other departments
including the other service departments. Normally the basis of choosing that service
department to start with is the service department that provides services to the greatest
number of other departments.
Another service department is chosen and its total costs allocated the remaining departments
excluding the first service departments.
Repeat the process until all the service department costs have been allocated to the production
departments.

REVISION QUESTIONS
QUESTION ONE
Given: Total budgeted overheads = Shs.240, 000
Production budget is as follows:
Product A B
i) Units 20,000 10,000
ii) Labour hours 20,000 20,000
iii) Labour cost Shs.17,500 Shs.22,500
iv) Machine hours 45,000 15,000
v) Material cost Shs.15,000 Shs.25,000

Required
The overhead absorption rater per unit of A and B using the following methods:
a) Unit method
b) Percentage on material cost.
c) Percentage on labour cost.
d) Percentage On prime cost.
e) Labour hour rate.
f) Machine hour rate.
(Total:20 Marks)
QUESTION TWO
A Factory issues a job employee A to produce 35 articles; it takes two standard hours to
produce each article. Another job is given to employee B to produce 60 articles; it takes one
and half standard hours to produce each article. For every hour saved, a bonus is paid at 50%
of the base, which is Sh.200 per hour. The factory works a 40-hour week and overtime is
paid at a rate of one and a third. At the end of the week, A‘s articles and B‘s clock cards
show 49 and 46 hours respectively and the work is complete. However, three of A‘s articles
and three B‘s articles failed to pass inspection. This was due to defective material and in
view of this all the articles produced were paid for, although as scrap they have no seleable
value.
Required
For both A and B:
a) Bonus due (8 marks)
b) Total gross wages due (8 marks)
c) Wages cost per unit of articles passing inspection (4 marks)
(Total: 20 marks)
BUDGETARY PLANNING AND CONTROL
LESSON SEVEN
OBJECTIVES
After you have studied this lesson you should be able to:
 Define budgets and explain the nature and purpose of budgets.
 Explain the Administration of budgets.
 Prepare the various types of budgets.
 Explain the behavioral aspects of budgeting.

CONTENTS
 Definitions
 Objectives of budgetary planning and control
 Preparation of budgets
 Flexible budgeting

INTRODUCTION
This lesson explores Budgetary, Planning and Control Techniques looking at the purpose,
preparation, application and interpretation of budgets as well as their behavioural aspects
7.1 Nature and Purposes of Budgets
Budgeting refers to the process of quantifying the plans of an organization so as to enable it
achieve its objectives in the defined period. The result of the process is budgets, which are
used for cost control, performance evaluation and future decision making.

Budgetary Planning and Control may be seen a s short-term quantification and monitoring of
long-term strategic plans of the organizations. Strategic planning involves preparation of
strategic plans, which define the objectives to be pursued within the framework of corporate
policy. It is by budgeting that a long-term corporate plan is put into action.

Budgets may be prepared for departments, functions or financial and resource items. In fact,
some people refer to budgeting as a means of coordinating the combined intelligence of the
entire organization into a plan of action.

7.1.2 OBJECTIVES OF BUDGETARY PLANNING

1) Coordination
The budgetary process requires that visible detailed budgets are developed to cover each
activity, department or function in the organization. This is only possible when the
effort of one department‘s budget is related to the budget of another department. In this
way, coordination of activities, function and department is achieved.
2) Communication
The full budgeting process involves liaison and discussion among all levels of
management. Both vertical and horizontal communication is necessary to ensure proper
coordination of activities.

3) Control
This is the process for comparing actual results with the budgeted results and reporting
upon variances. Budgets set a control gauge, which assists to accomplish the plans set
within agreed expenditure limits.

4) Motivation
Budgets may be seen as a bargaining process in which managers compete with each other
for scarce resources. Budges set targets, which have to be achieved. Where budgetary
targets are tightly set, some individuals will be positively motivated towards achieving
them.

5) Clarification of Responsibility and Authority

Budgetary process necessitates the organization of a business into responsibility and
budget centres with clear lines of responsibilities of each manager. This reduces
duplication of efforts.

6) Planning
It is by Budgetary Planning that long-term plans are put into action. Planning involves
determination of objectives to be attained at a future predetermined time. When monetary
values are attached to plans they become budgets.

7.1.3 Limitations of Budgeting

 Too mush reliance may cause resistance (inflexibility) to change.
 Difficult to set levels of attainment. This may result into too tight budgets that cause loss
of morale.
 Antagonism where budgets exert undue pressure.
 Budgeting control is a terminate exercise and therefore any report from investigation of
variances may b of little use to the current operations.

7.2 Organization of budgetary control

Budgetary control ideally involves the following steps:

1. The creation of budget centres.

2. The introduction of adequate accounting records.
3. The preparation of organization charts.
This defines the functional responsibilities of each member of management.
4. The establishment of a budget committee:
It will consist of operating and financial managers, who will be required to review,
discuss and co-ordinate business activities. The main function of this committee
involves:

 To issue instructions regarding budget requirements, deadline dates for the receipt of
budgets e.t.c.
 Draw up the budget preparation timetable. It takes the form of network analysis
whereby some activities are preceded by some others.
 To define the general policies of management in relation to the budget.
 Checking initial draft and problems considered. Limiting factors are usually
considered.
 Ensuring that the budgets are synchronized within the boundaries of available
resources.
 To analyze comparison of budgets and actual results and to recommend corrective
action where necessary.
 Review of budgets.
 Prepare the master budget after functional budgets have been prepared.
 The preparation of a budget manual. This is a document, which sets out the
responsibilities of the persons engaged in the routing of, and the forms and records
required for budgeting control. Such manual will provide such information as:

- Description of the system and its objectives.

- Definition of the responsibilities and duties.
- Reports and statements required for each budget period.
- Deadline dates by which data are to be submitted.

7.3 PREPARATION OF BUDGETS

THE MASTER BUDGET FRAMEWORK
The master budget is the overall quantifications of the budgeting plan. In it, functional
budgets are incorporated. A functional budget is a budget if income and/or expenditure for a
particular function. The master budget therefore combines all the budgets of the various
departments in an organizations. It is useful in ensuring that all the individual budgets are
consistent with one another and also presents a ‗unit‘ picture of the entire organization.

It is made up of both production and non-production budgets.

Production budgets include:

 Sales Budget
 Finished Goods Budgets
 Material budges
 Labour budgets
 Overheads budgets.

Non-Production Budgets Include

 Selling & Distribution
 Administration Budget
 Cash Budget
 Research and Development – Capex
 All these budgets translate into the projected
profit and loss a/c and the budgeted Balance
Sheet.
 The relationship between all these budgets is
summarized in the next page.

7.3.1 Sales Budget

It gives volume of sales and sales mix of the current operations. The sales forecast is initially
prepared and upon completion the sales budget is finalized. The following are usually
considered in coming up with the sales forecast.

 Actual sales in the previous periods.

 Reports from salesmen.
 Market research information.
 Level of orders already obtained in advance.

It essentially forecasts what the company can reasonably expect to sell to the customer during
the budget period.

7.4.2 Production budget

It is the forecast of the products to be manufactured during the budget period to most
forecasted sales above.

It is expressed as units of each type of product. The following are usually considered:
 Available production capacity.
 The sales forecast.
 Finished goods stock level policy.

The cycle for the preparation of the above budget usually is determined by the budget
committee. It is as follows:

i. Determine the production capacity available.

ii. Consider the possible ways in which the available production capacity may be
expanded if required.
iii. Linkage of production capacity available to the stock level.
iv. Determine the detailed budgets within the production budget.

Format

6 (Units) P (Units) J (Units)

Required Stock 31/12/19-0 xx xx xx
Add: Sales during the year xx xx xx
Less: Estimated Stock 01/01/19-0 (xx) (xx) (xx)
Production Requirements xx xx xx
It has two purposes

 Ensures that production is sufficient to meet sales demand.

 Ensures that economic stock levels are maintained according to the stock policy.

7.4.3 Direct Materials Budget

This budget shows the estimated quantities and costs of all the raw materials and components
needed for the output demand by the production budget. This consists of:

i. Direct Materials Usage Budget: Which shows the estimated quantities of

materials required for budgeted production.
ii. Direct Materials Purchases Budget: It ensures that materials are within the
planned materials stock levels i.e. after considering both usage material stock
required.

7.4.4 Direct Labour Budget

It represents the forecasts of direct and indirect labour requirements to meet the demands of
the company during the budget period.

The budgeted direct labour cost is therefore determined by multiplying direct labour hours
with the wage rates for every category of labour.

7.4.5 Factory Overhead Budget

This budget represents the forecasts of all the production fixed and variable and semi-variable
overheads to be incurred during the budget period.

The summation of budgeted costs of production for the budget period makes up Production
Cost Budget. It includes:

 Budgeted Materials Cost

 Budgeted Labour Cost
 Budgeted Overhead Cost

7.4.6 Non-Production Budgets

a) Selling and Distribution Cost Budget

It is the forecast of all costs incurred in selling and distributing the company‘s product
during the budget period. It is closely concerned with the sales budget in that it is mainly
based on the volume of sales projected for the period.

Expenses included are:

 Selling office costs

 Salesman salaries and commission
 Advertising expenses

b) Administration Costs Budget

It represents the costs of all administration expenses. Each department or budget centre
will be responsible for the preparation of its own budget. Management, Secretarial,
Accounting and Administration costs which cannot be directly related to the production
are included here.

The budget will be mainly incremental i.e. previous year‘s figure will tend to apply for its
next budget with an allowance for inflation.

c) Research and Development Cost Budget

These are costs, which are discretional in nature i.e. they are determined on need basis by
the managers concerned. Research cost is the cost of original investigation undertaken in
order to gain new scientific or technical knowledge and directed towards a specific
practical aim objective.

Development cost is the cost of using scientific or technical knowledge in order to

produce new or substantially improved materials, devices, products, processes systems or
services prior to the commencement of commercial production.

d) Capital expenditure Budget

It represents the expenditure on all fixed assets during the budget period. Addition
intended to benefit future accounting periods, or expenditure which increases the
production capacity, efficiency lifespan or economy of an existing fixed assets are also
incorporated.

e) Cash budget
It records the cash inflows and outflows, which are expected to take place in respect of
each functional budget. It may be prepared for a period span of one week, month or
quarter of the budget period. It has the following benefits/advantages:

 It ensures that sufficient cash is available when required.

 It shows whether capital expenditure projects can be financed internally.
 It indicates the cash needed for current operating activities.
 It indicates the effect the position of each seasonal requirements, large stocks, unusual
receipts and laxity in collecting account receivable.
 It indicates the availability of cash for taking advantage of discounts.
 It reveals the availability of excess cash so that short-term investments may be
considered.
 It serves as a basis for evaluating the actual cash management performance of
responsible managers.

Illustration
Venus plc produces two products A and B. The budget for the next year to 31st 2014 is to be
prepared. Expectations for the forthcoming year include the following:
Venus PLC
BALANCE SHEET AS AT 1 APRIL 2013

Fixed Assets Shs Shs Shs

Land and buildings 45,000
Plant and Equipment (NBV) 112,000
Current Assets
Raw materials 7,650
Finished goods 23,615
Debtors 19,500
Cash
4,300
55,065
Current Liabilities
Creditors 6,800
Taxation 24,500 (31,300) 23,765
180,765
Financed by
150,000 ordinary shares of Shs1 each 150,000
Retained profit 30,765
180,765

(b) Finished Products A B

The Sales Director has estimated the following:
(i) Demand for the Co‘s products 4,500 units 4,000 units
(ii) Expected S.P per unit Shs32 Shs44
(iii) Closing stock @ 31 March 2014 is required to be 400 units 1200 units
(iv) Opening stocks at 01 April 2013 900 units 200 units
(v) Unit cost of this opening stock will be Shs20 Shs28
(vi) The amount of plant capacity required for each
product is: Machining 15min 24min
Assembling 12min 18min
(vii) The raw material content per unit is
Material A 1.5 kg 0.5 kg
Material B 2.0 k g 4.0 kg
(viii) Direct labour hours required @ unit of each
product is: 6 hrs 9 hrs

Finished goods are valued at FIFO basis at full factory cost.

(c) Raw Materials Material X Material Y

(i) Closing stock requirements kilos at 31 March
2014 600 1000
(ii) Opening stock at 1 April 2013 kilos 1100 6000
(iii) Budgeted cost of raw materials per kilo Shs1.50 Shs1.0

Actual cost per kilo of opening stocks are as budgeted cost for the coming year.
(d) Direct Labour
The standard wage rate of direct labour is Shs1.50/hr.
(e) Factory overhead

Factory overhead is absorbed on the basis of machining hours with separate absorption rates
for each department.

The following are expected overheads in the production cost centre budgets.

Machinery Deport Assembly Deport

Shs Shs
Supervisors salaries 10,000 9,150
Power 2,400 2,000
Maintenance and running costs 2,100 2,000
Consumables 3,400 500
General Expenses 19,600 5,000
39,500 18,650

Depreciation is taken at 5% straight-line on plant and machinery equipment. A machine

costing the company Shs20,000 is due to be installed on 1 October 2013 in the machining
department which already has machinery installed to the value of Shs100,000 at cost.

(f) Selling and distribution expenses Shs

Sales commission and salaries 14,300
Traveling distribution 3,500
Office salaries 10,100
General administration expenses 2,500
30,400

(g) There is no opening or closing work in progress and inflation should be ignored.

Required
Prepare the following budgets for the year ended 31 March 2014 for Venus PLC.

i) Sales budget
ii) Production budget (units)
iii) Plant utilization budget
iv) Direct materials utilization budget
v) Direct labour budget
vi) Factory overhead budget
vii) Direct materials purchases budget
viii) Cost of goods sold budget
ix) Budgeted profit and loss account

Solutions
Venus PLC

(i) Sales Budget

Qty (units) Revenue (Shs)
A 4,500 144,000*1
B 4,000 176,000*2
TOTALS 320,000

(ii) Production Budget (units)

A(units) B (units)
Sales 4,500 4,000
Add: Closing Stock 400 1,200
Total requirements 4,900 5,200
Less: Opening stock (900) (200)
Production budget 4,000 5,000

(iii) Plant Utilization Budget

Machinery Assembling
A (4,000 units) *3 1000 hrs 800 hrs
B (5000 units) *4 2000 1,500
TOTAL PLANT UTILIZATION 3,000 hrs 2,300 hrs

15 min 12 min
*3 = 4000 x ; 4000 x
60 min 60 min

24 min 18 min
*4 = 5000 x ; 5000 x
60 min 60 min

(iv) Direct Material Uses Budget

Units @ Material X @ Material Y

A 4,000 1.5 6,000 2.0 8,000
B 5,000 0.5 2,500 4.0 20,000
Total Direct Materials 8,500 kg 28,000 kg
USAGE
(v) Direct Materials Purchases Budget

Mat X (kg) Mat Y (kg)

Current usage 8,500 28,000
Add: Closing stock 600 1,000
Total Req 9,100 29,000
Less: Opening stock (1,100) (6,000)
Material To Be Purchased (Kg) 8,000 23,000
Cost per Kg. Shs1.5 Shs1.0
Material purchase
Budget Shs 12,000 23,000

Total Material Purchases Budget:

Shs.
12,000
+ 23,000
35,000

(vi) Direct Labour Budget

Hrs
A 4000 x 6 24,000
B 5000 X 9 45,000
Direct Labour hrs 69,000
Standard Wage rate/hr Shs 1.6
Direct Labour Cost Budget Shs 110,400

Factory Overhead Budget

Machining Department (Shs) Assembly

department (Shs)
Budgeted Overheads ex 39,500 18,650
Cluding depreciation
Add: Depreciation
Less: Existing plant *5 5,000 4,350
New plant *6 500 -
Total budgeted overheads 45,000 23,000
Absorption Base (Machine hrs) 3,000 2,300
Overhead Absorption Rate *7 Shs1.5/mach hr Shs 10 mach hr

*5 = 100,000 x 5%; 87,000 x 5%

6
*6 = 20,000 x 5% x
12
45000 23000
*7 = ;
3000 2300

(viii) Cost of goods sold budget

A (Shs) B (Shs)
Opening stock (WI) 18,000 5,600
Add: Production (WII) 78,400 140,750
Less: Closing stock (WIII) 7,840 33,780
Cost of goods sold 88,560 112,570

Workings

I: Opening stocks

A: 900 x 20 = 18,000
B: 200 x 28 = 5,600

II PRODUCTION COST PER UNIT OF FINISHED PRODUCT

A B

Materials: A 1.5 x 1.5 2.25 0.5 x 1.5 0.75

B 2.0 x 1.0 2.0 4.0 x 1.0 4.0
Labour: 6hrs x 1.6 9.6 9 hrs x 1.6 14.4
Overheads
15 3.75 24 6.0
Machining 15 x 15 x
60 60
12 18
Assembly 10 x 2.0 10 x 3.0
60 60
Total production @ unit Shs19.6 28.15
Production Units 4000 5000
Valuation 78400 140750

III CLOSING stock valuation

A B

Closing stock units 400 1200

Unit cost 19.6 28.15
Stock units 7840 33780
(iv) BUDGETED PROFIT AND LOSS ACCOUNT

A (Shs) B (Shs) TOTAL (Shs)

Sales 144000 176000 320000

Cost of goods sold 88560 112570 201130
Gross Profit 55440 63430 118870
Less: Selling and administrations expenses 30400
Net Profit 88470

REVISION QUESTIONS

(a) State the objectives of budgetary planning and control systems. (3 marks)
(b) Identify the limitations of using budgeting systems to regulate business activities.
(5 marks)
(c) Kunda Limited manufactures one standard product. Currently it is operating on a normal
activity level of 70% with an output of 6,300 units, although he sales director believes
that a realistic forecast for the next budget period would be at a level of activity of 50%.

60% 70% 80%

Shs. Shs. Shs.
Direct materials 37,800 44,100 50,400
Direct wages 16,200 18,900 21,600
Production overheads 37,600 41,200 44,800
Administration overheads 31,500 31,500 31,500
Selling and distribution overheads 42,300 44,100 45,900
Total cost 165,400 179,800 194,200

Profit is 20% of selling price.

Required;
i) Prepare a flexible budget based on a 50% level of activity. (9 marks)
ii) State three problems which may arise from such a change in the level of activity.
(3 marks)
(Total: 20 marks)
INFORMATION FOR DECISION MAKING

LESSON EIGHT

OBJECTIVES
After you have studied this lesson you should be able to:
 Explain the nature of decision-making and the decision making cycle.
 Understand, explain and perform break-even point and cost volume point computations
 Explain the applications and assumptions of CVP analysis.
 Distinguish marginal costing and absorption costing.
 Apply marginal costing in stock valuation, profit reporting and decision making.
 Reconcile profits in marginal costs and absorption costing.
 Apply marginal costing principles in decision making situations.

CONTENTS
8.0 Marginal Costing and Absorption Costing
8.1 Marginal Costing and absorption Costing Compared
8.2 Distinction between marginal and absorption costing
8.3 Application of marginal costing
8.4 Assumptions of break-even analysis
8.5 Cost volume and profit analysis (CVP Analysis)
8.6 CVP Analysis in conditions subject to change
8.7 CVP and computer applications
8.8 The decision making cycle

8.0 Marginal Costing and Absorption Costing

Product costs are costs identified with goods produced or purchased for resale. Such costs
are initially identified as part of the value of stock and only become expenses when the stock
is sold. In contrast, period costs are costs that are deducted as expenses during the current
period without ever being included in the value of stock held. We saw how product costs are
absorbed into the cost of units of output. Now we describe marginal costing and compare it
with absorption costing. Whereas absorption costing recognizes fixed costs (usually fixed
production costs) as part of the cost of a unit of output and hence as product costs, marginal
costing treats all fixed costs as period costs. Two such different costing methods obviously
each have their supporters and we will be looking at the arguments both in favour of and
against each method. Each costing method, because of the different stock valuation used,
produces a different profit figure and we will be looking at this particular point in detail.
Marginal Costing is an alternative method of costing to absorption costing
In marginal costing, only variable costs are charged as a cost of sale and a contribution is
calculated which is sales revenue minus the variable cost of sales. Closing stocks of work in
progress or finished goods are valued at marginal (variable) production cost. Fixed costs are
treated as a period cost, and are charged in full to the profit and loss account of the
accounting period in which they are incurred.
Marginal Cost is the cost of a unit of a product or service which would be avoided if that
unit were not produced or provided.
The marginal production cost per unit of an item usually consists of the following:
 Direct materials,
 Direct labour,
 Variable production overheads.

Contribution is the difference between sales value and the marginal cost of sales.
Contribution is of fundamental in marginal costing, and the term ‗contribution‘ is really short
for ‗contribution towards covering fixed overheads and making a profit‘.
The Principles of Marginal Costing
The principles of marginal costing are as follows:
 Period fixed costs are the same, for any volume of sales and production (provided that
the level of activity is within the ‗relevant range‘). Therefore, by selling an extra item
of product or service of the following will happen:
- Revenue will increase by the sales value of the item sold,
- Costs will increase by the variable cost per unit,
- Profit will increase by the amount of contribution earned from the extra item.
Similarly, if the volume of sales falls by one item, the profit will fall by the amount of
contribution earned from the item.
Profit measurement should therefore be based on an analysis of total contribution. Since
fixed costs relate to a period of time, and do not change with increases or decreases in sales
volume, it is misleading to charge units of sale with a share of fixed costs from total
contribution for the period to derive a profit figure.
When a unit of product is made, the extra costs incurred in its manufacture are the variable
production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when
output is increased. It is therefore argued that the valuation of closing stocks should be at
variable production cost (direct materials, direct labour, direct expenses (if any) and variable
production overhead) because these are the only costs properly attributable to the product.
Before explaining marginal costing principles any further, it will be helpful to look at a
numerical example.
ILLUSTRATIONS
Marginal Costing
Water Ltd makes a product, the Splash, which has a variable production cost of Ksh.45,000
(production, administration, sales and distribution). There were no variable marketing costs.
Calculate the contribution and profit for September 19x0, using marginal costing principles,
if sales were as follows:
a) 10,000 Splashes
b) 15,000 Splashes
c) 20,000 Splashes
Solution
The first stage in the profit calculation must be to identify the variable costs, and then the
contribution. Fixed costs are deducted from the total contribution to derive the profit. All
closing stocks are valued at marginal production cost (Ksh.6 per unit). For 10,000, 15,000
and 20,000 Splashes this would be,

10,000 Splashes 15,000 Splashes 20,000 Splashes

Ksh. Ksh. Ksh. Ksh. Ksh. Ksh.
Sales (at Ksh.10) 150,000 200,000
Opening stock 0 0 0
Variable production cost 120,000 120,000 120,00
0
120,000 120,000 120,00
0
Less value of closing
stock 60,000 30,000 -
(at marginal cost)
Variable cost of sales 60,000 90,000 120,000
Contribution 40,000 60,000 80,000
Less fixed costs 45.000 45,000 45,000
Profit/(loss) (5,000) 15,000 35,000

Profit/(loss) per unit Ksh.(0.5 Ksh.1.0 Ksh.1.7

0) 0 5
Contribution per unit Ksh.4.0 Ksh.4.0 Ksh.4.0
0 0 0

The conclusions which may be drawn from the example are as follows:
a) The profit per unit varies at differing levels of sales, because the average fixed overhead
cost per unit changes with the volume of output and sales.
b) The contribution per unit is constant at all levels of output and sales. Total
contribution, which is the contribution per unit multiplied by the number of units sold,
increases in direct proportion to the volume of sales.
c) Since the contribution per unit does not change, the most effective way of calculating
the expected profit at any level of output and sales would be as follows:

- First calculate the total contribution,

- Then deduct fixed costs as a period charge in order to find the profit.

In our example, the expected profit from the sale of 17,000 Splashes would be as follows,

Total contribution (17,000 x Ksh.4) 68,000

Less fixed costs 45,000
Profit 23,000

So:
 If total contribution exceeds fixed costs, a profit is made,
 If total contribution exactly equals fixed costs, no profit and no loss is made and
breakeven point is reached,
 If total contribution is less than fixed costs, there will be a loss.

Plumber Ltd makes two products, the Loo and the Wash. Information relating to each of
these products for April 19X1 is as follows:

Loo Wash
Opening stock Nil Nil
Production (nits) 15,000 6,000
Sales (units) 10,000 5,000

Ksh. Ksh.
Sales price per unit
Unit costs 20 30
Direct costs
Direct materials 8 14
Direct labour 4 2
Variable production overhead 2 1
Variable sales overhead 2 3
Fixed costs for the month Ksh.
Production costs 40,000
Administration cost 15,000
Sales and distribution costs 25,000

Using marginal costing principles, calculate the profit in April 19x1. Use the approach set
out in Note (d) to the Water Ltd case, above.

SOLUTION
Ksh.
Contribution from Loos (unit contribution =Ksh.20 - Ksh.16 = Ksh.4 x 40,000
10,000)
Contribution from Washes (unit contribution =Ksh.30 - Ksh.20 = Ksh.10 50,000
x 5,000)
Total contribution 90,000
Fixed costs for the period 80,000
Profit 10,000

8.1 Marginal Costing and absorption Costing Compared

Marginal Costing as a cost accounting system is significantly different from absorption
costing. It is an alternative method of accounting for costs and profit, which rejects the
principles of absorbing fixed overhead into unit costs.
In Marginal costing:
Closing stocks are valued at marginal production cost,
Fixed costs are charged in full against the profit of the period in which they are incurred.
In absorption costing (sometimes referred to as full costing):
 Closing stocks are valued at full production cost, and including a share of fixed
production and include a share of fixed production costs.
 This means that the cost of sales in a period will include some fixed overhead incurred in
a previous period (in opening stock values) and will exclude some fixed overhead
incurred in the current period but carried forward in closing stock values as a charge to a
subsequent accounting period.
This distinction between marginal costing and absorption costing is very important and the
contrast between the systems must be clearly understood. Work carefully through the
following example to ensure that you are familiar with both methods.
ILLUSTRATION TWO
Marginal and absorption costing compared
Two Left Feet Ltd manufactures a single product, the Claud. The following figures relate to
the Claud for a one-year period,
Activity level 50% 100%
Sales and productions 400 800
(units)

Ksh. Ksh.

Sales 8,000 16,000

Production costs: Variable 3,200 6,400
Foxed 1,600 1,600
Sales and distribution Variable 1,600 3,200
costs:
Fixed 2,400 2,400

The normal level of activity for the year is 800 units. Fixed costs are incurred evenly
throughout the year, and actual fixed costs are the same as budgeted.
There were no stocks of Claud at the beginning of the year.
In the first quarter, 220 units were produced and 160 units sold.
Now:
a) Calculate the fixed production costs absorbed by Clauds in the first quarter if absorption
costing is used,
b) Calculate the profit using absorption costing,
c) Calculate the profit using marginal costing,
d) Explain why there is a difference between the answers to (c) and (d).
Solution
a) The fixed production costs absorbed by Clauds in the first quarter (with absorption
costing) are:
Budgeted fixed production costs £1,600

Budgeted output (normal level of activtiy) 800 units

Absorption rate = Ksh.2 per unit produced.

During the quarter, the fixed production overhead absorbed was 220 units x Ksh.2 =
Ksh.440.
b) The under/over recovery of overheads for the quarter would be,
Ksh.
Accrual fixed production overhead 400 ( 1 4 of £1,600)

Absorbed fixed production overhead 440

Over absorption of overhead 40

c) Profit for the quarter, absorption costing,

Ksh. Ksh.
Sales (160 x Ksh.20) 3,200
Production costs
Variable (220 x Ksh.8) 1,760
Fixed (absorbed overhead (220 x Ksh.2) 440
Total (220 x Ksh.10) 2,200
Production cost of sales 600
Adjustment for over-absorbed overhead 1,600
Total production costs 40
Gross profit 1,560
Less: sales and distribution costs 1,640
Variable (160 x Ksh.4) 640
Fixed (¼ of Ksh.2,400) 600
1,240
Net profit 400

d) Profit for the quarter, marginal costing

Ksh. Ksh.
Sales 3,200
Variable production costs 1,760
Less closing stocks (60 x Ksh.8) 480
Variable production cost of sales 1,280
Variable sales and distribution costs 640
Total variable costs of sales 1,920
Total contribution 1,280
Less:
Fixed production costs incurred 400
Fixed sales and distribution costs 600
1,000
Net profit 280

e) The difference in profit is due to the different valuations of closing stock. In absorption
costing the 60 units of closing stock include absorbed fixed overheads of Ksh.120 (60 x
Ksh.2), which are therefore costs carried over to the next quarter and not charged against
the profit of the current quarter. In marginal costing, all fixed costs incurred in the period
are charged against the profit,

Ksh.
Absorption costing profit 400
Fixed production costs carried forward in stock 120
values
Marginal costing profit 280

We can draw a number of conclusions from this example:

a) Marginal costing and absorption costing are different techniques for assessing profit in
a period.
b) If there are any changes in stocks during a period, marginal costing and absorption
costing give different results for profit obtained:
- If stock levels increase absorption costing will report the higher profit
because some of the fixed production overhead incurred during the period will be
carried forward in closing stock (which reduces cost of sales) to be set against
sales revenue in the following period instead of being written off in full against
profit in the period concerned (as in the example above),

- If stock levels decrease, absorption costing will report the lower profit
because as well as the fixed overhead incurred, fixed production overhead which
had been brought forward in opening stock is released and is included in cost of
sales.

c) If the opening and closing stock volumes and values are the same, marginal costing
and absorption costing will give the same profit figure.

d) In the long run, total profit for a company will be the same whether marginal
costing or absorption costing is used because in the long run, total costs will be the
same by either method of accounting. Different accounting conventions merely affect the
profit of individual accounting periods.
There are accountants who favour each costing method.
Arguments in favour of absorption costing are as follows:
 Fixed production costs are incurred in order to make output; it is therefore ‗fair‘ to charge
all output with a share of these costs.
 Closing stock values by including a share of fixed production overhead will be valued on
the principle required for the financial accounting valuation of stocks by
Statement of standard accounting practice on stocks and long-term contracts (SSAP 9).
 A problem with calculating the contribution of various products made by a company is
that it may not be clear whether the contribution earned by each product is enough to
cover fixed costs, whereas by charging fixed overhead to a product it is possible to
ascertain whether it is profitable or not.
Arguments in favour of marginal costing are as follows:
 It is simple to operate
 There are no apportionments, which are frequently done on the arbitrary basis, of fixed
costs. Many costs, such as the managing director‘s salary, are indivisible by nature.
 Fixed costs will be the same regardless of the volume of output, because they are period
costs. It makes since therefore, to charge them in full as a cost to the period.
 The cost to produce an extra unit is the variable production cost. It is realistic to value
closing stock items at this directly attributable cost.
 Under or over absorption of overheads is avoided.
 Marginal costing information can be used for decision-making but absorption costing
information is not suitable for decision-making.
 Fixed costs (such as depreciation, rent and salaries) relate to a period of time and should
be charged against the revenues of the period in which they are incurred.
Of course, the choice of method does not have to be between absorption costing and marginal
costing. We looked at ABC as an alternative to absorption costing. Attributable
contribution costing is another alternative. This involves attributing certain fixed costs to
the activities which cause them and then using marginal costing to calculate a contribution for
each activity, the surplus of contribution over attributable fixed costs being known as
attributable contribution.
Summary
Absorption costing is most often used for routine profit reporting and must be used for
financial accounting purposes. Marginal costing provides better management information for
planning and decision-making.
Marginal cost is an important measure in marginal costing, and it is calculated as the
difference between sales value and marginal or variable cost.
In marginal costing, fixed production costs are treated as period costs and are written off as
they are incurred. In absorption costing, fixed production costs are absorbed into the cost of
units and are carried forward in stock to be charged against sales for the next period. Stock
values using absorption costing are therefore greater than those calculated using marginal
costing.
Reported profit figures using marginal costing or absorption costing will differ if there is any
change in the level of stocks in the period. If production is equal to sales, there will be no
difference in calculated profits using these costing methods.
SSAP 9 recommends the use of absorption costing for the valuation of stocks in financial
accounts.
There are a number of arguments both for and against each of the cosign systems.
The distinction between marginal costing and absorption costing is very important and it is
vital that you now understand the contrast between the two systems.
 Define contribution
 How are stocks valued in marginal costing?
 If opening and closing stock volumes and values are the same, does absorption costing or
marginal costing give the higher profit?
 What are the arguments in favour of the use of marginal costing?
Absorption rates under ABC should therefore be more closely linked to the causes of
overhead costs and hence product costs should be more realistic, especially where support
overheads are high.

8.2 Distinction between marginal and absorption costing

These are two approaches of arriving at the cost of production or net profit for a given
period. The main difference between absorption costing and marginal costing is on the
treatment of the fixed cost
In absorption costing both variable and fixed production costs are included in the
determination of the cost of a product. This implies that the fixed cost is treated as a product
cost and not a period expense. It is important for the student to note the term ―fixed
production costs‖ as they are the only costs that make the difference between the marginal
and absorption in costs of production.
In marginal costing only variable costs are included in the determination of the production
cost. This implies that fixed costs are treated as period costs:
 Period costs
 Product costs

Illustration 1
The following information was extracted from the book of Happy Ltd for the year ended
31/12/2001

Output 100000 units

Production costs
Direct labour cost Shs 5 Million
Direct material cost Shs 2 million
Variable overheads Shs 2 million
Fixed overheads Shs 4 million
Units sold 90,000
Selling price per unit Shs 100.00
Assume closing stocks at the end of the previous period were nil.

Required
Using both absorption and marginal costing determine
i. Cost per unit
ii. Prepare the income statement

Solution
Marginal costing

( 5  2  2)
million  Shs.90
100 , 000
i. Cost per unit =
Note:
Only variable costs are considered. Fixed overheads are not included in the cost per unit.

∴Total units sold = 90,000 x 90 = Shs 8,100,000

∴Closing stock value = 10,000 x 90 = Shs 900,000

Total costs (variable) for the goods produced
= 100,00 x 90 = shs.9,000,000 = cost of finished goods

Absorption costing
Cost per unit = 5,000,000 + 2,000,000 +2,000,000 + 4,000,000 = Shs 130
100,000

Note
All costs (fixed and variable) are considered in arriving at the cost per unit.
∴Total cost of units sold = 130 x 90000 = Shs 11,700,000
Closing stock = 10,000 x 130 = 1300000
Total costs for goods produced = Shs 1,300,000 = cost of finished goods

ii. Income statement for the year ended 31.12.2001

Using MARGINAL ABSORPTION COST
COSTING
Shs Shs
Sales 90,000 x 100 9,000,000 9,000,000
Cost of sales
Opening stock Nil Nil
Cost of finished goods 9,000,000 13,000,000
Cost of goods available for sale 9,000,000 13,000,000
Less closing stock (900,000) (13,000,000
)
Cost of goods sold (8,100,000) 11,700,00
GROSS PROFIT/LOSS 900,000 (2,700,000
)
Period costs
Fixed overheads (400,000) -________
Net loss (3,100,000) 2,700,000

How can the above differences in net losses be explained?

Note that they are caused chiefly by the differences in cost of goods sold, which is in turn
caused by the differences in the cost per unit for finished goods and closing stock

Reconciliation of marginal costing and absorption costing profits

Net loss as per absorption costing (2,700,000)
Net loss as per marginal costing (3,100,000)
Difference 400,000
Value of closing stock as per absorption costing 1,300,000
Value of closing stock as per marginal costing (900,000)
400,000

8.3 Application of marginal costing

Break-even analysis and break-ever charts

Break-even point is the volume of sales at which there is no profit or loss. Break-even charts
graphically display the relationship of cost to volume and profits and show profit or loss at
any sales volume within a relevant range
Approaches to break-even analysis
Contribution margin approach
An equation or a graph can be used to determine a company‘s break-even point

Example
Sales price per unit Shs. 10
Unit variable expenses Shs. 4
Fixed expenses Shs. 3600
Contribution margin Shs. 10 unit sales price – E4 variable expenses = Shs. 6 unit
contribution margin

Contribution margin may also be expressed as a total. The following equation indicates sales
equal expenses because there is no income at the break-even point
x = Units to be sold at break even point
s = variable expenses + fixed expenses
Shs. 10x = Shs. 4x + Shs. 36000
Shs.6x = Shs. 36000
x = Shs.36000 Fixed expenses = 6000 units to break-even
Shs. 6 unit contribution margin

Break-even chart: It is a diagrammatic representation of the relationship between costs,

expenses, prices and the sales volume.

A break-even chart expresses revenue, costs and expenses on the vertical scale. The
horizontal scale indicates volume that may represent units of sales, direct labour hours,
machine hours or other suitable cost drivers.

Figure 5.0 Sales Revenue

costs,
sales Income area (profit)
Total expenses

Fixed expenses
Loss
area
0 Units Volume of Activity

X = Break-even point, No loss, no profit point!

Break-even chart showing contribution margin

Sales
Figure 5.1

Costs Profit Zone

Sales

Breakeven

Fixed

Expenses
Expenses

Loss Zone
Variable
Expenses

Volume of Activity

8.4 Assumptions of break-even analysis

1. The break-even chart is fundamentally a static analysis; normally changes can only be
shown by drawing a new chart or a series of charts
2. Relevant range is specified to define fixed and variable costs in relation to a specific
period and designated range of production level
3. All costs fall into either fixed or variable cost classification
4. Unit variable costs remain the same and there is a direct relationship between costs and
volume
5. Volume is assumed to be the only important factor affecting cost behaviour
6. Unit sales price and other market conditions are assumed to remain unchanged
7. Total fixed costs remain constant over the relevant range considered
8. Inventory changes are so insignificant that they have no impact on the analysis
9. The technology level does not change.

8.5 Cost volume and profit analysis (CVP Analysis)

CVP Analysis examines the relationship between cost, activity level and the profit.
CVP Analysis assists in a wide range of profit planning and decision making situations
including
a) The effect of production method changes
b) The effect of changes in product mix
c) The viability of special sales promotion campaign
d) The level at which service must be utilized to break-even
e) The impact of price changes on profit as price changes
8.6 CVP Analysis in conditions subject to change
Cost and revenue will change as well as sales volume due to a number of factors including:-

a) Increased competition may require selling price discounts in order to stimulate

demand
b) Material prices, wage rates and overhead costs may all change because of the impact
of inflation
c) Material usage may change where scrap is expected to fall because of improved
methods, better trained workers or better material quality
d) Labour efficiency may change where improved training programs or a reduction in
labour turn over is expected to occur
e) Overhead expenses may fall due to more efficient placement of order with suppliers
who offer best terms
f) Product mix may change either as part of overall company strategy or due to
increased competition

Changes in selling price and/or variable cost per unit

Figure 5.2

Profits

Shs. 0
B1 B2 B3 S
Sales
M2 Volume

Losses M
M1

The contribution sales ratio is affected by any change in selling price and or variable cost per
unit. This ratio is a measure of the rate at which profit is being earned and its size illustrated
by the steepness of the slope of the profit volume graph
Line xy shows the existing profit curve for a company
Fixed costs = OY
The profit at sales volume OS = SX; break-even point occurs at point B and the margin of
safety = M
An increase in selling price and/or a decrease in variable cost per unit will increase the
contribution; sales ratio resulting in a new point curve yx
A decrease in selling price and/or increase in variable cost per unit will reduce contribution;
sales ratio resulting in a new profit curve yx2

Change in fixed cost

In figure 5.3 graph yx shows the existing profit curve for a company with a fixed cost OY
break=-even point B, margin of safety M, profit SX where sales volume is OS. A change in
fixed cost does not affect the contribution to sales ratio, which is only influenced by selling
price and variable cost per unit
Figure 5.3 Changes in fixed cost
x1
x

Profits x2

O
B1 B B2 S
Sales Volume

y1 M2
Losses M

M1
y0
y2

Line y1,x1 shows the new profit curve when fixed costs are reduced to OY1. The following
should be noted
a) The profit at sales volume OS has increased to SX
b) Break-even point has been lowered to B
c) Margin of safety has been increase to M1
d) Contribution sales ratio is unchanged

Changes in product mix

A change in product mix where individual products have different contribution will have
different contribution. Sales ratio will result in a change in overall profit curve
Illustration 2
The summary results of Donlon Ltd are as follows:
Product A B C Total
Shs.000 Shs.000 Shs.000 Shs.000
Sales revenue 300 200 100 600
Variable costs 150 120 70 340
Contribution 260
Fixed costs 100
Net profit 160
Contribution sales ratio 0.5 0.4 0.3 0.433

Required
1. Prepare a profit volume graph which shows the overall results for Donlon Ltd
2. Prepare an amended profit curve where the market forces have led to a switch of Shs.
200,000 of sales from product A to product C
3. Prepare a summary which shows the value of each of the following for both the original
results and the amended results
a) Net profit
b) Break-even point
c) Margin of safety
d) Overall contribution sales ratio
Solution

175
x
150
125
100 xa
Profits75
50
25
0 50 100 150 200 250 300 350 400 450 500
-25 (sales Shs.000)
-50
-75
-100 y

The above profit volume graph shows the existing and amended cost curves for Donlon Ltd.
The amended data which implements the switch of Shs. 200,000 of sales from product A to
product C may be summarized as follows:
Product A B C Total
Shs.000 Shs.000 Shs.000 Shs.000
Sales revenue 100 200 300 600
Variable costs 50 120 210 380
Contribution 50 80 90 220
Fixed costs 100
Net profit 120
Contribution sales ration 0.50 0.40 0.30 0.367

Note
That the variable costs for product A are reduced proportionally while those of product C are
increased proportionally to the change in sales value according to the variable cost: sales ratio
for each product
The original curve is YX and the amended profit curve is Yxa
The following summary information may be read from the profit volume graphs

Product mix Existing Amended

Net profit Shs.000 160 120
Break even point Shs.000 230.77 272.73
Margin of safety Shs.000 369.23 327.27
Contribution sales ratio 0.433 0.367
8.7 CVP and computer applications
The wide availability of personal computers encourages more managers to apply cost volume
profit analysis
Computers can quickly make the computations for changes in the assumptions identifying
proposed projects e.g. computer spreadsheets allow managers to determine the most
profitable combination of selling process, variable and fixed cost volume. A manager enters
into the computer various numbers for price and cost in an equation based on CVP
relationships to yield target income for each combination because of a computers speed and
accuracy in providing this information the manager can select the most profitable actions
Limitations of CVP Analysis
The use of the basic CVP model is only relevant to planning and decision-making in an activity
range in which the basic cost and revenue behaviour assumptions are valid. Outside the relevant
range, CVP techniques may still be applied so long as the varying cost and revenue behaviour
patterns are taken into consideration.
However, the limitations o CVP analysis are actually its assumptions, which do not hold
outside the relevant range!

Nature of Decision-making
Decision-making may fall into any of the following categories
1. Short run operational decisions
2. Short run tactical decisions
3. Longer term strategic planning decisions
Short run operational decisions are made in relation to the achievement of short-term output
requirements. A decision may be made to work overtime in a department in order to have a
job completed in accordance with a scheduled delivery date to the customer. Such decisions
are aimed at ensuring that the current business plan is achieved
Short run tactical decisions are related to specific events which management wish to decide
upon and which will change the future operation of the business in some way. Its time
horizon is short and it is usually the next 12 months
Longer term strategic planning is more concerned with the overall direction of the business
plan. It may have a time horizon of 5 to 10 years. For example should a decision be made to
install a fully automated production line to replace existing labour intensive machine process.
These decisions require consideration of factors such ass
- The level of market likely to be available in future
- An estimation of changing price levels
- The timing of cash flows in relation to the decision
- The degree of uncertainty estimated in relation to data used in the evaluation
of the situation
- The strategy which competitors are likely to implement
- The cost of capital or target rate of return

8.8 The decision making cycle

Steps in decision-making cycle are:
a) Clearly define the objective, which is to be the focus of the decision. This is important
in order that the decision makers have a well-defined problem which has to be solved
and not a vague idea which lacks clarity.
b) Consider the alternative strategies available to the satisfactory attainment of the
objective. This is important in order that the final decision agreed upon has taken
account of all relevant possibilities.
c) Gather relevant information in order to compare alternative strategies in quantifiable
terms. This may require considerable thought and effort in order to ensure that all
relevant data are obtained.
d) Consider the qualitative factors, which are likely to influence the decision. This is
important as an element in decision making. There may be non-quantifiable costs and
benefits, which lead to the final choice of strategy being other than that giving the
highest quantifiable return.
e) Compare the alternative strategies using both quantitative and qualitative data and
then make a final decision.
f) Re-evaluate your decision; determine if you are achieving the objectives and if not,
repeat the process.

Relevant costs and decision-making

The relevance of costs will depend upon the purpose for which they are being used.
Relevance is related to future decisions
The relevance of costs in decision-making is related to whether they are avoidable in relation
to the decision made or if they are unavoidable, in that they will remain irrespective of the
decision taken.
Relevant costs in decision-making are therefore said to be incremental and future costs
relating to the decision to be made. Costs are incremental if they will result in a difference
e.g. avoidable costs result in reduced cots if they are avoided. Future costs are those costs
that have not yet been incurred i.e. they are not sunk costs or committed costs. This is
explained further in this text.
Limiting factors and decision making
A limiting factor may be defined as ‗any factor, which has a limiting effect on the activities
of an undertaking at a point in time over a specific period‘
The decision-making strategy, which managements wish to pursue, may be constrained
because of shortage of manpower, machinery, material, money, markets or a combination of
these. It may also be affected by the availability of management expertise and methods
improvement capability.
In short term decision making where one or more factors will limits the strategy which may
be implemented, it is likely that profit maximization will be seen as a major decision making
goal. It should be noted however that in practice a number of goals will form part of the
objective of an organization. In addition to short term profits management will wish to
consider a number of longer term goals, for example
- Consolidation of market share
- Product leadership
- Good industrial relations
- Improving longer term productivity and profitability
- Quality leadership
- Employee and customer satisfaction
- Social responsibility
This balance between short and long term goals is likely to lead to decisions which are profit
satisfying rather than profit maximizing resulting in the satisfactory profit level being earned
in the short term

REVISION QUESTIONS
QUESTION ONE
XYZ Company manufactures a product called ―PERMA‖. Pertinent cost and revenue data
relating to the manufacture of this product is given below:
Shs
Selling price per unit 66
Variable production cost per unit 44
Variable selling cost per unit 4

Fixed production cost (total) Shs.200,000

Fixed selling and administrative cost (total) Shs.99,000
Required
a) Calculate the break-even sales level in shillings;
b) Suppose the company desires to make a profit of shs.195,000, what should be the output
in units?
c) A new machine, which is more efficient, is installed. This machine increases the fixed
production cost by 20% but reduces the variable production cost per unit by 30%. What
is the new break-even point in sales revenue?
d) State five limitations of break-even analysis. (Total: 20 marks)

QUESTION TWO
Explain 10 limitations of Break-even analysis. (Total: 20 marks)
QUESTION THREE
a) Explain the following terms as used in CVP analysis.
Break-even charts
i. Variable cost ratio
ii. Contribution margin ratio
iii. Margin of safety
iv. Profit volume ratio
v. Marginal Income Ratio (12 marks)
SAMPLE EXAM QUESTIONS
QUESTION ONE
a) Define marginal costing and give its limitations. (6 marks)
b) The following data relate to Kenya Ltd for the year ended 31 December 1999.

Sh ‘000’
Sales 24,000
Less: Total costs 20,000
Net profit 4,000

Fixed costs account for 40% of the total costs.

Required:
i) Margin of safety. (2 marks)
ii) Break-even point in sales (2 marks)
iii) Sales required to earn profit of Sh 6,000,000. (2 marks)
iv) In order to increase sales, the management has the following two options:
1. To increase sales by 25% on incurring a sales promotion cost of
Sh 2,500,000.
2. To increase sales by 15% on reducing selling price by 5%.
Advise the management on which option they should take. (8 marks)
(Total: 20 marks)

QUESTION TWO
a) Explain the advantages of centralized system of maintaining stores. (5 marks)
b) Explain the assumptions behind the determination of Economic Order Quantity (EOQ).
(5 marks)
c) The following information is given for material Y-20.

Consumption:
Annual 360,000 units
Maximum 1,200 units/day
Minimum 800 units/day
Normal 900 units/day
Re-order period 12 – 24 days
Re-order quantity 32,000 units

Required:
i) Re-order level. (3 marks)
ii) Minimum stock level. (3 marks)
iii) Maximum stock level (3 marks)
(Total: 20 marks)

QUESTION FOUR
a) What is the basic difference between account classification method and high-low method as
applied in cost estimation? (4 marks)
b) Distinguish between the following cost accounting terminologies:
i) Direct and indirect costs (4 marks)
ii) Cost center and cost unit (4 marks)
iii) Joint products and by-products) (4 marks)
iv) Period costs and product costs (4 marks)
(Total: 20 marks)

QUESTION FIVE
c) What is the basic difference between account classification method and high-low method as
applied in cost estimation? (4 marks)
d) Distinguish between the following cost accounting terminologies:
v) Direct and indirect costs (4 marks)
vi) Cost center and cost unit (4 marks)
vii) Joint products and by-products) (4 marks)
viii) Period costs and product costs (4 marks)
(Total: 20 marks)

QUESTION SIX
Explain the term budgetary control and state its importance to a business firm. (10 marks)
State and briefly explain the limitations of budgets in the management of business firms.
(10 marks)
(Total: 20 marks)

QUESTION SEVEN
a) Describe the duties of a cost accountant in an organization. (4 marks)
b) Differentiate the following terminologies:
(i) Relevant costs and irrelevant costs (4 marks)
(ii) Cost center and cost unit. (4 marks)
(iii) Semi-fixed and semi variable costs. (4 marks)
(iv) Sunk costs and product costs (4 marks)
(Total 20 marks)

QUESTION EIGHT
a) State the assumptions that underlie the break-even analysis. (10 marks)
b) Explain how you would analyze and classify the marketing costs. What purposes are
served by such analysts and classification? (10 marks)
(Total 20 marks)

END