INSTITUTE OF CERTIFIED

PUBLIC ACCOUNTANTS
OF RWANDA

CPA

F2.1
MANAGEMENT
ACCOUNTING
Study Manual

2nd edition February 2020,

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Acknowledgement

We wish to officially recognize all parties who contributed to revising and updating this Manual, Our thanks are extended
to all tutors and lecturers from various training institutions who actively provided their input toward completion of this
exercise and especially the Ministry of Finance and Economic Planning (MINECOFIN) through its PFM Basket Fund
which supported financially the execution of this assignment
INSTITUTE OF CERTIFIED PUBLIC
ACCOUNTANTS OF RWANDA

Foundation F2
F2.1 MANAGEMENT ACCOUNTING

2nd Edition February 2020

This Manual has been fully revised and updated in accordance with the current syllabus/
curriculum. It has been developed in consultation with experienced tutors and lecturers.
Table Of Contents

Topic Title Page

1. The nature and scope of mangement accounting 8

Definition 8
Nature of management accounting 8
Scope of management accounting 9
What cost accounting provides for the organisation 10
Objects of a cost accounting system 11
The role of cost accounting in a management Information system 13
Desirable qualities of management accounting information 14
Cost classification 14
Ethical issues 21

The trainee management accountant 23

2. Cost accumulation systems 24

Introduction and definitions 24
Accountingformaterials 25
Outlineofprocedures 25
Organisationanddocumentationof purchasing 29
Receiving department 32
Goods inwards book and goods received note 33
Procedure in the accounts department 34
The storekeeper and stores issues 35
The general routine for stores issues 36
Stock levels 37
Stockturnover 41
Accounting records required for materials 41
Stocktaking 42
The pricing of material issues 45

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Economic batch quantity 50
Obsolete, dormant and slow-moving stock 51

Just-in-time (jit) 52
Labour 53
Indirect labour 68
Treatment of overtime 69
Notional expenses 71
Capital equipment 72
Introduction to overhead costs 73
Overhead allotment 75
Overhead absorption 83
Activity-based costing 91
Costbook-keeping 100
Cost accounting systems 100

3. Costing methods 108

Introduction to batch costing 108
Calculation of cost per unit 108
Product line information 108
Batch production versus continuous production 109
Service costing 111

Introduction 111
Service cost units 111
Internal service activities 112
Examples 112
Building up process costs 116
Examples of process costing 117
Losses in process costing – normal losses and abnormal losses 130

Process costing involving both losses and work-in-progress 134

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4. Costing techniques 142
Definition of marginal cost 142
The marginal cost equation: terminology of marginal Costing 142
Marginal profit and loss account 144
Marginal and absorption costing compared 148
Uses of marginal costing 154
Arguments against marginal costing 157
Assumptions of marginal costing 158
When production is constant but sales fluctuate 161

When sales are constant but production fluctuates 164

5. Information for decision making 167

Fixed,variable and semi-variablecosts 167
Cost estimation 168
Break-even analysis 172
Break-even chart 175
The profit volume graph 182
The profit/volume or contribution/sales ratio 187
Relevant costs 191
Market vulnerability analysis 202
Continue/close down decisions 203
Marginal costing in decision making 204

Decision making involving a single limiting factor 209

6. Information for planning and control 214

Budget (a plan in money) 214
Budgetary control 214
Advantages of budgetary control systems 216
Types of budget 217
Preparation of budgets 218
Control mechanism 223

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Public sector budgets 228
Functional budgets 231
Master budgets 239
Flexible budgets 247
Zero-base budgeting (zbb) 256
Budgetary control and standard costing - behavioural considerations 259
Standard costing and variance analysis 261
Introduction 261
Types of standard cost and system 262
Setting standards 263
Types of variance 268
The standard hour 269
Measures of capacity 270
Limitations of standard costing 271
Purpose of variance analysis 272
Meaning and possible causes of variances 272
Relationships between variances and investigation of their causes 280
Planning and revision variances 288
Worked example 289

Glossary of management accounting terms a-z 291

Key management accounting terms 291

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SUBJECT TITLE: F2.1 MANAGEMENT ACCOUNTING
Aim

The aim of this subject is to ensure that students develop a knowledge and understanding o f the
various cost accounting principles, concepts and techniques appropriate for planning, decision-
making and control and the ability to apply these techniques in the generation of management
accounting reports.

Management Accountingas an Integral Part of the Syllabus

This subject develops in students an understanding of how management accounting plays an

integral part in the modern commercial environment, supporting entrepreneurial activities in
both growing and established entities. It provide s an essential foundation in the study of cost
and management accounting and is a necessary prerequisite to the later studies in Managerial
Finance, Strategic Performance Management,Strategic Corporate Finance and Strategy &
Leadership.

Learning Outcomes

On successful completion of this subject, students should be able to:

• Explain the relative strengths and weaknesses of alternative cost accumulation methods and
discuss the value of management accounting information.
• Calculate unit costs applying overhead using both absorption costing and activity based costing
principles.
• Apportion and allocate costs to units of production in job, batch and process costing systems,
for the purpose of stock valuation and profit measurement.
• Identify and explain cost behavior patterns and apply cost-volume profit analysis.
• Define and use relevant costs in a range of decision-making situations.
• Prepare and present budgets for planning, control and decision-making.
• Compute, interpret and investigate variances.
• Demonstrate communication skills including the ability to present quantitative and qualitative
information, together with analysis, argument and commentary, in a form appropriate to the
intended audience.

Syllabus:

1. The nature and scope of management accounting

• The relationship between management accounting and financial accounting.
• Cost classifications.
• The role of the Management Accountant in a modern business environmentincluding the
recognitionof possible ethical issues that may arise.
2. Cost Accumulation Systems
• Accountingfor materials: stock valuationapproaches (FIFO; LIFO and AVCO); EOQ; JIT
concepts.
• Accounting for labour: remuneration methods; incentive schemes; productivity, labour turnover
and labour performance reports.

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• Accounting for Overheads: absorption costing and activity based costing
• (ABC) approaches to overheads.
• The preparationof integrated accounts.
3. Costing Methods
• Job and batch costing.
• Process costing for single products and the use of equivalent units calculations under both FIFO
and Weighted Average accounting systems.
• Process costing ledger accounts including normal and abnormal loss/gain.
• The role of costing in non-manufacturing sectors (Service costing).
4. Costing Techniques
• Marginal costing and the importance of contribution for decision-making.
• Comparison of marginal costing and absorption costing approaches.
5. Information for Decision Making
• Cost behavior patterns and identification of fixed/variable elements in a cost using High/Low
method, scatter-graphs and regression analysis.
• Break-even analysis and the importance of contribution.
• Break-even chart preparationand interpretation.
• Calculationof break-even point, margin of safety and target profit.
• Limitationsof Cost Volume ProfitAnalysis.
• Relevant costing principles including committed, sunk and opportunity costs.
• Relevant costs in decision-making.
• Make or Buy decisions
• Decision making with a single limitingfactor/constraint.
• Qualitativefactors relevant to specificdecisions.
6. Information for Planning and Control
• The role of budgeting including alternative budgeting systems (Fixed, flexible, incremental and
Zero Based Budgeting(ZBB)).
• Behavioral and motivational issues in the budgetary process.
• Functional and subsidiary budgets.
• Standard costing: role and procedures for standard setting including different types of standards.
• Variance analysis: the calculation and interpretation of basic sales/cost variances. Reconciliation
reports.
• The inter-relationship and possible causes of variances.

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TOPIC 1
THE NATURE AND SCOPE OF MANGEMENT ACCOUNTING

Definition
What Is “Cost Accounting”?
The Chartered Institute of Management Accountants, in its publication, “Terminology of
Management and Financial Accountancy”, defines cost accounting as:

that part of management accounting which establishes budgets and standard costs, and the
actual costs of operations, processes, departments or products and the analysis of variances,
profitability or social use of funds.”

This involves participation in and with management to ensurethat thereiseffective:

• Formulation of plans to meet objectives (long-term planning)

• Formulation ofshort-term operation plans (budgeting/profit planning)
• Correctiveaction to bringfutureactual transactions into line (financial control)
• Recording of actual transactions.

The up-to-date terminology by the Chartered Institute of Management Accountants gives the
following definitions.

Management Accounting has been defined in the words: “The provision of information required
by management for such purposes such as:

• Formulation of policies.
• Planning and controlling the activities of the enterprise.
• Decision taking on alternative courses of action.
• Disclosure to those external to the entity (shareholders and others)
• Disclosure to employees.
• Safeguarding assets.

Nature of Management Accounting

The main points which show the nature of management accounting:

1. No Fixed Norms Followed

In financial accounting, we follow different norms and rules for creating ledgers and other account
books. But there is no need to follow fixed norms in management accounting. Management
accounting tool may be different from one organization to other organization.
Using of different tools of management accounting is fully dependent on the persons who
are using it. So, business policy of each organization affects rules and regulation of applying
management accounting.

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2. Increase in Efficiency
It is the nature of management accounting that it is used for increasing in the efficiency
of organization. It scans the points of inefficiency through analysis of accounting
information. By taking action for improving, organization can increase the efficiency.

3. Supplies Information not Decisions

Management accountant supplies accounting facts and information and also provides
interpretation, but decision making is fully dependent on higher authorities. Management
accounting is just guide.

4. Concerned with Forecasting

It is the temperament of management accounting that it is fully concerned with forecasting.
In management accounting, historical accounting information is analyzed through common
size financial statement, ratio analysis, fund flow analysis and accounting data tendency for
knowing the probability of next fact. So, all these things are especially useful for forecasting.
These forecasting may be related with following things

• sales forecasting
• production forecasting
• earnings forecasting
• cost forecasting
Scope of Management Accounting
Scope of management accounting is very vast and includes various aspects of the business
activities. Management accounting has its scope in the following fields or systems:

1.  Financial accounting: - It is the foremost and indispensable part of accounting. In this system,
business transactions of financial character are recorded in the proper subsidiary book. Posting of
these transactions is done in ledger and from this the final accounts are prepared. Final accounts
include profit and loss account and balance sheet. Profit and loss account represents the profit/
loss earned during the accounting period and the balance sheet represents the financial position
of a company as on a particular date. Financial accounting is the foundation from management
accounting as it provides the necessary information for preparation of details and reports to be
presented to the management.

2.  Cost Accounting: - Cost accounting is one of the important branches of accounting. It ascertains
the cost of producing a particular commodity and rendering of services cost of selling and
distribution. It facilitates effective planning regarding commodities, proper decision-making and
cost control. Some of the important tools of cost accounting are marginal costing, standard
costing and budgetary control.

3.  Revaluation accounting: - Revaluation accounting ensures that capital is represented at its real
value in the accounts and the profit has been calculated keeping this fact in mind. In other words,
it assures that the assets are revalued according to the need and its effect has been brought
into the accounts. Management accounting helps to ascertain the revalued figures of the assets.
4.  Control accounting: - Controlling means to measure the variation, if any, between actual and
the standard results and taking corrective measures to remove that variation. Management
accounting is the indispensible part of control accounting, budgetary control, inventory control,
equality control are some of the important techniques of management accounting for control
accounting.

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5.  Statistical methods: - Management accounting is concerned with presentation of accounting
information in the most impressive and understandable manner. It makes use of graphs, charts,
index numbers, pictorial presentation and other statistical methods in order to make the information
more intelligible. For scientific analysis of financial statement and accounting  information various
statistical techniques such as mean, standard deviation, covariance, correlation, t-test, etc and
used in management accounting.

6.  Interim reporting: - Interim reporting means preparation of reports on monthly, quarterly and
half-yearly basis. These reports include income statement, cash flow statement, funds flow
statement, scrap reports etc.

7. Internal audit: - Internal audit means audit of various departments by the internal members of
the organization. The techniques of management accounting can be used to judge the efficiency
and economy of the organization. Ratio analysis and funds flow analysis are widely used to
judge the efficiency of an organization.

8. Taxation: - Tax planning and its management is an essential function of the management.
It includes computation of income as per tax laws, filing of returns and payment of tax within
stipulated time.

What Cost Accounting Provides for the Organisation

a) Additional Financial Information

When cost accounting was first used, its main purpose was to provide additional
Information concerning the financial operations of an organisation. For the majority of firms, this
is still considered as its main purpose. It usually implies historical costing and the production of
regular detailed statements and statistics.

b) Control Information
A more modern concept of cost accounting is that its purpose is to assist management by
Providing them with control information.

This usually demands more from the cost accountant. He or she will still produce statistical
statements, but will be required to analyses and interpret these statements. Comparisons will
be made with “budgets” and“standards”,and the cost accountant will probably use the exception
system of reporting, advising management only where action is required.

c) ManagementTool
Cost accounting has often been likened to a tool in the hands of management. Consider
what this means:

• It must be the right tool. The cost accountant, in consultation with management, must agree
what information is required and when ;the cost of providing it will also have to be taken into
consideration. The question must also be asked, is complete accuracy necessary? Will an
approximation within given limits be of more value, if it can be provided swiftly?
Any system of costing must be tailored to suit the organisation which it serves. In many cases
simple historical cost accounting will be sufficient; in others a more sophisticated system may
be necessary.

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• The tool must be capable of doing the job. The cost accountant must ensure that the facts and
figures produced provide management with the information they require, in an easily assimilated
form.
Do not forget that manufacturing conditions and markets will change over the years, and the
cost accounting system may need to be adapted to suit changing needs. A new system may
need to be designed and introduced.

• It is management who use the tool, and the extent of its success will depend up on the degree
of efficiency with which it is used.

Objects of a Cost Accounting System

Different firms will use cost accounting for different purposes. Nevertheless, every system
will involve some of the objectives listed below.

(a) Cost Control This will be assisted by:

• Finding out the cost of each product (or service),process and department-costs must be
ascertained in phase with manufacturing activity, enabling remedial action to be taken quickly
when it is required.
• Comparing the costs with budget, standard or past performance figures to indicate the degree
of efficiency attained.
• Analyzing the variances from budget and identifying the person or department responsible so
that prompt, remedial action may be taken.
• Disclosing to what extent production facilities are used and indicating the amount and cost of
idle and waiting time.
• Presenting the information suitably to management in such a form as to guide them in taking
any necessary action.

(b) Advice to Management in the Formulation of Policy

This will include:

• Provision of information to assist in the regulation of production and the systematic control of
the organisation.
• Provision of special investigations and reports. These might deal with such matters as:
Whether to manufacture apart or to sub-contract another firm. The advisability of installing new
machinery. The effect of increased or reduced production volumes on profitability.

(c) Advice on the Effects of Management Policy

This will be disclosed through reports (both regular reports and those following special
investigations).
(d) Estimating andPriceFixing
Figures will be provided from standards or past results as the basis for future estimates.
Cost is an important factor in price fixing, but it is not the only one. Demand and competitive
activity are also crucial. Therefore a firm’s profitability may depend largely on its ability to control
costs in ways described in(a) above.

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Cost accounting compared with financial accounting:
You will be familiar already with the end-products of financial accounting, namely the balance
sheet and the profit and loss account. These are valuable documents for management,
the first giving the position of a company or firm at a specific time, the second showing
the results of the company’s operations over a specific period of time. The books of
accountfromwhichtheprofitandlossaccountandbalancesheetarederivedarealsoof value, since
they provide a record of every transaction.

Despite the value of the financial accounts, it was their inadequacy which gave rise to the
introduction of costing and the development of costing techniques. The financial accounts show
primarily external transactions (sales, purchases, borrowing, etc.) and the profit for the organisation
as a whole. Management requires detailed knowledge of the cost of each product or unit, of each
department or process to show how the profit was built up and the relative profitability of each
section of the business. Cost accounting has now become an essential factor of every business.

It is of interest that in recent years “integrated accounts”(see later in this study unit) have grown
in popularity. Integrated accounts are merely the combining of the financial and cost accounts
into one set of books. We seem to have come full circle ,from the separation of the financial and
cost accounts, through the development of costing, to the joining together of the two systems into
one integral system. Of course, in many businesses increasing computerization has assisted this
development.

Relationship between Management Accounting and Financial Accounting

Cost accounting is part of management accounting which establishes budgets, standard costs
and actual costs, process, product costs and analysis of variances, profitability or the social use
of funds.

Management accounting is the application of accounting techniques and financial management to

provide information that help management in the formulation of policies and strategies, planning
and controlling the activities, decision making and optimization of use of resources.
Financial accounting is the process of recording, classification and interpreting financial
transactions.

Management information provides a common source from which is drawn information for financial
accounts and management accounts.
The data used to prepare financial accounts and management accounts are the same.

Differences between Management Accounting and Financial Accounting
1. Legal requirements: Financial accounts must be prepared as a statutory requirement while
management accounting is not compulsory as it depends on the management needs. It is a
statutory requirement for all public limited companies to produce annual accounts at the end
of every financial year while management accounting is optional.

2. Reporting requirements: Financial accounts must be prepared and presented in conformity

with GAAP while management accounting is not based on any accounting rules and regulations
and not bound to use generally accepted accounting principles.

3. Focus on part of organisation : Financial accounting reports describe the whole of the
organization/business while as management accounting focus on small parts of the organization.

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4. Reporting frequency: Financial accounts are usually prepared annually or semi annually
while as management requires information quickly if it is to act on it, and consequently
management accounting reports on various activities may be prepared at daily, weekly or at
monthly intervals. management reports are more routine (frequently prepared).

5. Primary users of information: Information generated under management accounting

system is used by members of management at different levels while the users of financial
accounting statements are mainly external to the business enterprise such as creditors,
financial institutions, potential investors, government authorities, etc.

6. Time dimension: Financial accounting reports what has already happened in the past in an
organization while as management accounting is concerned with future information as well
as past information
7. Unit of measurement: Management accounting addresses financial and non financial
performance measures (issues that cannot be quantified) as decision making cannot be
enhanced by using quantitative information only while financial accounting addresses
financial performance measures i.e. matters than can be expressed in monetary terms.
8. Auditing requirement: Financial accounts must be subjected to an external audit since
they are used by external parties but it is not a requirement to audit cost and management
accounts.

THE ROLE OF COST ACCOUNTING IN A MANAGEMENT INFORMATION SYSTEM

Product Analysis
Only the very simplest form of organisation does not need a cost accounting system, and even
In this case some “cost accounting “would be done, but the simplicity of the business renders a
special system unnecessary.
In a more complex organisation, results can be analyzed in depth. The cost of each process or
operation which goes to make up the final product can be ascertained, as can the cost of the
various “service “departments (stores, tool room, powerhouse,etc.).

InvestigatingCosts
The cost accountant would not be satisfied merely to ascertain the figures, however. Perhaps
costs can bereduced, and/or revenues, and/orproduction increased.
The cost accountant will consult the sales manager. It may be that increases in price will result in
a decrease in sales. Moreover, financial considerations are not the only ones to be borne in mind.

By pursuing such enquiries, the cost accountant is achieving these function of costing, that is,
cost control. It should be stated here that it is not the cost accountant’s job to make executive
decisions, but merely to express the management’s policy in terms of money, and to indicate
where efficiency may be increased.

Guiding ManagementPolicy
A most important idea to the cost accountant’s work is providing information to management
At all levels. His or her job is to advise management of the financial effects of alternative policies.
He or she is an adviser only; it is for the manager to make policy decisions. Thus the cost
accounting system will justify itself only when the information it produces is used by management.
(Management accountants are part of “Management” and make use of both cost accounting
information and financial accounting information for their involvement in management decisions.)

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Non-Financial Considerations
Clearly therefore, before management can make decisions, they require information on which
To arrive at the decisions and cost accounting information is one part of the required information.
Other matters need to be considered which are frequently of a non-financial nature, however.
These might include:

• position in themarket;
• environmental considerations;
• legal constraints;
• staff qualifications and training needs
Desirable qualities of management accounting information
To ensure that the management accounting information is used effectively, the following attributes
must be considered:

• Relevance: The information must be relevant for the purpose for which the manager wants to
use it.
• Accuracy: The information should be sufficiently accurate for the intended purpose. Incorrect
information could have serious and damaging consequences.
• Timing: The information must be produced in time for it to be used effectively. Information which
is not available until after decision is made will be useful only on comparison and long term
control, and may serve no purpose even then.
• Understandability: The information must be capable of being understood by the recipient. The
information must be clear to the user.
• Volume/Details: The amount of details in a statement or report will depend on the recipient
level in the organization. Reports to the management must therefore be clear and concise.
• Completeness: An information user should have all the information he needs to do his job
properly.
• Communication: Within any organization, individuals are given the authority to do certain tasks,
and they must be given the information they need to do them. Budget must be provided to the
managers so as to assist him in controlling the expenditures in his office.
• Channel of communication: There are occasions when using one particular method of
communication will be better than others. The channel of communication might be the company’s
in-house journal, a national or local newspaper, a professional magazine, a job centre or school
careers office.
• Cost: Information should have some value, otherwise it would not be worth the cost of collecting
and filing it. The benefits obtained from the information must also exceed the costs of acquiring
it, and whenever management is trying to decide whether or not to produce information for a
particular purpose a cost/benefit analysis ought to be made.

COST CLASSIFICATION
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.
14 F2.1 Management Accounting CPA EXAMINATION
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Cost Classification bases
Costs can be classified on either one or more of the following bases:

• Are the costs dependent on the level of output (variable) or are the costs the same irrespective
of the level of output (fixed)?
• Have the costs already been incurred (sunk) or are they going to be incurred in the future
depending on what we decide (incremental) ?
• Are they already incurred (sunk/historical) or are the costs due to a benefit foregone for not
taking a certain option (opportunity cost)?
• 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)?
• Are the costs actually incurred (actual) or are they the expected as per the expenditure guidelines
set by the management (standard)?
• 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)?
• 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)?
• What is the function that makes the costs to be incurred in the organization, is it production,
administration or selling and distribution?
• Is the cost incurred for manufacturing reasons (production cost) or for manufacturing support
reasons (non-manufacturing cost)?
• 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:

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Manufacturing/ Non-manufacturing

Direct/indirect

incremental/sunk

Direct/indirect historic/opportunity

Functional
Classification
Cost Behaviour
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 Importance 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

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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

b) Labour costs
What is labour?
Labour costs could be direct or indirect labour costs.
Direct labour cost refers to wages paid to workers who are directly involved in the conversion
of raw materials into finished goods. These are called direct labour costs
Indirect labour costs refers to the wages paid to workers whose efforts cannot be readily
identified with specific product units or batches e.g. labourers paid to maintain all the premises
utilized for production of goods and services.

c) Overhead costs:
They are also called indirect production costs. They are those costs which can only be charged
to a cost unit using some estimated basis. The estimating procedure allows a share of the
indirect costs to be charged to each cost unit. These costs cannot be identified specifically to
the end product.

• 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:

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• 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.
• 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.
• 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.
• 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
• 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.

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

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

18 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
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.

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
Costs

Fixed
Costs

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
Costs

Activity level

CPA EXAMINATION F2.1 Management Accounting 19

STUDY MANUAL
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
behaviour can be predicted.

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
Costs
Fixed component

Activity level

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.

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!

20 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
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.

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:

• 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.
• 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
• 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.
• Other functional classifications

ETHICAL ISSUES
Ethical responsibilities of management accountants
Management accountants have an obligation to the organisations they serve, their profession, the
public, and themselves to maintain the highest standards of ethics.
Management accountants should behave ethically. They have an obligation to follow the highest
standards of ethical responsibility and maintain good professional image.
The Institute of Management Accountants (IMA) has developed four standards of ethical conduct for
management accountants and financial managers. These standards has since then been revered as
the central code for accounting professionals.

1. Competence

• Maintain an appropriate level of professional competence by on-going development of their

knowledge and skills.
• Perform their professional duties in accordance with relevant laws, regulations, and technical
standards.
• Prepare complete and clear reports and recommendations after appropriate analyses of
relevant and reliable information.

2. Confidentiality

• Refrain from disclosing confidential information acquired in the course of their work except when
authorized, unless legally obligated to do so.
• Inform subordinates as appropriate regarding the confidentiality of information acquired in the
course of their work and monito- their activities to assure the maintenance of that confidentiality.
• Refrain from using or appearing to use confidential information acquired in the course of their
work for unethical or illegal advantage either personally or through third parties.

CPA EXAMINATION F2.1 Management Accounting 21

STUDY MANUAL
3. Integrity

• Avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential
conflict.
• Refrain from engaging in any activity that would prejudice their ability to carry out their duties
ethically.
• Refuse any gift, favour, or hospitality that would influence or would appear to influence their
actions.
• Refrain from either actively or passively subverting the attainment of the organisation’s legitimate
and ethical objectives.
• Recognise and communicate professional limitations or other constraints that would preclude
responsible judgment or successful performance of an activity
• Communicate unfavourable as well as favourable information and professional judgments or
opinions
• Refrain from engaging in or supporting any activity that would discredit the profession

4. Credibility

• Communicate information fairly and objectively.

• Disclose fully all relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, comments, and recommendations presented.

Resolution of ethical conflict

In applying the standards of ethical conduct, practitioners of management accounting and financial
management may encounter problems in identifying unethical behaviour or in resolving an ethical
conflict. When faced with significant ethical issues, practitioners of management accounting and
financial management should follow the established policies of the organisation bearing on the
resolution of such conflict. If these policies do not resolve the ethical conflict, such practitioners should
consider the following courses of action:

• Discuss such problems with the immediate superior except when it appears that the superior is
involved, in which case the problem should be presented initially to the next higher managerial
level.
• If a satisfactory resolution cannot be achieved when the problem is initially presented, submit
the issues to the next higher managerial level. If the immediate superior is the chief executive
officer, or equivalent, the acceptable reviewing authority may be a group such as the audit
committee, executive committee, board of directors, board of trustees, or owners. Contact with
levels above the immediate superior should be initiated only with the superior’s knowledge,
assuming the superior is not involved. Except where legally prescribed, communication of
such problems to authorities or individuals not employed or engaged by the organisation is not
considered appropriate.
• Clarify relevant ethical issues by confidential discussion with an objective advisor to obtain
a better understanding of possible courses of action. Consult your own attorney as to legal
obligations and rights concerning the ethical conflict.
• If the ethical conflict still exits after exhausting all levels of internal review, there may be no other
recourse on significant matters than to resign from the organisation and to submit an informative
memorandum to an appropriate representative of the organisation. After resignation, depending
on the

22 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
THE TRAINEE MANAGEMENT ACCOUNTANT
The current development is that this becomes an important pillar of developing the would be
accountants of the future. The trainee learns with the help of an already established qualified
accountant who acts as a supervisor and guides him/her through professional developments.

The role of a trainee management accountant

• Inputs income and expense transactions into the organization accounting system
• Manages organization invoices, these can range from customer invoices to payables invoices
• Checks data accuracy, this involves confirming from source documents
• Present Information, this involves doing simple reports to illustrate information
• Performs administrative duties such as inventory count participation, payroll preparation and
cost accounting

CPA EXAMINATION F2.1 Management Accounting 23

STUDY MANUAL
TOPIC 2
COST ACCUMULATION SYSTEMS

A. INTRODUCTION AND DEFINITIONS

You have so far in your studies learned how management and cost accounting differs from
financial accounting, we are now going to examine the elements of cost. The first element of
cost-material. Before we do so, however, you should study carefully the following definitions of
the various kinds of materials stock:

(a) Raw Materials

This is unprocessed stock awaiting conversion into saleable products. Remember that
The finished product of one process or industry is often the raw material of the next process or
another industry.

(b) Bulk Materials

These are materials not in unit form,i.e.they cannot be counted but must be measured
By weight, volume, bars, tubes or sheets. Such materials are not suitable for the work in hand
without any change in form.

(c) Part-Finished Stock

This is work-in-progress which has not reached the stage of completion as apart or
component.

(d) Finished Goods

These are manufactured goods, ready for sale or dispatch, e.g. to a customer or agent.
They may also be known as manufactured stock or completed stock, and represent work-in-
progress which has been completed and transferred physically, and by entry in the accounts, from
the manufacturing department to the warehouse.

(e) Finished Parts

These are items or component parts which are in store and are awaiting either final
Assembly or sale as spares.

(f) Scrap Material

This is discarded material which has some recovery value and which is usually either
disposed of without further treatment (other than reclamation and handling), or reintroduced into
the production process in place of raw material.

(g) Indirect Materials

These are materials which cannot be identified as part of the product ,e.g. material for the machine
which makes the product.

(h) Consumable Stores

This term refers to certain direct materials, such as lubricants, waste, cleaning materials, etc.

24 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
B. ACCOUNTING FOR MATERIALS
Accounting for materials is every bit as important as accounting for cash.

Waste
Adequate control is necessary to guard against the many forms of waste which occur, such as
carelessness, pilfering, breakages, breaking bulk materials into small lots, overstocking, etc.

Overstocking
This causes loss by wasting space and congesting the stores; physical deterioration through
evaporation, shrinkage, damporrust; obsolescence, so that space is wasted by out-of-date
material; and loss of interest on capital need lessly locked up.

Inefficient purchasing may result in direct financial loss by buying in the wrong market at the wrong
time, and in indirect loss by holding up the work on account of the failure to secure deliveries at
the required time.

Advantages of Accounting for Materials

The advantages of stores (material) accounting may be summarized briefly as follows:

• A check on the honesty of staff is provided.

• Differences are detected, investigated and prevented in the future. (c) Production is not held
up forlack ofmaterials.
• Overstockingis avoided.
• Systematic buying is facilitated.
• Obsolete stocks are detected and dealt with.
• Wastage due to various causes can be measured.
• In the event of a fire which damages materials in stores but not the relative records, or of
aburglary,there is evidence available to produce to the insurance company in connection with
the amount ofthe claim.

C. OUTLINE OF PROCEDURES
We shall now briefly outline the procedures necessary in the purchase, receipt, storage, issue
and transfer of materials.

CPA EXAMINATION F2.1 Management Accounting 25

STUDY MANUAL
StockControl

OrderingStock

ReceivingStock

IssuingStock

StoringStock

StockLevels

Buying

• Requests for the purchase of materials should always be made to the purchasing officer, who
can co-ordinate the requirements of several departments.
• The purchasing officer should maintain records so that the best possible terms can be obtained
for the goods required. (This will usually mean best possible price, but occasionally it may be
necessary to accept a higher price, for instance to obtain speedier delivery.)
• Official order forms should be issued by the purchasing department and copies should be raised
as follows:

26 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
• To supplier.
• To goods inward are to facilitate checking on arrival of goods.
• Copy retained to check supplier’s invoice when it arrives.
• Additional copies may be raised according to the requirements of the business, but the
number should be kept to a minimum.

Receipt
All goods should be introduced into the organisation through a designated and controlled
area. The material should be inspected by a competent official, who should prepare, in duplicate,
a goods received note. One of these forms should be passed to the purchasing department for
comparison with the copy of the order for mind the invoice when it comes to hand. The second
copy will be passed to the store man, who will enter details on the bin card when receiving the
goods. (Bin cards are more fully described in the next study unit.)

It is common for a firm supplying goods to require a signature of an authorized official of the
recipient organisation. Such procedures obviously improve the internal controls within the supplier
but often the recipient is acknowledging that he has received the goods, in full, in good condition.
In many cases the necessary testing and checking will take some time so it is usual to sign the
delivery note and add the word “unexamined”. This provides satisfactory evidence to the supplier
that a delivery was made, without preventing the recipient from taking action should some of the
goods be missing or defective.
It is essential that the goods are thoroughly checked as soon as possible after receipt and that
the supplier is advised of any problems at the earliest opportunity. Normally all contact on such
matters will be made by the buyer, who will make use of other technical expertise within the
organisation as necessary.

Depending up on the nature of the product, it is sometimes possible to undertake sample checking
of quantity or quality. In some circumstances it may be necessary to undertake a full testing
procedure, on a strictly limited basis, often to the point of actually destroying the component.
Again,depending up on the nature of the product, the purchaser may have made it a condition
of his order that, if the specified sample fails his acceptance test, he will be Entitled to reject the
whole batch. Such procedures are often used by multiple retailers, especially in the clothing
industry.

If the materials are not in good condition, the purchasing department must be informed immediately,
so that the supplier can be contacted. Often, a goods rejected note is prepared to maintain a
formal record and to prevent in advertent payment of the invoice.

Storage
The point at which goods are stored should be functionally designed and have adequate
security. Each storage should allow easy handling of ,and access to, each commodity stored. The
sites of stores in an organisation should be carefully planned in relation to cost reduction. Having
one centralised store will reduce accommodation costs and wages but will result in more internal
transportation and longer lead-times for production departments to get hold of materials.

Issue
The main transactions affecting a system of material control arise from the issue of materials
from storage. All materials are issued on an authorization known as a “stores requisition”. This

CPA EXAMINATION F2.1 Management Accounting 27

STUDY MANUAL
form, usually issued by the production planning department, is the authority for the store man to
pass out goods from his care into the production flow. The store man receives a departmental
signature for the goods, and enters details on the appropriate bin card.

The requisitions, bearing the number of the cost unit or department for which the goods are to be
used, are passed to the cost department, where they will be priced. Following normal double
entry principles, we must credit the material accounts and debit the job or process accounts with
the value of materials used.

Flowchart
The following flowchart (Figure11) illustrates the movement of goods and paperwork as
Described above.

Figure 11

28 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
D. ORGANISATION AND DOCUMENTATION OF PURCHASING
The Objects of a Purchasing System

• To obtain the right quality of materials.

• To obtain the right quantity of materials.
• To obtain delivery in such a manner as to co-ordinate the receipt of stocks with the production
programme or sales requirements.
• To pay the minimum price for the materials purchased, consistent with (a) to (c).
• To carry the minimum stocks without causing loss of production through shortage of materials.

Main Documents

• Purchase Requisition Form

• Purchase Order Form
• Specification of Materials
• Goods Received Note
• Goods Rejected Note

The Purchase Requisition

The form used to advise the purchasing department of the factory requirements and also to
Authorize the purchasing department to make the necessary purchase is the purchase requisition
(illustrated in Figure12).

ABC CO. LTD

PURCHASE REQUISITION

To Purchasing Department Serial No. 1

FROM DEPT. ......................CHARGE A/CNO. Date............... 20 ..

......................

Material Symbol Quantity Description Delivery

orCodeNo. Required of Material Requirements
E F G H

Purchase DateOrdered Supplier Authorized by:

OrderNo.
A B C D

Figure 12

CPA EXAMINATION F2.1 Management Accounting 29

STUDY MANUAL
The purchase requisition is completed as follows:

• Spaces A,B and C are filled in by the purchasing department.

• The signature in space D is that of one of the officials who are authorized to sign the requisition.
• Spaces E, F,G are filled in by the storekeeper.
• A space may also be provided for the insertion by the purchasing department of the price per
unit of the material and the total value of the order, to enable a control to be maintained of
purchase commitments.
• A copy of the purchase requisition will be retained by the person or department originating it.
• In space E the stock code number is entered.
• The “Quantity Required”(space F)is regulated by the maximum and minimum stocks, which are
fixed by the management. The maximum stock is the amount above which the storekeeper may
not allow the stock in hand to rise, and the minimum stock is the amount below which the stock
in hand should not fall.
• In space F the unit of quantity (i.e.lbs,tons,etc.) must be stated clearly, to avoid any possible
under-or over-ordering. It may be of advantage to have a separate space for “Unit of Quantity”.
To severe-handling on delivery, it is essential to indicate the form in which the goods are to be
delivered, e.g. in cartons of 100 units or pallets holding 1 gross of packets, etc.
• In space H the delivery instructions should include the unloading bay or direct to place or usage,
etc. Date required by may also be inserted.

Normally, three copies of the purchase requisition will be prepared and routed, as follows: (1) To
the purchasing department.

• To the planning department for information purposes, or this copy may be held by the authorizing
executive.
• Retained by the issuing department.

A list of officials with power to authorize requisitions should be compiled and properly authorized
requisitions only should be accepted by the purchasing department. Most requisitions will come
from the storekeeper, when stocks of standard materials need replenishing. Requisitions may
also be initiated by:

• Production control department, formaterials to beissued direct to jobs.

• Plant engineer, formaterials requiredforcapital projects ormaintenance.
• Heads ofadministrativedepartments, forindirectmaterials not kept as standard stock.

The Purchase Order

An official form, known as a purchase order, must be sent out for every order, to show the
Supplier that the order is an official one on behalf of the firm,and so that the receiving system
can function efficiently. In the case of new or non-standard materials, issue of the order will be
preceded by tendering procedure so that the best supplier can be selected.

The purchase order normally incorporates the purchaser’s terms and conditions of purchase;
acceptance of the order is deemed to imply acceptance under the purchaser’s terms. This is an
important consideration regarding the ultimate acceptance of the goods and any subsequent
claims made for defective goods. A significant amount of a purchasing officer’s time can often be
taken up in agreeing whose terms are applicable to a particular order.

30 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
PURCHASE ORDER

ABC CO.LTD & ADDRESS OrderNo..................

To: ................................................. Please quote this No. on your Invoice

.................................................
.................................................

Date ..........................

Please supply in accordance with the instructions given on the back of this order.

OurCode Quantity Particulars Rate Amount

Your quotation
No. ............................

Terms:

Signed
forABC Co.Ltd

.............................
Figure 13

Copies of the purchase order will generally be distributed as follows:

• To the supplier.
• To the receiving department.
• To the accounting department.
• To the department which issued the purchase requisition.
• Retained by the purchasing department.

CPA EXAMINATION F2.1 Management Accounting 31

STUDY MANUAL
Specification of Materials

Inward Order No
. No. Details
Date Delivery Note
Date
Item Code For use of Storekeeper
No. (if stock
Remarks Purchase
Details Quantity
Material)
Req. No.

1
2
3
4
5
6
7
8
9
10

Compiled by Drawing Office Ref.:

Checked by Planning Office Ref.:
Figure 14

A specification of materials (also known as a bill of materials) is a form which shows all the
materials and items which will be required for a particular order; this is prepared by the drawing
office.

On receipt of such specification, the store keeper will be able to foresee the requirements of the
particular job concerned, and will make sure that he has the necessary materials in stock. If he
is short of any of them, he will prepare a stock purchase requisition, and will inform the planning
department so that any re adjustment of plans necessitated by a shortage of material may be
made

RECEIVING DEPARTMENT
Duties

• Receiving and signing for goods from suppliers.

• Unloading the goods. (The department will have a copy of the purchase order, so that
arrangements can be made in advance for any special apparatus required.)

32 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
• Checking the contents as to quantity and condition and conformity with the purchase order.
• Taking the necessary steps to have the goods tested or inspected.
• Notifying the stores department or the requisitioning department of the receipt of goods.
• Delivering the goods to the appropriate point of storage or usage.

Goods Inwards Book and Goods Received Note

A goods inwards book may be kept to record all receipts from suppliers. Often goods cannot
be checked immediately on unloading, and recording the receipt of the goods in the goods inwards
book will ensure adequate control of the goods. The particulars usually recorded in the goods
inwards book are:

• Date received
• Supplier and carrier
• Very brief description of the goods
• Reference to the goods received note when compiled.

The next step is the preparation of the goods received note (see below).

Spaces A to G on the form shown (Figure 15) will be filled in at the goods receiving department. It
will then be sent with the goods to the stores department, where the goods will be unpacked and
their quality and condition inspected. If he is satisfied, the inspector will then sign in the space
H and the document will be forwarded to the purchasing department.

If the inspector is dissatisfied with the goods, he will issue a goods rejected slip and send this to
the purchasing department.

ABC CO. LTD

GOODS RECEIVED NOTE

Supplier: No. 1

..........................G.............................
...........................................................
........................................................... Date Received 19.........
...................

CodeNo. Quantity Description ofMaterial Remarks

Received
A B C

Purchase
Carrier Received by: Inspected by:
OrderNo.
D E F H

Figure 15
CPA EXAMINATION F2.1 Management Accounting 33
STUDY MANUAL
Space may be provided on the goods received note for the insertion of a goods rejected slip
number and the bin or location number where the goods are finally placed by the storekeeper.
Space may also be provided for the number and type of containers and for reference to a separate
report, e.g. inspection, shortage, damage report.

Rejected Goods
When goods are found to be defective or otherwise not in accordance with the order, they
will be rejected. When goods are rejected, a routine similar to the following should be adopted:

• A goods rejected note, similar to that shown in Figure 16 should be prepared in triplicate.
• One copy of this note should be sent to the purchasing department, which will then arrange with
the supplier to obtain credit and arrange for the replacement of the rejected goods.
• The second copy should be sent to the planning department, which may have to modify
its plans regarding work with the material concerned.
• The third copy is filed in the stores.
GOODS REJECTED NOTE

No.: .................................. Supplier:............................................

Examined by: ..................................
OrderNo.:......................................... Date .............................................
..

Code Specification Remarks Steps Signature

No. Taken (Purch. Dept)

Figure 16

C. PROCEDURE IN THE ACCOUNTS DEPARTMENT

Checking the Invoices
The supplier’s invoice will arrive sometime after the goods. It will be necessary to devise
carefully a system to check against errors on invoices. A suitable system is where each
invoice is, on receipt, entered into an invoice register and numbered. It is then impressed
with a rubber stamp, designed as shown in Figure 17.

Spaces (b) and (c) will be filled in by the purchasing department; the requisite numbers
are obtained by reference to the copy order book, in which the number of goods
received note will have been entered. If each invoice is entered and registered under
a serial number, this number being entered in the copy order book, there should be no
possibility of passing a duplicate invoice. The register of invoices may be compiled in
the purchasing department, the serial number being entered into space (a). The person
who is responsible for checking calculations will initial in space (d).

34 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
INVOICE STAMP
RegisterNo. (a)
OrderNo. (b)
G.R. NoteNo. (c)
Calculations Checked (d)
Checked with Order (e)
Prices Checked (f)
Allocation (g)
Bought Journal Forward (h)
StoresLedger

Forward (j)

Job Ledger

Passed forPayment (k)

Figure 17

In large businesses, where hundreds or thousands of invoices are handled daily, the
calculations may be checked by a special department.

Spaces (e) and (f) will be initialed by a member of the purchasing department, reference
being made to the signature on the goods received note for confirmation that the goods are of the
required quality and quantity.

The account to which the purchase is to be charged, e.g. whether it is ordinary stock material or
whether it is material purchased for a specific job which has to be charged to the cost account
for that job, will be entered in space (g). The folio of the entry in either the stores ledger (for
standard materials) or the job ledger (for orders in connection with special jobs) will be entered
in space (j).
The invoices will then be passed to the accounts office, where they will be entered in the purchase
journal for posting to the bought ledger and the bought ledger control account. The purchase
journal folio will be entered in space (h).

Finally, the invoice will be passed for payment by the authorised official, who signs in space (k).

THE STOREKEEPER AND STORES ISSUES

Duties of the Storekeeper
The storekeeper has considerable responsibility. The following is a list of his duties:

• To receive materials into the store.

• To keep all items in store neatly packed in their own containers and in the position allotted to
them.
• To issue materials against a duly signed stores requisition.

CPA EXAMINATION F2.1 Management Accounting 35

STUDY MANUAL
• To see that no unauthorised person is allowed to enter the store. Normally, the only persons
allowed access to the stores, apart from the storekeeper himself, are his assistants, stock-
takers and auditors.
• In some cases the responsibility for checking the quantity of goods in each container or bin
will rest with the storekeeper.
• To issue a stock requisition whenever the reorder level is reached (see later). (g) To
maintain records of receipts and issues.
• To report on any slow-moving and obsolete stocks.

The General Routine for Stores Issues

In no circumstances should materials be issued from store without the presentation of a
materials or stores requisition signed by an authorized person (see Figure 18). Only by strict
enforcement of this rule is it possible to guard against the misuse of materials and the pilfering of
stores.

ABC CO. LTD Serial No. .......................

STORES REQUISITION

Please supply to............................. Dept. Date ................... 20 .......

Job No. ...................

Code Description Price Amount Stores

Quantity
No. of Material Required Issued Ledger

Signed: Received by: Cost Off

.........................
............................ Foreman ............................ ................................

Figure 18

The price and amount will be entered by the cost office after the document has been recorded
by the stores.

The routine in connection with the above requisition is as follows:

• When any material is required for a job in a department, the foreman makes out a stores (or
materials) requisition. He signs this and it is taken to the storekeeper. Note that frequently the
requisitions for a particular job are made out by the planning or progress department from the
bill of materials and passed to the foreman only when he is ready to start the job. It is also
sometimes required that the requisition number should be entered on the bill of materials.

36 F2.1 Management Accounting CPA EXAMINATION

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• The storekeeper then issues the materials and signs the requisition, which is also signed by the
person receiving the goods.
• The requisitions are forwarded regularly to the cost office, where the issues are priced (see
later).

Materials Returned to Stores

Any unused materials normally should be returned to stores together with a stores return note,
sometimes referred to as a stores credit note. This document gives similar details to the
stores requisition but is usually printed in a distinguishing colour, e.g. red. The routine in
connection with the returns note is similar to that with the requisition.

Sundry Transfers of Materials

If goods are transferred from one cost unit to another after leaving the stores, it is necessary
to charge the receiving cost unit with the value of materials concerned and to credit the
cost unit originally charged. This is achieved by raising a materials transfer slip, which
bears a description of the goods transferred, the references of both cost units and the
signatures of both supervisors concerned.

Transfers should be made only if the goods are immediately required by another department and
if it is clearly more efficient (because of location) to make a direct transfer. Otherwise all unused
materials should be returned to the stores, as described above, for reissue.

D. STOCK LEVELS
In order to ensure that the flow of production is not impaired by the lack of materials and also that
excessive capital is not tied up in stocks, it is necessary to ensure that the level of stock held
always lies between certain limits.

Maximum Quantity
This represents the greatest amount of an item of stock which should be carried if the best use
is to be made of working capital.
In determining the maximum stock level, the following are among the factors considered: (a)
Capital tied up in stocks.

• Capital available.
• Cost of storage (including rent, insurance, labour costs).
• Storage space available.
• Consumption rate.
• Economic purchasing quantities (see later).
• Market conditions and prices, seasonal considerations.
• Nature of material - possible deterioration or obsolescence.

Minimum Quantity
This represents the level below which the stock should not normally be allowed to fall if the
requirements of production are to be met.

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STUDY MANUAL
The minimum level is determined by the rate of consumption of materials and the time
taken between placing an order and receiving the material.

Reorder Level
It is necessary to set a point at which an order must be placed. This point is known as the
reorder level. It will be higher than the minimum level, to cover use during the period
before the order is received.

Reorder Quantity
The reorder quantity is the quantity which should be ordered at the time the reorder
level is reached. It will depend on the discounts available from suppliers for bulk ordering, the
cost of placing an order and the cost of storage (see later).

Formulae
Reorderlevel = Maximum consumption ×Maximum reorderperiod.
Minimum stock = Reorderlevel – (Normal consumption ×Normal reorderperiod).
Maximum stock = Reorderlevel+Reorderquantity– (Minimum consumption × Minimum
reorderperiod).
Averagestock =Minimum stock +½ Reorderquantity.
These levels should be reviewed periodically to ensure that they reflect current conditions.

Example
Component A is used as follows:
Normal usage 50 perweek
Minimum usage 25 perweek
Maximum usage 75 perweek
Reorderquantity 300
Reorderperiod 4-6 weeks
Calculatethe reorderlevel, theminimum and maximum levels, and the averagestock level.

Solution
Reorderlevel = Maximum consumption ×Maximum reorderperiod
=75 ×6
=450
Minimum level = Reorderlevel – (Normal consumption ×Normal reorderperiod)
=450 – 50 ×5
=200
Maximumlevel = Reorderlevel +Reorderquantity– (Minimum consumption × Minimum
reorderperiod)
=450 +300 – (25 × 4)
=650
Averagelevel = Minimum stock +onehalfReorderquantity
= 200 +(300 ÷ 2)
=350.

38 F2.1 Management Accounting CPA EXAMINATION

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E. ECONOMIC ORDER QUANTITY

Formula

There is a formula which tells a company the optimum batch size in which to purchase
goods.

The formulais:

Q = 2CoDCh

Where:
Q is the economic order quantity;

D is the annual demand for the product;

Co is the fixed cost of placing an order, i.e. delivery charges, clerical time in placing
order, checking invoice, etc., which do not vary with the size of the order; if the goods are
produced internally it will include fixed production costs incurred specifically in producing
the batch, e.g. tool setting;

C1 is the annual cost of holding one unit of stock.

You should notice that the model is rather limited: the unit cost is assumed to be constant. There
is no provision for quantity discounts which might make it more attractive to purchase larger
quantities.

Or

1
Formula:
2 D Co
CH

Where:
Do = Demand
C = Cost of Ordering
C = Cost of holding
H

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STUDY MANUAL

Figure 19
The position of the economic batch quantity can be illustrated graphically (see Figure 19).
Obviously, the larger the batches which are bought, the fewer batches there need to be to
cover the annual demand. Therefore, the total fixed cost (S × number of batches) decreases as
the batch size increases. Conversely, buying larger batches will increase the average stock held,
and therefore increase the total stockholding cost. The economic batch quantity is at the point
where total costs are minimised.

Example
A company uses 4,000 components, type “A”, in a year. The cost of placing an order is
RWF20. The stockholding cost is RWF4 per item per year. Stocks are replenished when the
stock level falls to 50 units; orders placed are received the same day. Calculate the economic
order quantity.

Solution

2DS
Using the formula Q =
H
2 4,000 20
Then, Q = 4
40,000
=
= 200
orders should be placed for batches of 200 units at a time.

40 F2.1 Management Accounting CPA EXAMINATION

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Explanation
The correctness of the formula can be demonstrated by using the data of the above
example and "testing" different order sizes.
A Order size 100 160 200 250
B Number of orders p.a. 40 25 20 16
C Total ordering cost B × RWF20RWF 800 RWF500 RWF400 RWF320
D Average stock 50 + (½ × A) 100 130 150 175
E Stock holding cost D × RWF4 RWF 400 RWF520 RWF600 RWF700
F Total cost C + E RWF 1,200 RWF1,020 RWF1,000 RWF1,020
200 is the economic order quantity.

STOCK TURNOVER
This term expresses the number of times stock is sold or used within a given period. Usually it is
expressed as a ratio:
Cost ofsales fora specificperiod
Averagevalueofstock held

(Averagevalueofstockheld is (Openingvalue + Closingvalue)÷ 2.

Example:
Cost ofstock sold in Year1RWF600,000
Openingstock RWF30,000
Closingstock RWF20,000
RWF600,000
Stock turnover = = 24 times per year.
RWF25,000

ACCOUNTING RECORDS REQUIRED FOR MATERIALS

Bin Cards
Bin cards are prime entry records of the quantities of stock, kept on an in/out/balance basis,
held in designated storage areas.

These records are maintained at the physical point of storage and usually show only
quantities, not costs, of items held. The storekeeper is responsible for keeping the bin cards up-
to-date.

The bin card records receipts, issues and the balance remaining in stock. The receipts side
will show entries from goods received notes and returned to stores notes and the issues
portion shows the goods passed to production as per stores requisition slips. The balance on
hand shown on the card should equal the physical number of items in stock.

The bin card may also show the materials allocated, i.e. reserved for a particular cost unit but not
yet issued; and free stock, which is the balance on order and on hand less the allocated stock.
This is because the reorder level is sometimes set in terms of the free stock level.

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Stores Ledger Accounts
These accounts are maintained in a stores ledger held in the cost office, an account being
opened for each item held in stock. The entries mirror the transactions shown on
the bin cards, but show the values as well as quantities. The physical separation of the
bin cards and stores ledger accounts and the fact that different staff are involved helps
prevent fraud or pilfering of materials. Having a dual record also helps to detect clerical
error.

F. STOCKTAKING
This is a process whereby stocks (which may comprise direct and indirect materials, work-in-
progress and finished goods) are physically counted and are then valued item by item.

Perpetual Inventory and Continuous Stocktaking

When the stores balances are recorded after every issue or receipt of materials, a perpetual
inventory is in operation. This can be combined with a continuous stocktaking system whereby
a few items are actually counted every day. The physical quantity in stock is then compared with
the balance shown in the records.

The advantages of this system are as follows:

• The temporary dislocation of work caused by end-of-period stocktaking is avoided.

• The daily checking of items can be so arranged that all items are checked at least twice a
year, and fast-moving or valuable lines can be checked more frequently. Checking should be
carried out by non-stores staff, and advance notice should not be given of which items are to be
checked each day.
• Explanations of differences between physical stock and records can be made more easily and
perhaps measures can be taken to prevent a recurrence.
Such differences might be due to:
• Evaporation;
• Absorption of moisture;
unavoidable differences.
• Losses in breaking bulk;

• Unavoidable approximation in measuringissues;

• Pilferage;
avoidable differences.
• Poor storage conditions or handling, causing damage;
• Careless measurement.
• There is a reinforcement of the need for honesty on the part of the staff.
• The annual accounts can be prepared earlier, as the book value of the stores is
acceptable for balance sheet purposes. The stock value can also be used to prepare
monthly accounts.
• The opportunity can be taken to check that maximum stock levels are not being
exceeded so that the disadvantages of excessive stocks are more easily avoided.

The perpetual inventory routine needs to be thoroughly documented within the organisation,
and active measures taken to ensure that laid-down procedures are followed. This is
necessary not only to gain the greatest internal advantage of this approach, but also in order that
the auditors may be convinced of the validity of the stock figures. To this end the auditors will

42 F2.1 Management Accounting CPA EXAMINATION

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generally spend a lot of time satisfying themselves that the system is working correctly, especially
in the early years after its implementation.

Methods of Stocktaking

(a) Individual Count

Where items are individual and of the same generic group, it is necessary to count the number
of each type held in stock.

As a general rule this is only carried out when items are of reasonable size; where nuts, bolts or
nails are concerned, it is usual to weigh the items or estimate the amount by experience. The
individual count method is very slow and laborious if there are a large number of items involved.
This method can be greatly speeded up if stock is stored in standard quantities or bundles, so
that it merely becomes a question of counting the number of bundles.

(b) Measurement of Liquids

The method by which the liquid is stored and used will very largely determine the way
in which the physical stocktaking should be carried out. If liquid is delivered in bulk and drawn
off for use automatically, it is usual for meters to be installed which give the usage for a period
and the volume remaining in storage. The tolerance of accuracy is normally very small and,
subject to practical experience, it is usual to accept the reading on the meters for purposes
of stocktaking. Electronic measuring devices are extremely accurate and can be relied on to
provide a high degree of accuracy.

In certain cases usage may be measured by a type of meter which does not record deliveries or
stock remaining, e.g. a petrol pump of the older type. A theoretical stock value will be continuously
maintained, but the contents of the tank will be compared with this at regular intervals. A dip-
stick will normally be used for this purpose. This method of measurement relies on the fact that
one dip-stick is maintained for each size of tank, and the degree of accuracy will depend on the
calibration of the stick.

Measurement by Calculation
There are many materials which are solids but cannot be counted individually, e.g. coal,
flour or sugar. The amount of such items can be calculated by ascertaining the cubic space taken
up measured, for example, in cubic feet; so that by using the known weight of the commodity per
cubic foot, the total weight can be obtained for pricing.

Measurement by Technical Estimate

Where goods are incapable of being counted or measured by scientific means, it may be necessary
to resort to technical estimates.

CPA EXAMINATION F2.1 Management Accounting 43

STUDY MANUAL
Organisation of Annual Stocktaking
Many large organisations, which are not working on a perpetual inventory system, will
arrange for the physical stocks to be counted before the year end. This is a satisfactory
arrangement provided suitable systems are in place to monitor stock movements between the
date of the physical check and the financial year end. The auditors must be advised in advance
if this route is to be followed and it must be emphasized how important it is to have in place
procedures to monitor stock movement and to ensure that they are being correctly followed.

With an annual stock take (rather than a continuous system) the greatest problem is that of getting
the full procedure carried out in the time allowed. The deadline allowed for the completion of
stock figures is some time before the completion of the annual accounts. As the physical count
cannot take place before the close of the last day’s business, the time available is short and the
work to be done considerable.

(a) Preparatory Work

Time will be saved at the stocktaking if preparatory work can be carried out prior to commencement
of stocktaking. Jobs which can be done are: the typing of forms, the entering of static information
such as description and in certain cases price, the grouping of forms by departments and the
issue of stocktaking forms at least one week in advance of the date of action.

One week before stocktaking, therefore, a responsible official can check that the correct forms
have been issued to the various sections and departments and have been completed in
respect of date, heading and all static information. This will eliminate one of the common bottle-
necks caused by people complaining that they did not receive the correct forms or did not receive
any forms at all.
Careful design of forms can also save time at the actual stocktaking. They should be on stout card
so that they are not damaged in the stores, logically laid out so that the person completing
them can work from left to right, and should ask only for relevant information.

(b) Physical Counting and Measurement

This should be carried out by non-stores staff (but the stores staff should be on hand to assist
by showing the stock takers the location of each item). The stock takers should only be required
physically to measure the stock and enter this on forms on which the description of each item has
already been entered: all other entries to be made can be done in the cost office. The auditors
should normally be invited to attend the physical count, although their appearance will depend
upon the materiality of the stock figure.

(c) Valuation
Having ascertained the quantity of stock, this has to be converted to a value in RWF.We will
consider this later.

(d) Checking
On completion of the calculation and the checking, it should be the specific
responsibility of the official in charge of stocktaking to ensure that all stock sheets issued
have been returned fully completed.

Any additional sheets relating to new types of stock should be specially studied, so that at the
following stocktaking the appropriate preparatory work can be carried out.
All sections should then be merged into a stock summary, taking care to ensure a full audit
trail back from the final stock value to the individual items of stock.

44 F2.1 Management Accounting CPA EXAMINATION

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Conclusion
If the suggestions on form design and organisation of staff are carried out, accurate physical
stock figures can be obtained. Nevertheless, an annual stock taking is a major undertaking
needing a lot of work.

THE PRICING OF MATERIAL ISSUES

Problem of Pricing
In times of changing prices, firms have to decide on how they will price the materials issued
to production, when they are trying to arrive at overall production costs. Should it be the price
they actually paid for the material, or the current price of the same type of material (which could
well be higher)?
There are several different methods of pricing material issues, which we shall now discuss.

At Market Price Ruling at the Date of Issue

When quoting for business, it may be necessary to include materials on the basis of their
market price at the time, even though they may have been bought some time earlier at
a higher price; for, if a firm gives a high quotation in an attempt to recover the full cost of the
materials, it may lose the business altogether to a competitor whose quotation is based on the
current market price.

Conversely, if a manufacturer has, through good fortune or foresight, acquired considerable stocks
of a material at a price below that currently ruling and he acquires business which will use those
materials, he will want to take advantage of this good buying by placing a quote which includes
the current market value of the materials. (The manufacturer will not always get away with this!
In particular, if he is a contractor for a government department he will be obliged to charge for the
materials at cost.)

The use of market prices therefore gives credit for good buying and the reverse for bad
buying. The difficulty is to establish the current market price and, as this does not line up with
the actual cost of the materials, it is necessary to operate an adjustment account to take care of
the differences.

At Inflated Cost
This method is used to cover the unavoidable wastage which may occur in certain
circumstances. The changes which often take place in this wastage render the method
inaccurate and an adjustment account will have to be opened.

At Cost Price
Issue of materials is usually carried out on this basis, and clearly it is not necessary to use an
adjustment account. There are several conventions by which materials can be issued at cost
price; the most usual are described below.

(a) FIFO - First In, First Out

This is a method pricing material issues using the oldest purchase price first, i.e. the
oldest items in stock shown by the stock records are issued first.

If the transactions involved are numerous, this method involves a great deal of clerical effort, and
it is therefore best used for slow-moving stock where the value is high and the price does not
fluctuate a great deal. In times of rising prices, the valuation of issues tends to be low. On

CPA EXAMINATION F2.1 Management Accounting 45

STUDY MANUAL
the other hand, the value placed on the closing stock will reflect current prices, since if the first
stock to come in is deemed to be the first issued, it is the latest stock which remains.

Advantages of FIFO

• Probably represents what is really happening within the stores.

• Easy to use.
• Easy to explain to managers.
• The closing stock value should be near market value.

Disadvantages of FIFO

• Can be difficult to operate.

• Issues of stock can be at a lower cost than market price, especially in a period of inflation.

Example
Assume the following purchases were made in ABEZA Ltd
Date of purchase Units purchased Units issued Price/unit (RWF)
1 January 12 1.00
st

10th January 10 1.05

11th January 5
26th January 8
30 January 10 1.10
th

4th February 5
10th February 6
11th February 10 1.05
15th February 9

Required:
Determine the cost of units used and the value of the closing stocks

Solution
Receipts Issues Balance
Date Units Rate Amount Units Rate Amount Units Amount

RWF RWF RWF RWF RWF

Jan. 1 12 1.00 12.00 12 12.00

“ 10 10 1.05 10.50 22 22.50

“ 11 5 1.00 5.00 17 17.50

46 F2.1 Management Accounting CPA EXAMINATION

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“ 26 (7) 1.00 7.00
(1) 1.05 1.05 9 9.45

“ 30 10 1.10 11.00 19 20.45

Feb. 4 5 1.05 5.25 14 15.20

“ 10 (4) 1.05 4.20

(2) 1.10 2.20 8 8.80

“ 11 10 1.05 10.50 18 19.30

“ 15 (8) 1.10 8.80

(1)
1.05 1.05 9 9.45

Stock balance made up of 9 units @ RWF1.05 =RWF9.45.

FIFO may be inequitable in that two jobs on the same day may be charged different rates for
the same material.

(b) LIFO - Last In, First Out

This is a method of pricing material issues using the last purchase price first.
When this method is in operation, stores issued are charged at the prices of the latest items in the
stock from which the materials are drawn. In times of inflation, therefore, the cost of the present
high-priced material is charged to production as it is incurred. On the other hand, closing stocks
will be conservatively valued. Like FIFO, the method can be cumbersome to operate and possibly
inequitable.

Advantages of LIFO

• Fairly accurate method of accounting for inflation.

• Helps decision making.
• Stock that is issued is close to market value of stock.

Disadvantages of LIFO

• .Can be difficult to operate.

• Difficult to explain to managers.
• Variations in prices.
• Closing stocks become undervalued when compared to market value.

CPA EXAMINATION F2.1 Management Accounting 47

STUDY MANUAL
Example

Assume the following purchases were made in ABEZA Ltd

Date of purchase Units purchased Units issued Price/unit (RWF)
1st January 12 1.00
10th January 10 1.05
11th January 5
26th January 8
30th January 10 1.10
4th February 5
10th February 6
11th February 10 1.05
15th February 9

Required:
Determine the cost of units used and the value of the closing stocks

Solution

Receipts Issues Balance

Date Units Rate Amount Units Rate Amount Units Amount

RWF RWF RWF RWF RWF

Jan. 1 12 1.00 12.00 12 12.00

“ 10 10 1.05 10.50 22 22.50

“ 11 5 1.05 5.25 17 17.25

“ 26 (5) 1.05 5.25

(3) 1.00 3.00 9 9.00

“ 30 10 1.10 11.00 19 20.00

Feb. 4 5 1.05 5.50 14 14.50

“ 10 (5)) 1.10 5.50

(1) 1.00 1.00 8 8.00

48 F2.1 Management Accounting CPA EXAMINATION

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“ 11 10 1.05 10.50 18 18.50

“ 15 9 1.05 9.45 9 9.05

Balance of stock 1 @ RWF1.05 =RWF1.05

8 @ RWF1.00 =RWF8.00 =RWF9.05
Both FIFO and LIFO can produce anomalies - two jobs which receive materials on the same
day may be charged differently because one batch of purchases has been exhausted

(c) Weighted Average Price

Under this method, the price at which stores are issued is calculated by dividing the
total cost of the materials in stock from which the material to be priced could have been
drawn, by the total quantity of material in that stock.

This method has the advantage of spreading the cost more evenly. It can be used to advantage
where the price of materials fluctuates rapidly and is a useful method for computerized accounting.

However, like the LIFO and FIFO methods, it may involve a lot of clerical work.
Should there be an extremely high or low price, it is reflected in the costs for a long
time afterwards.
A simplification is to use a periodic weighted average, calculating the average net after each
receipt but retrospectively once a month (say). If this method were used in the previous example,
the average for January would be RWF1.0469 (32 units received at RWF33.50) and this would
be used for both issues in January. The balance on hand at the beginning of February would
then be valued at RWF19.89 (19 units at RWF1.0469), so the retrospective weighted average
for February would be RWF1.0479 ((RWF19.89 plus RWF10.50) divided by 29).

A further simplification is to use a simple average, i.e. adding up the prices without weighting for
quantity and dividing by the number of prices. Again this may be calculated on the continuous
or periodic system.

Using the continuous system, the simple average for the 1 January to 10 January
consignments would be RWF1.025 ((RWF1 plus RWF1.05) divided by 2). This method
should only be used when there is little fluctuation in prices, but it can be a useful time-saving
short-cut.

Advantages of Weighted Average Price

• Any fluctuations in price are smoothed out.

• Decision making is made easier using this method.
• Easier to operate.

Disadvantages of Weighted Average Price

• Prices and closing stock values can be lower than the market value.
• When using this system, actual price can run into several decimal places.

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(d) Standard Price
This is the method adopted when a standard costing system is in operation. Purchases
are posted to the stock account at the predetermined standard price and issues are
priced at standard price. The difference between the actual cost of purchases and their
value at standard price, called the “price variance”, is posted to a separate account.

(e) Replacement Price

Under this method, stores are issued at the current replacement price. Using standard
manual record cards it is not possible to maintain details of the value of goods in stock, although
the physical balance is maintained and may be multiplied by the current replacement price to arrive
at a replacement cost stock figure. This stock figure would need to be adjusted subsequently,
before it could be used in the financial accounts of the company.

Good records are essential, as the replacement price at the time of each issue must be known
and this is only likely to be realistic in a fully computerised environment. The system has the
advantage that all issues are made at current economic value, but this in itself will lead to the
generation of sundry profits and losses on stock holdings.

G. ECONOMIC BATCH QUANTITY

When an organisation manufactures its own stock items in batches, it will order a fresh
supply of the item as a batch quantity. The Economic Batch Quantity (EBQ) represents the
quantity that minimises the aggregate total of the costs of stockholding and the cost of setting up
the batch for manufacture.

It is similar in concept to the Economic Order Quantity (EOQ), when ordering goods from an
external supplier. However, there is an important difference. When stock is manufactured internally
in a batch, units of the stock item can start to be delivered into stores before the batch production
run has been completed.

The first units of the batch will therefore be delivered into stores before the final units have been
manufactured and these units can be used immediately.

The average stock level is therefore not Q/2, because this is the average stock level when the
maximum stock level is Q. With internal batch production, the maximum stock level is:
Q(1 – D/R)
Where:
D = the rate of demand for the stock item
R = the rate at which the stock item can be manufactured

The Economic Batch Quantity is therefore:

2C0D
EBQ =
CH(1 – D/R)
Where:
C0 = Fixed Costs per batch
D = Expected annual sales problem
CH = Holding Cost per stock unit per annum
R = Replenishment Rate

50 F2.1 Management Accounting CPA EXAMINATION

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Example
A company uses 60,000 widgets every year. It manufactures these widgets internally and can
produce them at a rate of 240,000 units each year. The cost of holding a widget in stock for
one year is 4 and the cost of ordering and setting up a batch production run for the widgets is
RWF2,025.

What is the Economic Batch Quantity?

Solution

2 x 2,025 x 60,000

4(1 – 60,000 / 240,000)

EBQ = 9,000 units

H. OBSOLETE, DORMANT AND SLOW-MOVING STOCK

Obsolete Stock
Obsolete stock can be a serious matter. All stock represents cash and should be turned into
products and sold to bring the money back in again.

Obsolete stock is dead cash. All possible steps must be taken to prevent stock
from becoming obsolete by the co-ordination of the efforts of all concerned. For
example, the design department may agree to a modification being held back until
existing stocks have been used; or the sales department may have a big “push” on an
item which is shortly to be dropped, so as to clear out stocks.

Yet some obsolescence is unavoidable. It is a good thing to keep a separate section of the
stores, to which any stocks declared obsolete should be transferred immediately.

Thought must be given as to whether there will be a demand for spares for old models
still in existence and, if so, some parts must be set aside for this purpose.

The remaining problem then is the one of finding the best possible market for the
remainder. The buying department is usually in the best position to do this.

Remember, it is not only the cost of the materials which is tied up, but storage space, labour, etc.

Dormant and Slow-Moving Stock

In addition to obsolete stock there is the problem of dormant stock, and of slow-moving
stock. Dormant stock means an item which has not moved for a considerable period. It is not
obsolete because it has not been replaced by a new item, and in the future it is expected to move
again.

Slow-moving stock may consist of items which are only issued at long intervals. Obviously an
item like this will not be featured as a stock receipt until, after a long interval, it drops to reorder
level. At that time, either the storekeeper will mark the reorder requisition “SM” so that the matter
will be investigated, or, in the case of an automatic system, the item will be printed out by the
computer as an exception for special study.

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O. JUST-IN-TIME (JIT)
Traditionally organisations in the West have used a “push” production flow system. This system
has the following stages:

• Buy raw materials and place them in stock

• Produce goods based on sales forecasts
• Requisition goods from stock and make products according to the production schedule
• Place finished goods into finished goods store
• Sell to customers from finished goods when customers request products

However, Japanese companies, most notably Toyota, developed a different system, known as
Just-In-Time or Stockless Production. This system is not a “push” system but a “pull” system.

A product is not made until the customer requests it and components are not made until they are
required by the next production stage. In a full JIT system, virtually no stock is held; that is no
raw material stock and no finished goods stock, but there will usually be a small amount of work-
in-progress.

JIT stock management methods seek to eliminate any waste that arises in the manufacturing
process as a result of using stock. JIT purchasing methods apply the JIT principle to
deliveries of material from suppliers. With JIT production methods, stock levels of raw materials,
work-in-progress and finished goods are reduced to a minimum or eliminated altogether by
improved work-flow planning and closer relationships with suppliers.

Advantages of JIT
JIT stock management methods seek to eliminate waste at all stages of the manufacturing
process by minimising or eliminating stock, defects, breakdowns and production delays. This is
achieved by improved workflow planning, emphasising quality control and firm contracts between
buyer and supplier.

One advantage of JIT stock management methods is a stronger relationship between buyer and
supplier. This offers security to the supplier, who benefits from regular orders, continuing future
business and more certain production planning. The buyer benefits from lower stock holding
costs, lower investment in stock and work-in-progress and the transfer of stock management
problems to the supplier. The buyer may also benefit from bulk purchase discounts or lower
purchase costs.

The emphasis on quality control in the production process reduces scrap, re-working and set- up
costs, while improved production design can reduce or even eliminate unnecessary material
movements. The result is a smooth flow of material and work through the production system, with
no queues or idle time.

Disadvantages of JIT
A JIT stock management system may not run as smoothly in practice as theory may suggest,
since there may be little room for manoeuvre in the event of unforeseen delays. For example,
there is little room for error on delivery times.

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The buyer is also dependent on the supplier for maintaining the quality of delivered materials
and components. If delivered quality is not up to the required standard, expensive downtime
or a production standstill may arise, although the buyer can protect against this by including
guarantees and penalties in the suppliers contract. If the supplier increases prices, the buyer may
find that it is not easy to find an alternative supplier who can meet his needs at short notice.

I. LABOUR

A. METHODS OF REMUNERATION
Fixing Wage Rates
Wage rates may be fixed by individual agreement between employer and employee, or more
commonly by collective bargaining between trade unions and employers’ associations.

An employer may pay wages on an hourly basis, per piece, or may adopt one of the various
bonus methods of payment, but the general principle of a wages policy is to obtain the maximum
production per RWF of wages paid while maintaining an acceptable quality of production, within
the limits of “social justice” (i.e. employees should receive a “fair day’s wages”).

In deciding on the method of remuneration to use, attention must be paid to the following
factors:

• The relative importance of quantity and quality, and the cost of spoilage.
• The degree of specialisation and standardisation of the product.
• The degree to which automatic or semi-automatic machines are used.
Main Methods
Workers may be paid by time of attendance or by results. The latter method provides an
incentive to increase production. “Payment by results” covers:

(a) Piece Rates:

These may be:

• Straight piece rates

• Piece rates with guaranteed minimum
• Differential piece rates.
(b) Bonus Schemes:
These can be any of the following:

• Bonus schemes for direct workers individually

• Bonus schemes for direct workers in groups
• Bonus schemes for indirect workers
• Bonus schemes for staff.

(c) Performance-Related Pay

(d) Indirect Monetary Incentives:

These may take the form of:

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• Co-partnership schemes
• Profit-sharing schemes
• Allowances and expenses of various kinds.

(e) Non-Monetary Incentives:

These are further inducements to increase output. They include security of employment,
prospects of promotion and the satisfaction that a job gives to an employee (i.e. craft
work as opposed to repetitive production).

B. TIME RATES
At Ordinary Levels
This system is the most common method of wage payment in Britain. It is a system of paying
workers for the time worked rather than for work produced. It may be in the form of an hourly
rate, or shift or weekly rate for an agreed number of hours. We must examine the circumstances
in which it is most favored, and its advantages and disadvantages.

a) Where the System Can be Favoured

• Where the work done is very difficult to measure, e.g. when a service is rendered - nurses,
policemen, probation officers, lift attendants, teachers - or when the work cannot be
standardised, e.g. the majority of clerical operators or administrative work.
• When workers are learning, e.g. apprentices.
• Where the speed of the machine, operation, or process governs the speed at which the operator
can work, e.g. assembly lines, chemical plants, and process industries such as bottle or paper
making.
• When quality of production is of prime importance and would be endangered by encouraging
an operator to work faster.
• When safety is likely to be endangered if the operation is speeded up, e.g. lorry driver.
• When it is found that good employer/employee relations exist and a satisfactory output is
being achieved. The introduction of an incentive scheme may disrupt the good employer/
employee relations, causing discontent and possibly lower production.
• When work is so unstandardised that the expense and difficulty involved in measuring the
work done, etc. would be so great as to outweigh any advantages accruing from an incentive
scheme.

(b) Advantages

• The system is simple to understand and simple to operate, saving on clerical labour in
number and quality of staff.
• Wages are stable, an advantage rated very highly by many workers.

(c) Disadvantages

• The system provides no direct incentive to the worker to increase output or to produce better
quality work.
• It tends towards higher production costs because the workers tend to work at an accepted
minimum rate.
• It requires close supervision, and in times of full employment the worker’s output is greatly
dependent on his goodwill and conscientious attitude, since there is no fear of dismissal.

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(d) Effect of Variations in Output
Any gain or loss arising from variations in the operators’ efficiency will be borne by the
employer. Thus, if the daily wage of each of four operators is RWF40:
If A produces 20 units his labour cost per unit is RWF2, i.e. RWF40 divided by 20 units.
If B produces 40 units his labour cost per unit is RWF1, i.e. RWF40 divided by 40 units.
If C produces 80 units his labour cost per unit is RWF0.50, i.e. RWF40 divided by 80 units.
If D produces 100 units his labour cost per unit is RWF0.40, i.e. RWF40 divided by
100 units.

Clearly, labour cost per unit falls with increased production. This is illustrated in Figure20.

Figure 20

High Wage Plan

(a) Significant Points

• An appreciably higher than average wage is paid compared with other factories in the area.
• A higher standard of output, both in quality and quantity, is set.
• As a vacancy attracts a larger number of applicants, the employer can secure the services of
better workers, who will be willing to maintain the higher standard in order to retain their jobs
and the higher wages.

(b) Advantages

• It is simple to understand and operate.

• Wages are stable.
• It overcomes the lack of incentive of ordinary time rates.
• Output increases, and as a result, the cost per unit falls, compensating the employer
for the increase in wages.

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(c) Disadvantages

• As with ordinary time rates, this system still does not provide incentive for exceptional
effort and ability.
• It requires close supervision.

Graduated Time Rates

These are time rates adjusted for particular reasons, e.g. changes in the cost of living,
additional rates for merit, loyalty, etc.

C. INCENTIVE SCHEMES
General Principles
There are some general principles which should apply to all incentive schemes:
• The reward should be as nearly related to effort as possible, both in amount and in time of
payment.
• The scheme should be fair to both employer and employee.
• There should be mutual agreement to ensure that the basis of the scheme is fully
understood, covers all reasonable points, and is not capable of being misinterpreted.
• The scheme should be strong and positive; it should have clearly defined, worthwhile and
attainable objectives.
• There should be no limits placed upon the amount of additional earnings.
• The incentives should not be affected by matters outside the employees’ control.
• The incentive should be reasonably permanent, not merely a device to be used by the employer
when business is good and dropped when it is not.
• The rates for payment by results should be fixed only after the job has been properly assessed.
• Piece rates or time allowances, once fixed, should remain, unless conditions or methods change.
• The standard of performance set must be reasonably attainable by the average employee
and it should be possible to demonstrate that this is so.
• The scheme should be simple, capable of being understood by the workers so that they can
make their own calculations, and easy to operate with the minimum of clerical work.
• A properly prepared incentive scheme should assist supervision and help to reduce the cost
of it.
• The scheme should be in conformity with any national, local or trade agreement.

Reasons for Having an Incentive Scheme

Before we discuss various incentive schemes, it would be useful if we considered the
difference such a scheme of remuneration might make to certain firms. Firms with high fixed
overheads will want to increase output as much as possible, because by increasing output they
can spread the fixed overheads over a larger number of units, thus reducing the fixed cost per
unit - assuming, as we have already seen, that absorption costing is in operation.

Under some incentive schemes the labour cost per unit will rise, but by increasing the output, the
total cost per unit will fall (again employing absorption costing).

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Example
Under an Under an

Under a Guaranteed Incentive Increased

Fixed Wage Scheme Incentive
A B C D

(a) No. of units produced 150,000 200,000 250,000 300,000

(b) Total fixed cost RWF500,000 RWF500,000 RWF500,000 RWF500,000

b
(c) Fixed cost per unit RWF3.33 RWF2.50 RWF2.00 RWF1.67
a
(d) Total wages cost RWF100,000 RWF100,000 RWF120,000 RWF160,000
d
(e) Wages cost per unit RWF0.67 RWF0.50 RWF0.48 RWF0.53
a
(f) Material cost per unit RWF1.00 RWF1.00 RWF1.00 RWF1.00

(g) Total cost per unit

(c) + (e) + (f) RWF5.00 RWF4.00 RWF3.48 RWF3.20

You will note that the increased production in B has caused the fixed cost per unit and labour cost
per unit to fall considerably. In C the fixed cost per unit has again fallen, but because the incentive
scheme is in operation the labour cost per unit has hardly fallen at all. Because an increased
incentive is operating in D, the wages cost per unit has risen, but this is more than compensated
for by the reduction in fixed cost per unit.

D. PIECE-RATES
Advantages of Piece Rates
• Time wasted by employees is not paid for, although much depends on the cause of the idle
time and on the agreement in force in the particular industry.
• Each worker is paid on his merits, and thus individual effort is encouraged.
• The increase in production through the workers being induced to work faster causes a decrease
in the fixed expenses chargeable to each unit (in an absorption costing context).
• The employer knows in advance the exact direct labour cost of each job; this information
is invaluable when tendering for work.
• The workers tend to be more careful with tools and equipment when they know that any mishap
to these will reduce their own earning powers.

Disadvantages

• Difficulty may be encountered in fixing an equitable rate

• Slow workers may feel discontented as they will receive a lower wage than the faster worker.
Trade unions are often opposed to piece work on this ground and also on the ground that the
greater speed of production due to piece work may reduce employment opportunities in the
long run.

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• Excessive waste of material may be caused through the workers attempting to work quickly.
Scrapped work will not be paid for, but the employer will lose to the extent of the overheads
involved and the cost of the material spoilt, particularly if any of the unsatisfactory work has
been allowed to continue in production and has passed through subsequent operations. It
would be advantageous to introduce a penalty for spoiled work but this would be very difficult.
• Unless some differential or bonus system is introduced, there is no extra reward for exceptional
effort, e.g. a worker is paid the same per unit for producing one unit or 50 units. Conversely,
no fine is levied for slow production and although only a small wage is earned, the overhead
expenses per unit will increase.
• Payment may be irregular, because of numerous factors, e.g. sickness, breakdown of
machinery, shortage of raw materials, and bad weather.
In many industries, however, there are now agreements providing for the payment of a
guaranteed minimum week when causes outside the control of the workers operate to disturb
or prevent normal production.
• If the proportion of overhead to labour cost is very low, then there is little advantage to be
gained.
• It is stated that over-production may result from speedy work, although it should be possible,
with an efficient planning and production control (or progress) department, to ensure that only
the required amounts of any commodity are produced.
• The risk of accidents may be increased.
• Piece rates may encourage individuals to work purely for themselves and there may be a lack
of co-operation in the department.
• There may be a tendency towards absenteeism and bad time-keeping, especially when workers
feel they have earned “enough”.

E. DIFFERENTIAL PIECE-RATE SYSTEMS

The principle behind differential piece-rate systems is to introduce an additional incentive, at the
point when most workers feel it is not worthwhile putting any more extra effort into their work - in
other words, to encourage them to put in that extra effort.

For example, let us consider lifting potatoes. If there are 12 potato plants in each row, it
will not be difficult to dig up one row in one day, but if we are only being paid RWF2 per
row it will not give us much of a day’s wage. If we dig up 20 rows this will give us a
wage of RWF40, 21 rows a wage of RWF42 and so on. You will probably agree that to
dig another row after the twenty-first is going to involve considerable effort - much more
effort than the first row. Under a straight piece-work system, we are still paid RWF2
for the first or the twenty-first row.

MR. Taylor realised that the straight piece-work system gave no additional incentive to
workers for outstanding effort. He introduced the differential piece-work system, under
which a worker receives an additional bonus after he reaches a certain level of output.
Thus, in our example of potato lifting, Taylor might have introduced a rate of RWF3 per
row once the work has reached 25 rows. Once the figure of 25 has been reached, the
RWF3 per row will be paid for all the rows dug (not just for those after 25), thus giving a
very strong incentive to the worker to reach and pass the 25 figure.

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Differential piece-rate systems are suitable when there are relatively high fixed costs in comparison
with direct wages; the aim is continuous maximum production.

F. PREMIUM BONUS SCHEMES

The main systems using the premium bonus principle are Halsey or Halsey-Weir and Rowan
systems. These are important and most examination questions on incentive schemes will he
based on them

In premium bonus systems a time allowance and not a piece rate is made for a job. The
bonus arising from greater production is shared between employer and employee. Compare this
with straight piece work where all the gains or losses arising from labour efficiency or inefficiency
are borne by the employee, while the reverse is true with guaranteed time rates, when all gains
or losses arising from labour efficiency are borne by the employer

Basic Features
The following points apply to premium bonus schemes:

• Basic time rate is guaranteed.

• The hourly rate of employees increases, but at a lower rate than production.
• A low task is set, e.g. 70% of standard. The result is that employees begin earning bonus
at a relatively low level of output, encouraging them to increase efforts.

Advantages and Disadvantages

(a) Advantages

• (c) above is probably the most important - it encourages workers and even learners to
increase efforts.
• There is a guaranteed basic wage.
• The system is reasonably simple to understand.
• The employer benefits by sharing in the saving of time, which may encourage him to install
time-saving machinery and improve methods.
• The system is suitable where it is impossible to measure production standards with a high
degree of accuracy.
• The system can be operated after very little time study and investigation.
Obviously, the more elaborate the preparation the more accurate will be the rate setting, but
this will increase the overhead costs. Being able to operate the system almost at once can be
a very important advantage.

(b) Disadvantages

• Employees often object to sharing the savings in time and it is difficult to explain or to justify the
principle to the workers.
• Incentive is not nearly as strong as for straight piece work.
• Direct labour costs increase at low levels of output when compared with a straight piece-work
system and even when compared with a guaranteed day-wage system.

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Halsey System, or Halsey-Weir System
This is a premium bonus scheme with a time-rate guarantee. Standard time is allowed for the
job, and if this time or longer is taken, time rate is paid. If less time is taken the worker is paid
a fixed percentage of the saving in time. In practice the bonus percentage varies between
30% and 70% of time saved; the usual proportion is 50%.

To apply this on a 50% basis, look at the following example.

Earnings are: Time rate × (Time taken + 1/2 Time saved). Assume: Time rate RWF4 per
hour
Time allowed 50 hours
Time taken 40 hours

Earnings will be: RWF4 × (40 hours + 1/2 × 10 hours)

= 45 × RWF4 = RWF180
or 45 hours’ pay for 40 hours’ work.

To find the effective hourly rate, divide the amount earned by the time (number of hours)
taken to earn it.

Rowan System
This is also a premium bonus scheme. A standard time is allowed for a job and a bonus paid
for the time saved. The bonus is paid as a percentage addition to the time rate, equal to the
percentage of time saved to standard time.

There are two methods of calculation:

a) Time wages + (% Hours saved × Time wages).

b) T
Assume: Time rate RWF4 perhour
Time allowed 50 hours
Timetaken 40 hours

Earnings would beRWF160 +(20%×RWF160)=RWF192.

You will notice that, under the Rowan system, the worker is paid more than under the Halsey
system at levels of production just over standard; but the Halsey system gives the worker a much
higher incentive at high levels of efficiency.

G. GROUP BONUS SCHEMES

General Principles
Incentive bonus schemes can be applied to the group as well as to individuals. The bonus is
calculated for the group and shared among them on an agreed basis.

(a) Use
Group bonus schemes are usually introduced where particular circumstances apply:

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• Where there is a desire to encourage an “esprit de corps” in the factory.
• Where it is impossible to measure an individual’s output, as in many automated processes. The
output is dependent on the group.
• Where individual bonus schemes are causing jealousy among workers and possibly a
reduction in co-operative effort.

(b) Advantages

• The great advantage is that the group bonus scheme promotes team work. The bonus is paid
to all workers, i.e. not only direct workers but foremen, inspectors, internal transport workers,
tool-men, etc.
• It may encourage poorer workers to work harder, following the lead of better workers. Poorer
workers may feel that they cannot let their team-mates down and may therefore put extra effort
into their work
• Group bonus schemes are usually simple and fairly cheap to operate compared with individual
schemes.
• Mutual supervision is often exercised by the group members.
(c) Disadvantages

• Many employers contend that total output tends to fall because good workers have not
the same incentive to work as efficiently.
• The incentive may be lessened as wages tend to be more constant than in individual
schemes.

Bonus Schemes for Indirect Workers

These usually take the form of, say, a proportion of the average bonus of a related group of
direct workmen, or of a shop.

Staff Incentive Schemes

These are not common but may take many forms.
A bonus for a foreman may be related to the output of his department, or the total hours saved in
his department.
The grading of clerical staff may persuade people to work to attain a higher grade and thus
increase earnings. In some cases work measurement may be made the basis (see later). This
applies particularly to machine operators such as typists and data processing input operators.

H. PERFORMANCE-RELATED PAY
In recent years many organisations have introduced remuneration systems in which the wage
and salary levels are based upon the performance of individual employees. These systems are
aimed at rewarding employees according to their performance, ensuring that those employees
who perform the best receive the highest rewards. Incentives are also built into the remuneration
system that motivate employees to improve their performance at work. Examples of performance-
related pay are:

• Sales personnel who are paid a commission on sales.

• Branch managers whose pay is based upon the profits earned by each branch.

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I. PROFIT SHARING AND CO-PARTNERSHIP
Profit sharing and co-partnership are not synonymous; you should be able to define each one.

Definitions
(a) Profit Sharing
The definition of profit sharing, as agreed at an international congress in 1889, is that “an
employer agrees with his employees that they shall receive in partial remuneration of their
labour, and in addition to their wages, a share, fixed beforehand, in the profits realised by the
undertaking”.

Be careful to note that the share in the profits is fixed beforehand and is not a bonus granted at
the discretion of the employer, although the agreed formula will usually define the limits which
will permit a profit share.

(b) Co-Partnership
Co-partnership gives the workers an opportunity to share in the profits, capital and control of the
undertaking.
Thus, the worker will participate in the profits of the firm in addition to standard wages. He should
be able to accumulate his share of profits in the capital of the company and, if these are in the
form of shares with voting rights, he will automatically share in the control of the undertaking.
A share in the control of the undertaking may also be secured by forming a co-partnership
committee of workers, which will have some influence in the management of the firm.

Methods
There is a great variety of methods used in schemes for profit sharing and co-partnership.
Circumstances differ among firms and consideration will be given to the following points:

• Capital employed and the division of profit between capital and labour.
• Labour employed and to what extent labour influences output and cost of production

Once the amount of profit to be divided among the workers has been decided upon we have a
problem, namely how is this money to be divided among the workers? A straight percentage of
wages would not compensate for loyalty, long service, etc. On the other hand, a person employed
for a few months has not contributed fully to the profits.

This brings us to the question of qualification for participation in the scheme, e.g. at age 21 or
after one or two years’ service are possible qualifications. It is important that the
qualifications are decided before the scheme begins - and agreed with those who hope to
participate in it.

Advantages and Disadvantages

(a) Advantages

• The most important advantage is that the scheme can be designed to reduce labour
turnover, e.g. double bonus may be paid after five years’ service or there may be a system of
increasing bonuses after every four years’ service.
• It does help to build up a team spirit. The status of the worker is raised, particularly
with co-partnership, when workers may have a little influence in management decisions through
their share voting rights.

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• It is said to stimulate interest in the work and increase efficiency; for instance, the employee may
feel it is worthwhile making more suggestions.
• It is said to increase productivity.

(b) Disadvantages

• There is considerable difficulty in deciding on a basis for apportioning the profits as indicated
above.
• Profits fluctuate; therefore bonuses will fluctuate and may sometimes be zero.
• Workers in fact have little say in management policy. Although policy decisions may be best for
the firm in the long term, they may not be for immediate profits.
• Trade unions have been against such schemes, arguing that they weaken the trade unions, and
that share ownership is “an extension of the capitalist society”.
• The poor workers share equally with good workers.
• The scheme provides no direct incentive because rewards are too long deferred, i.e. paid
once, or possibly twice, per annum.
• Employees may not trust the figures given by management.
• The amount of profit is not controlled solely by the workers, efforts, and this makes
them suspicious of the scheme. For example, suppose the workers work at the same level of
efficiency in two successive years, but because the buying department makes a highly profitable
purchase, the first-year profits and bonuses are high. In the second year there could be a
trade depression and profits and bonuses will probably be non-existent.
• Workers share in the profits of good years but do not suffer the losses of bad years.

J. NON-MONETARY INCENTIVES
Purpose
Financial incentives aim mainly at immediate results, while the object of non-monetary
incentives is, in general, to build up output over a long-term period, by the following
methods:

• Encouraging loyalty in the firm and reducing labour turnover.

• Improving the employees’ health, thus reducing absences through illness and
increasing efficiency because the workforce is physically fitter.
• Building up a happy and contented staff, thus reducing absenteeism and increasing output
through more willing co-operation.
• Making prospects with the firm attractive so that it can select the best workers when a
vacancy arises.
• Building up good industrial relations, thereby reducing strikes.
• Giving the worker a sense of purpose and a feeling of security through the interest shown
by management in providing the various amenities.

Various Aspects
It is impossible to list all non-monetary incentives but you should consider the following:

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(a) Health:

• Medical unit in the factory staffed by trained nursing and first-aid staff and
possibly a doctor.
• Safety officer.
• Provision for private medical treatment.
(b) Canteen:

• Subsidized meals, ensuring that workers have at least one substantial meal per
day.
(c) Social:

• Sport as well as dancing and social gatherings.

(d) Education:

• Day-release facilities or provision for full-time sandwich courses.

• Prizes and/or increments in salary for examination successes.
• Training in all branches of the firm so that employees have the experience when there is a
possibility of internal promotion.

K. MEASUREMENT OF THE EFFICIENCY OF LABOUR

In addition to the use of labour turnover ratios to measure the changes in work force, we can use other
ratios to measure other aspects of labour performance. These ratios include the labour efficiency ratio,
the labour capacity ratio and the production volume ratio.

Labour efficiency ratio

This measures whether we are working slower or faster than expected.

Labour efficiency ratio = standard labour hours for actual output x 100
actual labour hours worked
Labour capacity ratio
This measures whether we were able to obtain more or less working hours than we originally
budgeted on being available.
Actual hours worked x 100
Budgeted hours
Labour production volume ratio
This measures whether we were able to produce more or less than we expected to produce based
on the budgeted hours available

Production volume ratio = standard labour hours for actual output x 100
budgeted labour hours
Example:
A company budgeted to produce 10,000 units and taking 4000 hours. During the period, they actually
produced 12000 units and took 4200 hours.

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Required:
Compute the labour efficiency ratio, the labour capacity ratio and the production volume ratio.
Standard labour hours for actual output = 12.000 x 4,000 hours = 4,800 hours
10,000
Budgeted labour hours = 4,000 hours Actual labour hours = 4,200 hours
Labour efficiency ratio = Standard labour hours for actual output x 100
Actual labour hours

= 4.800 x 100 = 114%

4,200

A ratio that is higher than 100 % is favourable. The higher, the ratio, the better. If it is 100%, then
standard labour hours for actual output are equal to actual labour hours. A ratio less than 100% is
adverse.
Labour capacity ratio = actual hours workedx 100
budgeted hours

= 4,200 hours x100 = 105%

4,000 hours
A ratio higher than 100% indicates that we were able to obtain more working hours than we originally
budgeted on being available. A ratio lower than 100 % means we obtained less working hours than
we originally budgeted on being available.

Labour production volume ratio = standard labour hours for actual outputx 100
budgeted labour hours
= 4,800 x 100 = 120%
4,000
A ratio higher than 100 % means we were able to produce more s than we expected to produce based
on the budgeted hours available and a ratio lower than 100% indicates we were able to produce less
than we expected to produce based on the budgeted hours available.

Output per Man/Hour

This is an alternative method of measuring overall efficiency, where total output is divided by
the number of hours taken to produce it.

The method of calculating “man-hours” may or may not include both direct and indirect workers.
It is probably better, from the point of view of controlling labour costs, to include both.

Trends in this statistic need careful interpretation. For instance, if further mechanisation is
introduced, output per man/hour should increase. (The efficiency ratio would automatically
take account of such changes because the standard hours allowance would be adjusted on any
change in methods.)

An alternative to “output per man/hour” would be “output per RWF100 of labour cost”. This takes
account of wages increases: if a pay rise is awarded, output must increase if the “output per
RWF100” statistic is not to decrease.

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Ratio of Direct to Indirect Labour
Provided the degree of mechanisation does not change, management should control the
proportion of indirect labour. If the ratio shows that indirect labour forms an increasing proportion,
this points to administrative inefficiency. On the other hand, too low a proportion of indirect labour
may mean that direct workers are not receiving the back-up services they need.

Care needs to be taken in interpreting this measure, however, as clearly the proportion of
direct workers will fall with increasing mechanisation. There is thus no “ideal” ratio which can be
quoted.

L. LABOUR TURNOVER
We mentioned in the previous study unit that the various incentive schemes can help to
reduce labour turnover. Now we will study this topic in more detail.

Measuring Labour Turnover

The most common measure of labour turnover is:
Number of leavers replaced
x100
Average workforce

Thus, if a reduction in the workforce were planned, e.g. by offering early retirement, the people
retiring early would not enter into the turnover statistics. In measuring labour turnover,
management is concerned to control the cost of having to replace those employees who leave.

Cost of Labour Turnover

The cost of labour turnover can be high. It includes the following:

(a) Personnel Department

Under this heading come all the costs associated with recruitment: advertising,
interviewing, interviewees’ expenses, etc.

(b) Training New Recruits and Losses Resulting

Every new recruit must have some training. Training costs money, i.e. the time of another
operator who has to show the new beginners how to do the job; or the time of a supervisor or
training school.

Even after training, the beginner will be unable for some time to do a full day’s work equivalent to
that of a skilled operator with years of experience. The result is that the machines used by the
new recruit are underemployed, causing further loss.

The new recruit is also likely to cause more scrap and possibly break tools and equipment more
readily than a skilled operator. He or she is also more liable to accidents, causing further loss.

Reasons for Turnover

A certain amount of labour turnover is inevitable - employees retire or die, thus giving
younger staff opportunities for promotion. However, as has been pointed out, labour turnover is
costly and so should be controlled. Every effort should be made to find out why workers leave
and, where defects are found, to put them right.

66 F2.1 Management Accounting CPA EXAMINATION

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Where labour turnover is high and workers are being regularly lost to other firms in the same
locality, the following factors require careful consideration:

• Methods of wage remuneration, e.g. is skill being adequately rewarded? Does average
remuneration compare well with other local firms? Can workers reach an adequate rate of
earnings without a high proportion of overtime working?
• Have the employees confidence in the future long-term prospects of employment within the
organisation?
• Is there any antagonism on the part of the employees, owing to inefficient
management?
• Are there sufficient general incentives to encourage employees to stay within the organisation,
e.g. long service awards, pensions, canteen facilities, joint consultation, sports and recreational
facilities, etc?
Suggested Remedies

(a) Personnel Department

If recruitment procedures are good, labour turnover will be reduced because the right
people will be given the right jobs.

The personnel department can also help reduce labour turnover by developing and maintaining
good employee/employer relations. Joint consultation may be developed. Clearly wage rates will
be an important issue, as will opportunities for training and promotion.

(b) General Welfare

Good employee/employer relations may be developed by the personnel department but
certain services will also go a long way towards maintaining such relationships and improving
morale. The most important of these include the provision of sports
facilities, e.g. sports field, tennis court, , etc; canteen facilities with, possibly, subsidised
meals; adequate first-aid facilities with possibly a medical centre run by a doctor (depending on
the size of the firm); pension scheme - a very powerful factor in reducing labour turnover among
employees.. Part of the expense of providing these facilities must be set against the cost
of labour turnover, although some of these services will also tend to reduce absenteeism and
sickness.

M. RECORDING LABOUR COSTS

The calculation of wages and payroll normally requires two sets of documentation in respect
of each employee, i.e. a time record and a work summary record. By evaluating each record
separately and then comparing the respective payable hours, we can be sure that a full
analysis has been made for cost purposes.

Time Recording
The recording of gate times, i.e. the arrival of each employee at the works in the morning and
his or her departure in the evening, is very important. A number of methods are in use, depending
on the number of employees involved, and you must know the outline of these methods. If you
work in a large factory with the latest machinery you may feel that some of these methods are
old fashioned, but in cost accounting it is important to bear in mind that circumstances in different
concerns vary considerably and what may be old fashioned and cumbersome in a large works
may be the most convenient way of dealing with a small factory of 20 or 30 employees. You
must remember that the costing methods to be used in any business must be the most suitable
for that business, and not necessarily those which have proved successful elsewhere.

CPA EXAMINATION F2.1 Management Accounting 67

STUDY MANUAL
More attention is being paid nowadays to effective clocking systems. The sellers of the many
types of clock claim, quite justifiably, that an installation which includes a time clock, other clocks
and a “hooter”, all synchronised, more than pays for itself in a short time by reason of the extra
production resulting from more prompt starts, precisely-timed tea breaks, etc. These systems
are usually obtainable on a rental basis, which includes full maintenance, at a reasonable
cost.

Try to inspect some different types of machine and system; make sure that you are fully
aware of the method adopted by your own employer.

Time Recording Methods

Time Book
Here, employees on arrival write their names in a book which is ruled off at the time for
starting, late arrivals signing below the line, or alternatively the names are placed in alphabetical
order and each employee enters his or her time of arrival.

Check or Disc Method

Here, numbered metal discs are hung up outside the office. On arrival, each employee
removes a disc bearing his or her own number and places it, either in a receptacle, or on another
board, also numbered.

Note that the time book and disc methods record only the fact of early arrival or lateness and not
the extent of this, but they both have the advantage of being simple to operate.

N. INDIRECT LABOUR
In all works, some staff will be employed on servicing work, e.g. plant maintenance. Where an
employee is continuously engaged on the same type of service or indirect labour, a record of
his or her work may not be required since the total wages may be charged to the one expense
account. Where an employee undertakes various kinds of indirect work, however, it may be
necessary to keep some record of the manner in which he or she spends his or her time, so that
the labour costs may be allocated to the correct accounts in the cost ledger. A time-sheet similar
to that shown in Figure 27 may be used.

(From Study Unit 2 you will recall that direct labour is where the employee’s efforts are applied
directly to a product or saleable service which can be identified separately in a product cost.)

Name:

Clock No.: Rate per Hour

Hours
Nature of Work Th. Fri. Sat. Mon. Tues. Wed. Total
RWF
Machinery Repairs
Dept A
“ B

68 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
“ C
Machine Cleaning
“ Oiling

Sig. ..........................................................

Figure 27: Indirect Labour Record

Examples of Direct and Indirect Labour

Direct Indirect
Wages of Support Staff
Bonuses
Basic Pay of Indirect Workers
Basic Pay of Direct Workers
Cost of Idle Time
Overtime at Request of Customer Order

O. TREATMENT OF OVERTIME
It is not within the scope of a cost accountant’s duties to decide whether or not overtime working
should be authorised, but he or she must record the cost of such working, analyse the cause and
report the facts to management. Clearly, when a department has had idle time during normal
working hours and has worked overtime, this situation should be referred to higher management.

There should be a separate column on the pay sheets for overtime so that it is possible to obtain
the total overtime cost quickly.

For employees who are required to work “unsocial hours” it is now common practice to make
shift premium payments as an additional incentive. These are a particular feature of
operations that have to be run on a 24-hour, 365 days of the year basis and, eventually, they tend
to lose their free incentive advantage, once the employee has become used to receiving them on
a regular basis.

The underlying principle for charging overtime is: charge the cost to the cost unit causing the
expense. This may be illustrated as follows:

(a) Job Cost

Charge to individual jobs if customer wishes delivery date to be brought forward and
overtime has to be worked to do so.

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STUDY MANUAL
(b) General Overhead
This category of overhead account is charged with overtime if general pressure of
business has caused occasional overtime working. It would be unfair to make an extra charge to
those jobs which just happened to be done in the evening.

(c) Direct Labour Cost

On the other hand, if overtime is worked regularly and consistently because of a
shortage of direct workers, it is really part of the normal direct labour cost and should be
treated accordingly. An average hourly rate would be calculated based on the number of hours
at standard rate and the number of hours at premium rates, and all jobs would be charged with
labour at this average rate.

(d) Departmental Overhead

• If inefficiency within a particular department has caused overtime then that

departmental overhead account should be charged with the cost.
• If overtime has been worked in Department B because Department A was inefficient, the cost
of overtime in Department B should be charged to the departmental overhead of Department
A.
P. SUMMARY
The information given in this study unit covers a broad spectrum of the recording systems used.
It must be emphasised that each industry has its own problems in recording both attendance
times and work-on-the-job times and that the solutions adopted are likely to be unique. Great
care needs to be taken to ensure that enough data is collected to meet central requirements
without making the procedure so onerous that it becomes inefficient.

A. EXAMPLES OF EXPENSES
So far we have examined two of the components of cost, namely labour and material costs.
The third cost element is expenses, which comprises all items not falling within the other two
categories. Examples therefore include rent, rates, telephone charges, power, royalties
payable to an inventor, depreciation of equipment, etc.

Direct and Indirect Expenses

We saw with both material and labour that such costs could be direct or indirect. For
instance, the wages of a skilled carpenter in a furniture factory are a direct cost, but the wages
of a foreman or of a clerk in the cost office are normally indirect. The distinction is that the
carpenter’s wages can be identified with particular products, whereas the others cannot.

The same distinction applies in the case of expenses, although there are in fact very few examples
of direct expenses. Royalties payable to the inventor of a product are clearly a direct expense.
Another example would be the running cost of a machine used entirely for one particular product;
in practice, however, most machines are used for a variety of products so their associated costs
are indirect expenses.

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B. NOTIONAL EXPENSES
Rent
If a business rents its factory, the rent payable is, of course, an expense. Often, even if the
premises are owned and no rent is paid, a notional charge in lieu of rent is included in the cost
accounts. This allows for the fact that the real cost of premises is not only the depreciation of
those premises but also the interest on the capital which is tied up (which a landlord would allow
for in fixing the rent). This permits direct comparison of costs of production between different
sites.

Interest on Capital
It may similarly be argued that the expenses in the cost accounts should include a notional
charge for interest on capital in respect of all manufacturing equipment (regardless of
whether money was in fact borrowed to purchase that equipment). Arguments for and
against this approach are as follows:

(a) In Favour of Including Interest on Capital

• Just as wages are the reward for labour, interest is the reward for capital.
Therefore an economist would argue that interest, as well as wages and other costs, ought
to be taken into account in calculating profit.
• False conclusions may be drawn from comparisons if interest is not taken into account. If one
manufacturer makes his own sub-assemblies while another buys them ready-made, interest
on the additional capital which the first manufacturer has tied up must be taken into account in
deciding which of them has taken the more economical option.
• Interest takes account of the time factor, which is of prime importance in production.

(b) Against Including Interest on Capital

• Interest payments depend on the manner in which the business is financed. One manufacturer
may provide his own capital, while another may decide to raise loans. The manner of financing
does not affect the manufacturing cost but only the way in which the ultimate profit is distributed
(whether used to pay interest on loans or available for the owner).
• How should interest be calculated? Should the cost of fixed assets alone be used, or should
capital tied up in stocks also be taken into account? What rate of interest should be used?
Problems arise when comparisons are required between firms in the same industry and in many
cases production costs may be widely different.
• Inclusion will complicate the cost accounts and, if interest is included in stock valuations in the
cost accounts, an adjustment would be required in order to arrive at stock valuations for the
financial accounts.

The arguments against often outweigh the arguments in favour of inclusion of this interest
as an expense. However, when pricing a large order which the manufacturer will
have to finance for a long period before receiving payment, it is reasonable to include an
amount to cover interest on capital

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C. CAPITAL EQUIPMENT
Depreciation
Depreciation is charged in order to apportion the capital cost of a fixed asset over its working
life. Depreciation is often a major part of the total overhead expense, so it is worth looking in
some detail at the methods which are used to calculate it.

There are at least two methods of calculating an annual depreciation charge in common use: i.e.
the straight line method, whereby the capital cost of the machine, less any estimated residual
value at the end of its life, is spread equally over the estimated number of years of life; and the
reducing balance method, in which a percentage of the remaining book value of the machine
is written off each year, so that the charge declines as the asset gets older.

In costing, we want to arrive at a level of annual charge for depreciation and find a means of
apportioning it (along with other costs) to the individual products or jobs. This is done by:

• Estimating the number of hours to be worked by the machine per year and dividing the annual
depreciation by this estimated number of hours, to arrive at a machine-hour rate.
• Estimating the number of hours to be worked by the machine throughout its life, and dividing the
capital cost, less any estimated residual value, by this number of hours, to arrive at a machine-
hour rate.
• Calculating a combined charge for depreciation and repairs, by dividing the capital cost less
residual value plus the total expected repair bill over the asset’s life, by the estimated
number of hours of use. The advantage of this method is that the cost charged in each
year of the asset’s life is the same - the rate does not rise with the higher repair bills which
will arise in the asset’s later years. However, this method may be impractical, since it is difficult
to estimate the total repair bill.

A better approach here is to use the reducing balance method. Indeed, some would argue that
this is one advantage of using the reducing balance method. Consider the case of a company
with only one large machine. It can use either the straight line or the reducing balance method
for depreciation. It is known that with each year of usage, repair and maintenance costs will
increase.

Machine Cost: RWF200,000

StraightLine10% Reducing Balance10%

Dep. Rep./Maint. Total Dep. Rep./Maint. Total

RWF RWF RWF RWF RWF RWF

Yr1 20,000 0 20,000 20,000 0 20,000
2 20,000 2,100 22,100 18,000 2,100 20,100
3 20,000 3,500 23,500 16,200 3,500 19,700
4 20,000 5,600 25,600 14,580 5,600 20,180
5 20,000 7,080 27,080 13,122 7,080 20,202

You will note that in these circumstances straight line depreciation plus repairs and maintenance
will rise each year, whereas reducing balance depreciation plus repairs and maintenance will
have a tendency towards equality each year. (The figures in the example have been chosen
to illustrate this clearly.)

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D. INTRODUCTION TO OVERHEAD COSTS
Definition
An overhead cost is defined in the CIMA Terminology as:

“The total cost of indirect materials, indirect labour, and indirect expenses”.
This means those items of material, wages or expense which, because of their general nature,
cannot be charged direct to a particular job or process but have to be spread in some way over
the various jobs or processes.

Identification of Overhead Costs

In considering what is a direct charge and what is an indirect charge, i.e. overhead, regard
must be paid to the type of industry, the method of production and the organisation of the firm
concerned. For instance, in a general machine shop making a variety of products, the foreman’s
wages would be an indirect or overhead charge, as there is no obvious method of identifying the
cost of the foreman’s wages with a particular job; on a building site, the foreman’s wages would
be a direct expense, as they can only relate to the contract in hand.

The Changing Problem of Overhead Costs

50 years ago most labour was manual, and such overhead expense as existed was a
comparatively small proportion of total cost; today the position has changed radically. Direct
labour, as such, becomes an increasingly small proportion of total cost, and overhead
expenses very much larger. This tendency will undoubtedly continue as mechanisation and
automation develop; and the cost accountant must always move with the times, developing
and rearranging information to suit requirements.

We said earlier that a costing system must suit the business; it must suit not only the kind
of business but also the stage of development of the business. A costing system which
was suitable for a car manufacturer 20 years ago is probably not suitable now - because of
the changing relationship between direct labour and overheads and the enhanced information
demands to manage the business.

With automation becoming increasingly important, there is a tendency for overheads to increase
and for prime costs to decrease. The installation of new machines will increase the depreciation
charges and such items as service labour, while fewer workers will be needed to operate them
(direct labour)

Classification by Function
There are three main classifications of overhead: production, administration and selling, and
distribution overhead. These headings are associated with the three main functions of the
business organisation and we should, as a first step, attempt to classify overhead expenditure
into the appropriate categories. Clearly, there are certain items of cost which appertain to all
three, such as electricity, rent and rates, and it will be necessary to break these individual charges
down to the shares appropriate to the main headings.

(a) Production Overhead

Before any business can start producing goods, it must have a building, which has to be heated,
lit, ventilated and provided with energy to operate the machines. The building must be kept clean
and will need repair and redecoration from time to time, and in addition rent and rates will have
to be paid. The products will have to be designed and production must be planned, supervised

CPA EXAMINATION F2.1 Management Accounting 73

STUDY MANUAL
and checked. Records have to be kept, wages calculated, some form of stores must be operated
and materials must be conveyed from point to point within the building.

These functions, and others, are not directly concerned with actual production, but are nonetheless
essential and may be looked upon as services to the actual job of production. It is the
cost of providing these services which constitutes the production overhead.

Specific examples of this type of overhead are as follows:

• Rent and rates of factories and land.

• Insurance and depreciation of plant and machinery, and buildings.
• Salaries of the technical staff.
• Repairs and maintenance of plant and machinery.
• Consumable stores used in the factory.
• Holidays, paid sick leave and idle time of factory employees.
• Factory heating and lighting.
• Internal transport expenses.

(The above is not intended to be an exhaustive list.)

(b) Selling and Distribution Overhead

The dividing line between production overhead and selling and distribution overhead
comes when the finished goods are delivered to the finished goods store. Examples of selling and
distribution overhead are:

• Salesmen’s salaries
• Salesmen’s expenses
• Salesmen’s commission
• Advertising
• Samples
• Depreciation of delivery vehicles
• Carriage outwards
• Vehicle drivers’ wages
• Warehouse charges

(c) Administration Overhead

Examples are:

• Office repairs
• Office salaries
• Depreciation of office machinery
• Office heating and lighting
• Postal charges
• Stationery
• Share of rates.

74 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Collection of Overhead
All expenditure as it is incurred is allocated its appropriate code number and is accumulated
against each cost centre. (Remember the definition of “cost centre” given in Study Unit 2.) This
will comprise wages and payments which are incurred at irregular intervals. For example, rates
may be paid either half-yearly or yearly and it is, therefore, possible that during a shorter
period of, for instance, three months, either no expenditure will be incurred, or, alternatively, a
whole year’s expenditure may be included.

We must, therefore, prepare a periodical “expense summary”, which ascertains the total
expenditure to be charged to costs of production in respect of each cost centre. It is necessary
to improve the simple figures of payments made, by providing for expenditure incurred but not
yet paid and for expenditure paid in advance.

Example
Electricity bill of RWF800 per annum paid quarterly in arrears on 28 February (RWF250),

31 May (RWF200), 31 August (RWF100) and 30 November (RWF250). Rates paid in advance at
RWF2,500 (payable 1 April for full year).
As at 30 September the accounts will show:

(a) Electricity payments RWF550

(b) Rates RWF2,500

An apportionment would give:

9
(a) Electricity × RWF800 = RWF600 financial accrual RWF50.
12
6
(b) Rates 12 x RWF2,500= RWF 1,250 financial prepayment = RWF 1,250

E.OVERHEAD ALLOTMENT
Allocation and Apportionment
You should learn the following CIMA definitions of cost allocation and cost apportionment:

(a) Cost Allocation

“The charging of discrete identifiable items of cost to cost centres or cost units.”

(b) Cost Apportionment

“The division of costs among two or more cost centres in proportion to the estimated benefit
received, using a proxy, e.g. square feet.”

As an example of cost allocation, repairs to the building housing the raw materials store could be
allocated directly to the stores department cost Centre.

Those items which cannot be allocated must be apportioned. As the definition implies, there is
no single correct way to apportion costs. We have to use the most logical basis possible with the
data at our disposal.

CPA EXAMINATION F2.1 Management Accounting 75

STUDY MANUAL
Cost Allocation

Dept 1
Direct Costs C
O
S
T

A
L Dept 2
Direct Costs L
O
C
A
T
I
O
N ervice Centre

General Overhead Cost

Centre

Cost Apportionment
You will find the following methods of cost apportionment among those used in practice:

(a) Capital Value of Cost Centre

Where cost is increased by reference to the capital value of the cost centre it should be apportioned
in the same way, e.g. fire insurance premium charged by reference to
capital value.

(b) Cost Centre Labour Cost

Where the cost depends on the extent of labour cost of the centre, such as in the case of
employers’ liability insurance premiums, this should also form the basis for the apportionment
of the premium paid.

76 F2.1 Management Accounting CPA EXAMINATION

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(c) Cost Centre Area
Where cost depends on the floor area, it should be apportioned in the same way, e.g.
rent and rates.

(d) Cost Centre Cubic Capacity

Where cost is incurred in phase with cubic capacity, it should be spread back on this
basis, e.g. lighting.

(e) Number of Employees at Cost Centre

The cost of providing a canteen service is generally proportional to the numbers
employed, so it is reasonable to apportion it by reference to the number of employees at each
cost centre.

(f) Technical Estimate

The chief engineer of a factory is in a position to estimate how the cost of certain
expenses should be apportioned between the various cost centres of the factory. Examples
of this type of expense are as follows:

• Light
The wattage used in each department can be calculated and the cost of lighting
apportioned to each cost centre accordingly.
• Power
The horsepower of machines in each cost centre can be established and the cost of power
apportioned on this basis.

(g) Proportionate to Materials Issued

The expenses of operating the stores department, and “normal” stores losses, may be
apportioned by this method, measuring materials by value, weight or volume, as appropriate.

(h) Proportionate to Production Hours

There are many items of expenditure which can be apportioned on this basis, although
the figures are usually available only where a fairly comprehensive costing system is in operation.
Either labour hours or machine hours may be used. Items which may be apportioned on this
basis are:

• Overtime wages (where not allocated direct).

• Machine maintenance (where not chargeable direct

Examples

Example 1
Here is an example of overhead allotment.

A company has two production departments, X and Y and three service departments, stores,
maintenance and production control.

The data to be used in apportioning costs is:

CPA EXAMINATION F2.1 Management Accounting 77

STUDY MANUAL
Stores Maintenance Production X Y Total
Control

Area in sq. m. 300 400 100 3000 4200 8000

Number of 4 12 30 200 300 546

employees

Value of - 8 - 20 12 40
equipment

(RWF000s)

Electricity - 20 - 320 210 550

(000 units)

Number of 1 2 - 14 23 40
Extraction
points

78 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Item Apportionment Total Cost Stores Maintenance Production X Y
Basis Control

RWF RWF RWF RWF RWF RWF

Rent Area 800 30 40 10 300 420

Indirect Allocation 174 11 25 44 31 63

material
Indirect Allocation 5,463 287 671 1,660 1,040 1,805
labour

Factory Number of 2,184 16 48 120 800 1,200

administration employees

STUDY
Machine Value 440 - 88 - 220 132

depreciation

CPA EXAMINATION
MANUAL
Power Electricity 550 - 20 - 320 210
Heat and light Area 80 3 4 1 30 42

Machine Value 40 - 8 - 20 12
insurance

Fumes Number of 120 3 6 - 42 69

extraction extraction points
plant
9,851 350 910 1,835 2,803 3,953

79 F2.1 Management Accounting

We have now arrived at an estimate of the overhead appropriate to each department or cost
centre. However, we really need to express all overhead costs as being appropriate to one or
other of the two production departments, for instance, so that we can include in the price of
our products an element to cover overhead - for it is only in this way that costs incurred will
be recovered. Although costs have been incurred by the service departments, they have
really in the end been incurred for the production departments. The next step is therefore to re-
apportion the costs of the service departments. We do this in a similar way to that used in the
original apportionment.

Additional data is provided: the total number of material requisitions was 1,750, of which
175 were for maintenance department, 1,000 for Department X and 575 for Department Y. This
data will be used to apportion the cost of the stores department to these three departments.
Maintenance costs will be directly allocated to production control and Departments X and Y. (In
practice, a record may be kept of the number of maintenance hours needed in each department
to provide data for cost apportionment.) Production control costs will be apportioned between
Departments X and Y according to the number of employees in those departments (already
given)

80 F2.1 Management Accounting CPA EXAMINATION

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Item Basis of Stores Maintenance Production X Y
Apportionment Control
RWF RWF RWF RWF RWF

Costb/ffrom

350 910 1,835 2,803 3,953

previous table

Stores Department No. of -350 35 - 200 115

costs re-apportioned requisitions

Maintenance Allocation - -945 126 263 556

Department

STUDY
costs allocated
Productioncontrol Numberof - - -1,961 784 1,177
costs re-apportioned employees

CPA EXAMINATION
MANUAL
TOTAL Nil Nil Nil 4,050 5,801

81 F2.1 Management Accounting

Note that when a department’s costs are re-apportioned, the cost is credited to
that department.
Having completed the re-apportionment, you will see that the total of overhead now
attributed to Departments X and Y is, of course, equal to the original total of overhead. This is
something you should always check in doing examination questions of this type.

Examiners have been known to include direct costs in the list of costs, to trap the unwary, e.g.
costs such as direct material and production wages. If you are asked to allocate overheads,
ignore direct costs.

In the above example, some of the stores department’s cost was incurred on behalf of the
maintenance department, but not the other way round. When service departments serve each
other as well as the production departments (sometimes called reciprocal services), we must use
repeated distribution to apportion their costs to the production cost centres. An example
follows.

Example 2
A manufacturing company has two production departments (machining and assembly) and
two service departments (tooling and maintenance).
The expenses of the service departments are dealt with as follows:

Tooling 70% to Machining

20% to Assembly
10% to Maintenance

Maintenance 50% to Machining

30% to Assembly
20% to Tooling

Overhead incurred during the month was:

Machining Assembly Tooling Maintenance

RWF RWF RWF RWF

Indirect Material 4,600 5,200 1,800 600

Indirect Labour 6,100 1,200 2,700 1,600
Miscellaneous 700 900 500 300
We are required to apportion all costs to the production departments.
The first stage is to find the total of all the costs incurred. We can then apportion the costs of
each service department in turn until our objective is achieved.

82 F2.1 Management Accounting CPA EXAMINATION

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Machining Assembly Tooling Maintenance
RWF RWF RWF RWF

Total 11,400 7,300 5,000 2,500

Service department costs redistributed:
Tooling 3,500 1,000 (5,000) 500

Maintenance 1,500 900 600 (3,000)

ooling 420 120 (600) 60
Maintenance 30 18 12 (60)
Tooling 9 3 (12) -

RWF 16,859 RWF9,341 NIL NIL

(In the above exercise, brackets are used instead of minus signs.)

F. OVERHEAD ABSORPTION
Introduction
Overhead absorption is the allotment of overhead to cost units by means of rates separately
calculated for each cost centre.

In other words, when we talk about the amount of overhead absorbed by a product, we mean the
proportion of the total overhead which we estimate is appropriate to that product.

If all items produced by a department were identical, there would be no problem. We should simply
take the total overhead incurred by each productive department (determined by the methods
already described) and divide it by the number of products made, to arrive at an overhead rate for
the product. In practice, it is rarely as simple as that, for units are not identical. The following
are methods of overhead absorption found in practice:

Percentage on Prime Cost

This system is still, unfortunately, in widespread use where costing is fragmentary, and it
must not be dismissed until you are quite clear why it is inadequate.

Imagine, a manufacturer asked to make a million pairs of army boots. If the boots cost him RWF1
to make they would be sold to the government for RWF1.10, so he would have an income of
RWF0.10 per pair to meet general overheads and profits. If, however, he was a very inefficient
manufacturer, so that his boots cost him RWF2 per pair to make, they would be sold to the
government for RWF2.20 and he would have a sum of RWF0.20 to meet overheads and profits.
He had thus a very direct incentive to inefficiency and it is probably true to say that the need to
remedy this abuse was one of the powerful factors contributing to the development of the cost
accounting profession.

The only thing that can be said in favour of this percentage on prime cost is that it is simple and
requires little clerical work, but it would only be approximately true when materials used on every
job were equal in price, wages were uniform throughout (both for skilled and unskilled labour)
and any equipment used was employed equally on all jobs. As these conditions virtually never
apply, the system should virtually never be used.

CPA EXAMINATION F2.1 Management Accounting 83

STUDY MANUAL
Overhead for the period
Formula: x Percentage of prime cost
Prime cost for the period

Percentage on Direct Wages

This is a slight improvement on “percentage on prime cost”, because fluctuations due to the
varying prices of direct materials are eliminated and, furthermore, there are a few items of
expenditure which can, in fact, be reasonably absorbed on the basis of direct wages. It is still
very unsatisfactory in general, however, and the criticisms against it may be summarised as
follows:

• The ratio of wages cost to total hours spent on production may vary considerably where on one
job skilled men are using expensive machines, and on others a large number of unskilled men
are employed without much equipment.
• The slower, and therefore usually the more inefficient, worker attracts a larger burden of
overheads.
• Where piece rates are used, the overhead recovered per piece will be constant, although much
of this may have been done quickly by expert workers and the other part slowly by beginners.

Overhead for the period
Formula: × 100= Wages percentage rate
Wages for the period

Points in its favour are:
• It is simple and easy to calculate, especially where the costing system is rough and ready.
• More consideration is given to the time factor.

Percentage on Direct Material

This method has the worst features of the previous two. Only rarely is it found in practice
that overhead is proportionate to material used.

Overhead for the period

Formula: × 100= Material percentage rate

Absorption on Basis of Time

Anyone who has had any experience of costing will have concluded that much overhead
expenditure is, above all else, subject to the time factor in its relation to output. If one article takes
twice as long to go through the factory as another, it should attract to itself twice the charge for
lighting the factory as the other product, and this is only one example which you can probably
multiply many times out of your own experience. It is generally true, therefore, that by far the
most valuable method of apportioning overhead is on a time basis, and this is usually of one of
two kinds, a direct labour-hour rate and a machine-hour rate.

Occasionally a combination of both these will be in operation and a composite rate per production
hour may be used.

84 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
(a) Direct Labour-Hour Rate
Where this system is used, the number of hours of direct labour worked at a production centre is
estimated, and the number divided into the total figure shown in the expense summary for that
production centre (or costing department) for the corresponding period. The resultant figure
gives an amount to be added to the direct cost of the output for every hour of the direct labour
used throughout.

Hours may be either the number of hours expected to be worked, or the number of hours
which would relate to working at normal capacity.

This is a very satisfactory method, particularly where a production centre uses little elaborate
or expensive machinery, and when it may reasonably be said that every hour of direct labour
absorbs the same amount of expense. You must remember, however, that separate direct
labour-hour rates should be calculated for each production centre and that holidays should be
excluded, as should overtime hours, except when this is a regular recurring feature.

The advantages of this system are as follows:

• The result is not invalidated by use of skilled and unskilled labour.

• Proper provision is made to deal with fast and slow workers who are paid piece rates.
• The figure of labour hours is a more useful guide to the management than the value of wages
paid, because fluctuations due to varying overtime rates and wages increases are avoided

Overhead for the period

Formula: =Direct labour-hour rate
Direct labour hours worked or budgeted
to be worked in the period

(b) Machine-Hour Rate

Where machinery rather than labour is the dominant feature of a production centre, a rate of
overhead per hour of machine time should be substituted for a rate per direct labour hour.

The “machine-hour rate” is defined as:“A rate calculated by dividing the budgeted or estimated
overhead or labour, and the overhead cost, attributable to a machine or group of similar machines
by the appropriate number of machine hours.

The hours may be the number of hours for which the machine or group is expected to be operated,
the number of hours which would relate to normal working for the factory, or full capacity.”

To find this machine-hour rate, it is necessary to estimate the number of hours of operation of the
machine or machines in the cost centre during the period under consideration. Allowance must
be made for idle time and for cleaning and setting-up time. The total expense is then divided by
the number of working machine hours.

As an example, let us return to Example 1 in Section E of this study unit. After the service
department’s costs had been re-apportioned, the costs attributed to the production departments
X and Y were RWF4,050 and RWF5,801 respectively.

Now suppose that Department X has five identical machines working 162 hours each during the
period under consideration.

CPA EXAMINATION F2.1 Management Accounting 85

STUDY MANUAL
Department Y is not automated and has 20 direct workers, each working 160 hours during the
period.

The total number of machine hours worked in Department X is 5 × 162 = 810 hours. Therefore
the machine-hour rate is:

RWF 4,050 = RWF5 per machine hour

810
The total number of direct labour hours worked in Department Y is 20 × 160 = 3,200 hours.
Therefore the labour-hour rate is:

RWF 5,801 = RWF1.81 per direct labour hour

3,200

Suppose that the manufacture of an article takes four machine hours in Department X. It is then
passed to Department Y for hand-finishing, which takes six hours. Then the amount of overhead
absorbed by this article is:

RWF4 × 5 (Department X) + RWF6 × 1.81 (Department Y)

= RWF30.86

In determining the total cost of the article, this sum would be added to the cost of the direct
materials, direct labour and direct expenses incurred.

In the illustration above, only one hourly rate has been calculated for each department. In
practice, fixed and variable overhead will, if possible, be kept separate, and a separate
absorption rate calculated for each.

(c) Machine-Hour Rate Where Machines Are Not Identical

In the above illustration the department operated identical machines. Where the
machines are not identical, however, it is necessary to calculate the rate for each machine
separately. You can apply the following principles:

• Some expenditure can be directly allocated to the particular machine, e.g. power, cost of repairs,
depreciation.
• Overhead chargeable to the production centre in which the machine is located, and not to
the individual machine, e.g. rent, rates, heating, is apportioned on the basis of area occupied.

Example
Using the data below, you are required to calculate a machine-hour absorption rate for
multi-drilling machine no. 5.

Relating specifically to machine no. 5

Original cost: RWF13,300
Estimate life span: 10 years
Estimated scrap value after 10 years: RWF300
Floor space occupied: 250 square metres
Number of operators: 2

Estimated running hours: 1,800 per annum
Estimated cost of repairs: RWF240 per annum
Estimated cost of power: RWF1,000 per annum

86 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Relating to the department in which machine no. 5 is situated
Floor area: 5,000 square metres
Number of operators: 60
Rent: RWF4,400 per annum
Supervision: RWF3,600 per annum

Solution
In addition to the costs specifically relating to machine no. 5, the following apportioned
costs must be taken into account:

• Rent - on the basis of floor area occupied.

• Supervision - on the basis of number of operators for machine no. 5 compared with
the number employed in the whole department.
Therefore the total costs appropriate to machine no. 5 are as follows:

RWF per annum

13,300 RWF300
Depreciation: RWF 1,300
10
1
Rent ( of department’s cost) 220
20
1
Supervision ( 20 of department’s cost) 120
Repairs 240
Power 1,000

Total RWF2,880 per annum

Therefore the machine-hour rate is:

2,880
RWF = RWF1.60 per machine hour
1,800

G. THE USE OF PREDETERMINED ABSORPTION RATES

Introduction
In the examples considered so far, we have been dealing with a known total of overhead
which we have allocated or apportioned to cost centres and hence to cost units. In practice,
of course, costs are being incurred while production is taking place, so that total costs are not
known until the end of the period. But management needs timely information on product costs
as they are being incurred. To overcome this problem, predetermined overhead rates are
used. These are based on estimated overheads and estimated production levels. Each job then
absorbs overhead at the predetermined rate.

Overhead Adjustment Account

At the end of each period it is necessary to compare the overhead which has been absorbed
with that actually incurred. Almost certainly there will be differences. Overhead will have been
over-absorbed if the production level was greater than anticipated, or if overhead costs were
lower than anticipated. Conversely, overhead will have been under-absorbed if the production
level was lower than anticipated or overhead costs were greater.

CPA EXAMINATION F2.1 Management Accounting 87

STUDY MANUAL
The overhead over- or under-absorbed each month is transferred to an overhead adjustment
account, and at the end of the year the net amount over- or under-absorbed is transferred to profit
and loss account. This method is preferable to the alternative of carrying forward a balance
on the overhead account each month, although this alternative method is acceptable if the under-
or over-absorption is caused purely by seasonal fluctuations where an average annual rate of
overhead absorption is in use. In this case, there will be under-absorption in some periods and
over-absorption in other periods because of the seasonal factors, but the net effect over a year
will be nil. Nevertheless, since a cost accountant will rarely be in a position to say that all
under- or over-absorption is due to seasonable factors, it is still considered preferable to operate
an overhead adjustment account.

Example
In a period in which 1,600 direct labour hours are expected to be worked, fixed overheads are
expected to be RWF20,000. In fact only 1,550 direct labour hours are worked and the actual
overhead incurred is RWF19,750.

The predetermined rate for absorption of overhead is RWF12.50 per direct labour hour

RWF 20,000 Thus, for instance, a job which took 20 hours to complete would absorb
1,600
RWF250 fixed overhead.

Because 1,550 direct labour hours are worked, the amount of overhead which has been
absorbed by the end of the period is 1,550 × RWF12.50 = RWF19,375.
Comparing this with the actual overhead incurred, we see that overhead has been under-
absorbed by RWF375.

Extracts from the relevant accounts are shown below:

OVERHEAD CONTROL
RWF RWF
19,750 Work-in-progress -absorbed
Incurred overhead 19,375
Overhead adjustment -under-
absorbed overhead 375
RWF19,750 RWF19,750

WORK-IN-PROGRESS
RWF RWF
Direct material Transferred to finished
Direct labour goods stock

Overhead absorbed 19,375

88 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
OVERHEAD ADJUSTMENT
RWF RWF
Overhead control - under- Profit and loss 375
absorbed overhead 375
RWF375 RWF375
Analysis of Under-/Over-Absorbed Overhead
In the last section we arrived at a figure of RWF375 for under-absorbed overhead. It would
be useful to management to know the reasons for this under-absorption.

From the above workings, we know that the amount of overhead absorbed is RWF19,375.

Had the expected number of hours been worked, overhead absorbed would have been
RWF20,000.

Therefore, because of the shortfall in hours worked, there is under-absorption of RWF625.

However, this is offset by RWF250 because the overhead bill of RWF19,750 is less than expected.

To summarise: RWF

Under-absorption owing to shortfall in hours 625

Over-absorption owing to lower total cost 250
Net under-absorption RWF375

“Blanket” Overhead Absorption Rates

Overhead absorption rates should preferably be calculated separately for each department.
However, a “blanket” rate for the whole factory may be acceptable in the following
circumstances:

• Where only one product is manufactured.

• Where there are several products but they use approximately equal amounts of the
services of all departments.
• Where overhead forms a small proportion of total cost, and the extra work involved in calculating
departmental absorption rates would not be worthwhile.

H. TREATMENT OF ADMINISTRATION OVERHEAD

It is not generally worthwhile to attempt to be too scientific in apportioning administration costs to
products. For pricing purposes, the inclusion of an agreed percentage on production costs will
generally be adequate. For other purposes, there is no need to absorb administration
costs into product costs: instead they can be treated as period costs to be written off in the
profit and loss account.

CPA EXAMINATION F2.1 Management Accounting 89

STUDY MANUAL
I. TREATMENT OF SELLING AND DISTRIBUTION OVERHEAD
Variable Elements
Some elements of selling and distribution overhead vary directly with the quantities sold - for
instance, commission of so much per unit paid to a salesman. Such items can be charged
directly to the product concerned in addition to the production cost.

Fixed Elements
Other items are incurred whether products are sold or not - for instance, rent of showrooms,
salaries of salesmen. Such items may be treated as period costs and written off in the profit and
loss account or may be absorbed in one of three ways:

(a) Percentage on Sales Value

Selling overheads for year RWF250,000

Estimated sales value for year RWF2,500,000

Cost 250,000
Absorption rate = Activity × 100 = × 100 or 10%
2,500,000

In this case, we add 10% of the sales value of the cost unit to the cost to cover selling overheads.
This method is useful when prices are standardised and the proportions of each type of article
sold are constant.

(b) Rate per Article

Selling overheads for year RWF250,000
Number of articles to be produced 1,000,000
Cost 250,000
Absorption rate = or 1,00,000 RWF0.25 per article
Activity

For each article produced, 0.25rwf is added to the cost.

The method is particularly applicable where a restricted range of articles is produced,

but it can be used for an extended range by evaluating different sizes using a points
system.

(c) Percentage of
Selling overheads for the year RWF250,000
Estimated production cost of sales for year RWF2,000,000

Absorption rate = Cost or 250,000 × 100 = 12½%

Activity 2,000,000

12½% of production cost of each unit is calculated and added to that cost.

Care must be taken in applying this method. For instance, suppose a company makes two
products, A and B. A costs twice as much as B to produce. Therefore, a percentage on
production cost basis would charge A with twice as much selling and distribution overhead as B.
However, it may very well be that there is a ready market for A, so there is no need to advertise
it, whereas B is in competition with others and the company spends RWF10,000 on advertising
B. It is therefore clearly incorrect to charge A with twice the overhead which is charged to B.

90 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Indeed, the advertising cost should have been charged directly to B. The method is, however,
acceptable if the costs involved are small, or if there is a limited range of products and those
costs which do not vary with the cost of production can be charged direct.

J. ACTIVITY-BASED COSTING
What is Activity-Based Costing?
The two traditional costing methods are absorption costing and marginal costing, as we have
seen. Absorption costing allocates and apportions all overheads to products. In order to do this,
companies must allocate and apportion service overheads to the main production departments.
Direct labour and/or machine-hour rates are then derived, which are used to calculate the
overheads attributable to each product. The approach was developed in the early part of
the 20th century and assumes that overheads directly relate to the level of production. This is
not always the case under current production methods, as factors such as sales mix, complexity,
range and production techniques all influence overhead costs. The method of apportionment
can also seem arbitrary and the resulting product costs are sometimes difficult to interpret.

Marginal costing, on the other hand, makes no attempt to apportion overheads and
a product’s marginal cost only includes direct material, direct labour and directly attributable
overheads. Sales less marginal cost establishes the company’s contribution, which should be
managed in such a way that it covers all fixed overheads and generates the required level of
profit. Critics of this approach point to the danger of not apportioning all overheads to products
and the possibility that these costs will not be recovered in selling prices. As a result, the
company may drift into loss and eventually go out of business.

Absorption costing requires a lot of time and energy put into the basis of overhead allocation
and apportionment but often the factors leading to the generation of these costs are obscured.
Marginal costing tends to ignore these fixed overheads and relies on budgets to control cost levels.
Activity-based costing provides an alternative approach to the treatment of fixed overheads. It
focuses on the activities that generate overheads and the factors, or cost drivers, that
cause costs to change. These cost drivers are at the heart of ABC and are used to determine
the basis of overheads attributable to each product. Attention is focused on each activity and the
factors that cause cost levels to change. In consequence, the nature of each cost will be better
understood and increased control and better decisions should result.

Terms used in Activity-Based Costing

Activity: Discrete services or related tasks which are carried out repeatedly.
Cost Driver: The factor or event which causes a cost to occur.
Cost Pool: All the costs incurred when an activity takes place.

• Professors Kaplan and Cooper of Harvard University created the idea of activity based costing.
It was designed to deal with the problem of allocating costs to output where such costs are not
related to volume of production.
• In the traditional methods overheads are apportioned to output using a basis such as
machine hours.
• For every cost driver the cost per unit of activity is calculated and this is then used to divide
costs into individual cost units.

CPA EXAMINATION F2.1 Management Accounting 91

STUDY MANUAL
Examples of: Activities & Cost Drivers Used
Purchasing Dept No. of Invoices

Accounting Dept Costs No. of Accounting Reports

Set up Costs No. of Manufacturing Set Ups

Engineering Dept. Costs No. of Production Orders

Advantages of Activity-Based Costing (ABC)

• Better basis for cost apportionment.

• Overheads are traced to the product.
• ABC brings attention to cost behaviour and helps in the reduction of costs.
• ABC provides a useful means of getting financial and non financial data.
• More realistic product costs.
• Forces managers to consider the drivers of cost in their business.
Disadvantages of Activity-Based Costing

• Difficulty in picking cost drivers.

• Very time consuming.
• The problem of common costs.
• A full ABC systems having numerous cost pools and cost drivers is more complex and more
expensive to operate.

The stages involved in ABC are:

• Identify the activities that cause overheads to be incurred.

• Change the accounting system so that costs are collected by activity rather than by cost centre.
• Identify the factors that cause each activity’s costs to change. These factors are the cost drivers.
• Establish the volume of each cost driver.
• Calculate the cost driver rates by dividing the activity’s cost by the volume of its cost driver.
• Establish the volume of each cost driver required by each product.
• Calculate overheads attributable to each product by multiplying (f) by (e).

ABC concentrates on the activities which are essential in order that services are provided or
goods produced. All related costs are charged to the activity and each activity is itself necessary
for the final product to be produced. Examples could be:

• Personnel department costs

• Material handling
• Spare parts administration.
These activities are known as “cost drivers” (defined as “an activity that generates cost”). Having
separated expenses into these cost drivers, then the most appropriate method of allocation is
determined for each cost driver and used. For example, the total cost of the personnel
department might well be allocated on the basis of numbers of personnel in each cost centre, etc.

92 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
By having different activity costs, each having different methods of allocation, it is argued that
the allocation/apportionment task is refined and, being less arbitrary, more correctly reflects “true
cost”.
The following example will illustrate how this works.

Worked Example
One of the findings of companies that have used ABC is that high-volume production tends
to be over-costed, whilst low-volume, small-batch work is often under-costed. This probably
results from the additional overheads associated with short production runs not being adequately
reflected in the company’s costing system. Our example will therefore consider two products.
Product X is manufactured in long production runs, whilst Product Y has more components,
greater variety and is manufactured in small batches.

Product X Product Y

Monthly production 5,000 6,000

Direct material costs RWF RWF
Department A 4.00 5.00
Department B 4.00 4.00
Department C 2.00 3.00
RWF10.00 RWF12.00
Direct labour costs RWF5.00 RWF7.00
Machine-hours Hrs Hrs
Department A 0.50 0.60
Department B 0.50 0.90
Department C 0.25 0.50
Overheads RWF
Production Department A 20,000
Production Department B 15,000
Production Department C 10,000
Purchasing 6,000
Production control 5,000
Tool-setting 12,000
Maintenance 3,000
Quality control 4,000

CPA EXAMINATION F2.1 Management Accounting 93

STUDY MANUAL
Product Costs Calculated Using Absorption Costing
The first step is to apportion the service department overheads to the production departments. In
this example we will use the following basis of apportionment:
RWF
Purchasing 6,000 Direct material costs
Production control 5,000 Direct material costs
Tool-setting 12,000 Direct material costs
Maintenance 3,000 Machine-hours
Quality control 4,000 Machine-hours

The monthly material costs and machine-hours can be calculated from the previous data, and
are presented on the following page.

Dept A Dept B Dept C Total

Machine-hours
Product X 2,500 2,500 1,250 6,250
Product Y 3,600 5,400 3,000 12,000
6,100 7,900 4,250 18,250
Departmental % of total 33.4% 43.3% 23.3% 100.0%
Direct Material

Product X 20,000 20,000 10,000 50,000

Product Y 30,000 24,000 18,000 72,000
50,000 44,000 28,000 122,000
Departmental % of total 41% 36% 23% 100%

The overhead analysis sheet apportioning service department overheads to production

departments can now be prepared:

Overheads Department

RWF000 Basis A B C
Production Department A 20 20.0
Production Department B 15 15.0
Production Department C 10 10.0
Purchasing 6 Material 2.4 2.2 1.4
Production control 5 Material 2.1 1.8 1.1
Tool-setting 12 Material 4.9 4.3 2.8
Maintenance 3 M/C 1.0 1.3 0.7
hours
Quality control 4 M/C 1.3 1.7 1.0
hours
75 31.7 26.3 17.0
94 F2.1 Management Accounting CPA EXAMINATION
STUDY MANUAL
The machine-hour rates are therefore:
Cost Machine-hours Rate
RWF RWF
Dept A 31,700 6,100 5.20

Dept B 26,300 7,900 3.33

Dept C 17,000 4,250 4.00

Overheads apportioned to each product under a traditional product costing system can be
calculated by multiplying the product’s machine-hours by the appropriate departmental rate. The
answer to these calculations is presented next.

Product X Product Y

RWF RWF
Dept A 2.60 3.12
Dept B 1.67 3.00
Dept C 1.00 2.00
5.27 8.12
This example has been simplified but is not untypical of systems found in practice.
Overheads are apportioned to products based on a machine-hour rate, which in this example
does not take into account the fact that Product Y is manufactured in small batches requiring
additional tool-setting, production control and quality control effort.

Product Costs Calculated Using ABC

An activity-based costing method would regard these costs as activities that can be
controlled, and seek to identify the cost drivers that determine the cost levels. These cost
drivers may not necessarily be the number of items produced and in this example we will assume
they are as follows:

Activity Cost Driver

Purchasing Number of orders
Production control Number of components produced
Tool-setting Number of tool changes
Maintenance Machine-hours
Quality control Number of components inspected
Production Department A Machine-hours
Production Department B Machine-hours
Production Department C Machine-hours

In order to keep this example simple, it is assumed that the production department overheads
are directly related to machine-hours worked. In practice it would be possible to divide each
department into a number of different activities, each with its own cost driver.

The additional information required to calculate activity-based costs is:

CPA EXAMINATION F2.1 Management Accounting 95

STUDY MANUAL
Product X Product Y Total
300 900 1,200
Number of orders
Components produced 15,000 48,000 63,000
Components inspected 2,000 11,000 13,000
Machine-hours 6,250 12,000 18,250
Tool changes 10 60 70

The cost driver rates are calculated below:

Overheads
RWF Cost Driver Rate
Volume
Production Department A 20,000 6,100 3.28 per m/c hr
Production Department B 15,000 7,900 1.90 “ “ “
Production Department C 10,000 4,250 2.35 “ “ “
Purchasing 6,000 1,200 5.00 per order
Production control 5,000 63,000 0.08 per part
Tool-setting 12,000 70 171.43 per change
Maintenance 3,000 18,250 0.16 per m/c hr
Quality control 4,000 13,000 0.31 per
inspection

The overhead rate per product under activity-based costing becomes:

Product X Product Y

Rate Volume Overhead Volume Overhead

RWF RWF RWF

Dept A 3.28 2,500 8,200 3,600 11,808
Dept B 1.90 2,500 4,750 5,400 10,260
Dept C 2.35 1,250 2,938 3,000 7,050
Purchasing 5.00 300 1,500 900 4,500
Production control 0.08 15,000 1,200 48,000 3,840
Tool-setting 171.43 10 1,714 60 10,286
Maintenance 0.16 6,250 1,000 12,000 1,920
Quality control 0.31 2,000 620 11,000 3,410
21,922 53,074
Quantity produced 5,000 6,000
OVERHEAD PER RWF4.38 RWF8.85
PRODUCT

96 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Product Y’s cost is greater than that obtained from the traditional absorption costing method and
reflects the additional costs involved in its manufacture.

Further Considerations
The ABC approach to ascertaining cost of production was introduced as an important
innovation in management accounting in the 20th century. It is a further development in
relating overhead expenses to production.

Over recent years, rapid changes in methods of production have resulted in direct labour costs
per unit of output being reduced. More expenditure is now indirect overhead not directly
related to units of production.

In marginal costing the only variable activity considered is volume of sales. It is established
that, at a certain level of production and sales, a breakeven point will be reached; the
contribution per unit thereafter is related to profit. In the case of absorption costing, overhead
costs are absorbed in the most logical way by units of production. Allocation and absorption is
achieved arbitrarily but as logically as possible. As overheads have become a greater proportion
of total production cost, any arbitrariness in how they are charged to products becomes more
significant.

In activity-based costing the overheads are considered to be related to the use made by production
of the facilities (cost drivers) responsible for incurring them. This is considered a more logical
way to obtain accurate information on the cost of production. The advocates of ABC consider the
following points in promoting this approach:

• It provides more accurate product costs, which should enable the management to make
decisions on pricing, most profitable product mix etc. in a more logical manner.
• It is argued that production resources are more efficiently utilised.
• It extends the variable cost approach to short-term and long-term costs and volume changes.
This is because these costs are related to the activities and not only to volume of production.
• Costs are considered in more detail as to whether they add value to production or not.
• In this way management can achieve better cost control.
• The management will have better understanding of the economics of production and of activities
performed by the company.

Although ABC is a better approach in relating overheads to production, it is still an arbitrary method.
It is in a sense an extension of absorption costing, as ABC product costs are full absorption costs.
ABC can be applied to all costs incurred in an organisation, not only production costs. It is being
used increasingly in service organisations such as hotels, schools and hospitals.

ABC in Service Industries

The nature of the ‘product’ in service industries means that the cost structure typically differs
from manufacturing industries. Direct costs tend to be a smaller proportion of total cost,
because the direct material content of a service is usually small. The direct labour content of a
service can, however, be significant.

CPA EXAMINATION F2.1 Management Accounting 97

STUDY MANUAL
The impetus for the application of ABC in service industries is mainly a desire for more
understanding of the costs of providing services, as an aid to decision-making and cost
control. There may be a tendency in service industries to view all costs as overheads, bearing
no direct relationship to the level of service provided. This results in cost control being
aimed at the inputs to the process rather than the outputs, so it will be relatively ineffective. The
application of ABC in service industries requires clear specification of what services are provided,
so that the activities driven by and underpinning the services can be specified. Examples of cost
units used in service industries could include:

Business Cost unit

Healthcare (hospitals) (a) Bed occupied
(b) Out- patient
Hotel & catering Room/cover
Professional services (accountants, architects, lawyers)
Chargeable hour
Education (a) Enrolled student
(b) Successful student
(c) School meal

These cost units could be refined to reflect significant differences in the activities and drivers
relating to them. One hospital changed its cost unit on adopting an ABC approach. The initial
unit was a patient-day, but analysis of the activities necessary to provide a patient-day revealed
a range of activities falling into two broad categories: those relating to the nursing care a patient
received, and those relating to bed occupancy.

The latter category, such as the provision of ward cleaning services and patients’ meals was
mainly driven by the number of beds, and these activities were largely independent of the specific
types of patient occupying the beds. The nursing care activities, however, were driven by
the medical needs of particular types of patient. On the change of cost unit, every ward’s head
nurse rated each patient and arrived at a level of ‘acuity’ on a five-point scale. The ‘acuity’ rating
was the driver for the cost of nursing activity, and was used both in charging patients for
their hospital stay, and in preparing a flexible budget for nursing costs in each ward.

The solution in this instance of the hospital is compatible with the approach of a traditional costing
system - it equates to a manufacturing company changing from a plant-wide absorption
rate to cost-centre absorption rates. However, this does not indicate a general compatibility
between the traditional and the ABC approach in service industries.

A key factor in the ABC approach is the recognition of cost at levels other than the unit level.
The cost of making a bed available is largely a facility-level cost, while the cost of providing
nursing care to patients at a particular sickness level is a unit-level cost, i.e. it will increase as
the number of patients with this level of sickness increases. ABC and traditional costing result in
the greatest differences when cost drivers are batch- and product-related, rather than unit- and
facility-related.

In some service industries, e.g. public relations, the specific output may be difficult to
identify and quantify. Where there are multiple outputs, identifying support activities with particular
outputs may be even more difficult. Even strong advocates of ABC acknowledge that the costs
of applying it in such circumstances may well outweigh the benefits. For example, a hotel may

98 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
incur significant costs in tending its gardens and maintaining communal areas. Allocating these
facility-sustaining common costs to particular ‘products’, such as overnight stays, must be
largely arbitrary.

However, ABC can be very suitable for the service sector in identifying customer profitability
rather than ‘product cost’. Customer focus is vital in service industries - customers may
make very different demands even when using the same ‘product’. In some cases common costs
may be more easily identified with customers than products; e.g. a hotel swimming pool may
be used more by families than by business people, even though both types of guest are being
provided with overnight accommodation. An ABC analysis of customer profitability in service
industries may yield valuable information to assist management in, for example, price-setting.

CPA EXAMINATION F2.1 Management Accounting 99

STUDY MANUAL
COSTBOOK-KEEPING

A. COST ACCOUNTING SYSTEMS

The Principle of Double Entry

In some businesses, the cost accounts may consist of little more than statistical memoranda,
but in a business of any size or complexity, it is preferable for the cost accounts to be kept on a
double entry basis, as this will provide more detailed information and a check on the arithmetical
accuracy of the entries.

While double entry cost accounts are generally to be preferred, you must remember that the
system has to suit the business and not the reverse. An elaborate system should not be
introduced merely for the sake of theory; the purpose of cost accounting is to provide
management with information.

We shall assume that you are familiar with the elements of double entry book-keeping, and the
arguments which show the necessity of keeping the financial accounts on a proper double entry
basis. The same arguments apply to the cost accounts. As in financial accounts, the golden
rule applies - “for every credit there is a debit” - and if you keep to this you will not go far wrong.

Main Classification
Accounting systems which are used for costs may be classified as follows:

(a) Interlocking Systems

In these systems two separate ledgers are kept, one for costing figures (the cost ledger)and one
for financial figures (the financial ledger). Most figures in the cost ledger will have been extracted
from the financial ledger. For example, materials entering the store, which will be recorded in
the cost ledger, will already appear in the purchases account in the financial ledger. This is
why the systems are described as “interlocking”. Since both ledgers describe the transactions
of the business during the same period, they must be capable of reconciliation.

(b) Integrated or Integral Systems

In these systems one ledger is kept, in which both the financial and cost data are recorded.

B. INTEGRATED OR INTEGRAL SYSTEMS

Description
Integrated accounts are a set of accounting records which provide financial and cost accounts
using a common input of data for all accounting purposes.

An integrated accounting system avoids the need to open a cost ledger control account and to
reconcile the cost and financial accounts.

Figure 2 shows the accounting flow within an integrated system. If you compare this
flowchart with Figure 1 you will see that they are very similar. In the integrated system the
debtors, creditors, bank and fixed assets accounts have replaced the cost ledger control
account.

100 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
In the interlocking system these accounts were, of course, part of the financial ledger, and the cost
ledger control account was the means of interlocking the two ledgers, transferring items from the
financial to the cost ledger. The integrated system is more straightforward as this intermediate
step is eliminated.

If you now compare the integrated system with what you learned about the financial ledger in your
Accounting Framework course, you will notice that the integrated system has dispensed with the
purchases account. The figure of purchases is derived from the creditors control account and
posted straight to the stores control account.

CPA EXAMINATION F2.1 Management Accounting 101

STUDY MANUAL
Worked Example
In view of what we have said about integrated systems, you may be surprised that separate
cost and financial profit and loss accounts are asked for. The cost profit and loss account is
not in fact part of the double entry system. It is a memorandum account only, prepared to show
what the profit would be without the effect of purely financial items. Company policy determines
whether two accounts are prepared or whether one is considered adequate.

Question
ABC Ltd started the year with the following trial balance:

RWF RWF
Capital 100,000
Fixed Assets 30,000
Debtors 10,000
Stores 20,000
Work-in-Progress 20,000
Finished Goods 30,000
Creditors 20,000
Bank 10,000
120,000 120,000
During January the following transactions took place:

RWF
Raw materials purchasedon credit 20,000

Sales on credit 25,000

General operating expenses (cash) 10,000
Wages 10,000
Discounts allowed 1,500
Discounts received 1,000
Creditors paid 15,000
Payments bydebtors 20,000
Issues from Raw Material Store 30,000
Issues from FinishedGoods Store 20,000
Finished production entering Finished Goods Store 40,000

102 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Depreciation was taken as 1% forthemonth on fixed assets.
Prepare:

• All ledger accounts;

• Cost profit and loss account;
• Financial profit and loss account;
• Trial balance as at themonth end.

Answer
* The asterisked items are the balancing figures in the accounts.

CAPITAL

20.. RWF 20.. RWF

Balance b/f 100,000

Debtors

20.. RWF 20.. RWF

Balance b/f 10,000 20,000
Bank
Sales 25,000 Discounts 1,500
Allowed
Balance c/f 13,500
35,000 35000

WORK-IN-PROGRESS

20.. RWF 20. RWF

Balance c/f 20,000 Finished Goods 40,000

Stores 30,000 Balance c/f 30,300*
Bank (Wages) 10,000
Overhead Control 10,300
70,300 70,300
Balanceb/f 30,300

CREDITORS

20.. RWF 20.. RWF

Bank 15,000 Balanceb/f 20,000
Discounts Received 1,000 Stores 20,000
* Balance c/f 24,000
40,000 40,000
Balanceb/f 24,000
CPA EXAMINATION F2.1 Management Accounting 103
STUDY MANUAL
BANK

20.. RWF 20.. RWF

Balanceb/f 10,000 Work-in-Progress (Wages) 10,000
Debtors 20,000 Overhead Control 10,000
Balancec/f 5,000 15,000
35,000 35,000

Balanceb/f 5,000
FIXED ASSETS

20.. RWF 20.. RWF

Balance 30,000

STORES CONTROL ACCOUNT

20.. RWF 20.. RWF

Balanceb/f 20,000 Work-in-Progress 30,000

Creditors (Materials 20,000 Balance c/f 10,000*
Purchased)

40,000 40,000
Balanceb/f 10,000

FINISHED GOODS

20.. RWF 20.. RWF

Balance c/f 30,000 Cost ofSales 20,000

Work-in-Progress 40,000 Balance c/f 50,000*

70,000 70,000
Balanceb/f 50,000

PROVISIONS FOR DEPRECIATION

20.. RWF 20.. RWF
Balance c/f 300 Overhead Control 300
300 300
Balanceb/f 300

104 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
OVERHEAD CONTROL

20.. RWF 20.. RWF

Bank 10,000 Work-in-Progress 10,300

Provision forDepreciation 300

10,300 10,300

COST OF SALES

20.. RWF 20.. RWF

Finished Goods 20,000 Profit andLoss 20,000
20,000 20,000

SALES

20.. RWF 20.. RWF

Profit andLoss 25,000 Debtors 25,000

25,000 25,000

DISCOUNTS ALLOWED

20.. RWF 20.. RWF

Debtors 1,500 Profit andLoss 1,500

1,500 1,500

DISCOUNTS RECEIVED

20.. RWF 20.. RWF

Profit andLoss 1,000 Creditors 1,000
1,000 1,000

COST PROFIT AND LOSS ACCOUNT (MEMORANDUM ONLY)

20.. RWF 20.. RWF

Cost ofSales 20,000 Sales 25,000
Profit 5,000
25,000 25,000

CPA EXAMINATION F2.1 Management Accounting 105

STUDY MANUAL
FINANCIALPROFITAND LOSSACCOUNT

20.. RWF 20.. RWF

Cost ofSales 20,000 Sales 25,000

Discounts Allowed 1,500 Discounts Received 1,000

Profit c/f 4,500

26,000 26,000

TRIAL BALANCEASAT31 JANUARY

DrCr

RWF RWF
Capital 100,000
Profit 4,500
Fixed Assets 30,000
Provision forDepreciation 300
Stores 10,000
Debtors 13,500
Work-in-Progress 30,300
Finished Goods 50,000
Creditors 24,000
Bank 5,000
133,800 133,800

Make sure that you understand all the entries used in this answer; once you have studied it
carefully, you should attempt the exercise of posting the entries given in the question.

Advantages of Integrated Accounting Systems

Provided that integrated accounting can be fitted conveniently into the organisation, there are five
distinct advantages:

• Savings in accounting costs can be made.

• There is no need for reconciliation of cost and financial accounts.
• Better use can be made of accounting information, since all the facts are known.
Together with this is the better co-operation which should ensue from the cost and financial
accounting staff also being “integrated”.
• Single data capture greatly simplifies automated linkages between the process control
systems, accounting systems and the overall management information systems.

106 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
• When introducing computerised systems, it is not sensible to use two separate ledgers, with
all the attendant control problems. Computer systems are best at handling large volumes of
data and exercising overall control, but problems often arise when control level interfaces are
necessary such as when two or more ledgers are maintained. To overcome these problems
the purchase and sales ledger areas of a computerised accounting system are usually kept
apart from the nominal ledger and are physically defined as separate modules by the software
supplier

If the accounts are not computerised, the work has to be sub-divided and, historically, this was
why separate ledgers evolved for the cost and financial accounts.

CPA EXAMINATION F2.1 Management Accounting 107

STUDY MANUAL
TOPIC 3
COSTING METHODS
INTRODUCTION TO BATCH COSTING
The CIMA Terminology defines a batch as a “group of similar units which maintains its identity
throughout one or more stages of production and is treated as a cost unit”.

It is a form of specific order costing in which costs are attributed to batches of products. A batch
is very similar in nature to job costing, the only real difference being that a number of items are
being costed together as a single unit, instead of a single item or service.

Having calculated the cost of the batch, the cost per item of that batch can be determined by
dividing the total cost by the number of items produced.

Batch costing can be applied in many situations, including, for example:

Where customers order a quantity of identical items;
Where a batch of similar items are produced and held in stock awaiting customers’ orders

Where an internal manufacturing order is raised for a batch of identical parts, for example
components to be used in production

Examples include a batch of bakery where items are cooked in batches or a batch of identical
teddy bears produced by a toy factory.

CALCULATION OF COST PER UNIT

As mentioned, the procedure is similar to job costing. The batch is treated as the job and the
costs for the batch are collected on the job card which is then subsequently used to value
work in progress.

A cost sheet (or computer file) will be used to record the direct and indirect costs incurred by (or
allocated to) the production of the batch. This cost sheet is called a batch cost sheet. When the
products (or components) are finished, the batch cost sheet is closed and the products will be
transferred to stores or charged to sales at the average cost of the batch.

PRODUCT LINE INFORMATION

Batch costing is usually used where a wide variety of products are held in stock. The cost
accountant will be called upon to provide detailed information on product costs for the following
areas:

Production Planning / Control

Scheduling to maintain stock levels and to meet fluctuations in demand could pose a major
problem. It would require continuous information to be ascertained on set-up costs, stock
movements and machine utilization. (Note the Economic Batch Quantity can be calculated to
assist in production scheduling – see section F below).

108 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Pricing
Management will require regular analyses of product costs and profits. This information will
assist in directing sales effort and help to determine sales policy.

Research
Cost information will be required in the development of new products / improving operations

BATCH PRODUCTION VERSUS CONTINUOUS PRODUCTION

Many organisations operate a continuous production line or series of lines which individually
perform tasks, the combined result of which is the finished product.

These organisations do not manufacture to the requirements of a specific customer, per

se, but they might employ a version of batch costing to attach a cost to their product. In these
circumstances, the costs are ascertained for a batch and an average cost per unit is calculated.
The difference, however, is in determining the batch. Often, this is done by reference to time (for
example an accounting period).

Batch production differs from a continuous production line because with continuous production,
the same product is made all the time (or for long periods of time) without interruption. However,
Batch production consists of a sequence of production runs, with a different product made in
each batch. The costs of setting up the production line for a new batch and cleaning up after a
batch has been produced can be significant. Batch set-up costs are charged to individual batches
where they can be identified and recorded.

EXAMPLE
Bookillbo Limited manufactures embroidered school uniforms. The following details are available
from the company’s budget:

Cost Centre Estimated Estimated Level of

Overheads Activity
Cutting and sewing RWF93,000 37,200 machine hours

Embroidering and RWF64,000 16,000 direct labour hours

Packing
Administration, selling and distribution overhead is absorbed into batch costs at a rate of 8%
of total production cost. Selling prices are set to achieve a margin of 15%.

An order for 45 school jumpers has been produced for St. Archibald’s Boys School. Details of
this batch are as follows:

Direct Materials RWF113.90

Direct Labour:
Cutting and sewing: 0.5 hours @ RWF9/hr RWF4.50
Embroidering and packing: 29 labour hours @ RWF11/hr RWF319.00

Machine hours worked in cutting and sewing 2

Fee paid to designer of logo for crest on school jumper RWF140.00

CPA EXAMINATION F2.1 Management Accounting 109

STUDY MANUAL
REQUIREMENT:
Calculate the selling price per school jumper

Solution:
RWF RWF

Direct material 113.90

Direct labour:
Cutting and sewing 4.50
Embroidering and packing 319.00
323.50
Design costs 140.00
Prime cost 577.40
Production Overhead:
Cutting and sewing: 2 mach. hrs x RWF2.50 (w1) 5.00
Embroidering and packing: 29 lab. hrs x RWF4 (w1) 116.00
121.00
Total Production Cost 698.40
Administration etc. (RWF698.40 x 8%) 55.87
Total Cost 754.27
Profit margin (RWF754.27 x 15/85) 133.11
Total selling price of batch 887.38

Selling price per school jumper RWF887.38 / 45 RWF19.72

Working 1

Calculation of overhead absorption rates:

Cutting and sewing: RWF93,000 / 37,200 machine hrs = RWF2.50 / mach. hr

Embroidering and packing: RWF64,000 / 16,000 labour hrs = RWF4.00 / lab. hr

110 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
SERVICE COSTING
A. INTRODUCTION
Service costing is defined as “cost accounting for services or functions, for example
canteens, maintenance and HR. These may be referred to as service centres, departments or
functions”.

Service industries are different to manufacturing in that their outputs are intangible. However,
service outputs still have a production cost and the organisation must be able to determine these
costs in order to run the business efficiently.

It is important to note that no new costing principles are involved when moving from one type
of business to another. But it must be decided what are the relevant cost units and how the
elements of cost in materials, wages and other expenses may be analysed and classified in order
to ascertain the cost of these cost units.

B. SERVICE COST UNITS

One of the biggest problems in service industries is identifying a cost unit that represents an
appropriate measure of the service provided. A composite cost unit is often used. The nature of
the service provided should determine the cost unit used.

Examples of these composite cost units are given below:

Service Cost Unit

Hospital Patient days
Accountancy Services Chargeable man-hours
Electricity generation Kilowatt hours
Restaurant Meals served
Transport company Passenger miles
Carriers Ton-miles
In addition, some service organisations may use a number of different cost units the measure the
various kinds of service that it provides. For example, a hotel provides a variety of services, each
of which may be measured separately as follows:

Service Cost Unit

Accommodation Occupied bed nights or Guest days
Restaurant Meals served
Function facilities Time based (e.g. hours)

C. COST COLLECTION AND COST SHEETS

Having decided the cost unit to be used, it is important that the appropriate statistical information
is gathered and recorded properly. Cost Sheets record the costs of each service that is provided.

At regular intervals, these cost sheets are prepared by the cost accountant to provide information
to management. The cost sheet would, typically, include the following for both the current period
and the aggregate year to date:

CPA EXAMINATION F2.1 Management Accounting 111

STUDY MANUAL
• Cost information
• Cost units statistics
• Cost per unit. This is the average cost per unit and can be calculated as follows:
Total costs per period
No. of service units supplied in period
• Perhaps some non-cost statistics may also be provided which may be useful to management,
for example, average miles per gallon of fuel

The data from these cost sheets are then used to provide cost reports. These reports are a
summary of the totals for the period and may be further analysed into fixed and variable costs.

D. INTERNAL SERVICE ACTIVITIES

Most modern organisations have internal services departments, such as HR, stores, maintenance,
canteen etc. It is not unusual for these departments to involve significant costs. The cost of these
departments must be calculated, principally for two main reasons.

• To control costs in the service department. This enables management to compare the cost
against a target (budget) and also to compare actual costs against previous period costs for the
department.
• To control costs of the user department and prevent the unnecessary use of services. If the cost
of services is charged to the user departments so that the charges reflect the use made of the
departments of the services, the overhead cost of user departments will be established more
accurately and may discourage excessive use of the service if that cost is significant.

E. EXAMPLES
1. Sunshine Hotel

The following information is provided for the month of June for the rooms department of the
Sunshine Hotel.

Twin Bed Rooms Single Bed

Rooms
Number of rooms in hotel 260 70
Number of rooms available to let 240 40
Average number of rooms occupied daily 200 30
In addition the following information is available:

Number of guests in the period 6,450

Average length of stay 2 days
Total revenue in period RWF774,000
Number of employees 200
Payroll costs for the period RWF100,000
Items laundered in period 15,000
Cost of cleaning supplies in period RWF5,000
Total cost of laundering RWF22,500
Listed daily rate for twin-bed room RWF110
Listed daily rate for single room RWF70

112 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
The hotel calculates a number of statistics, including the following:
Statistic Measurement Method
Room Occupancy Total number of rooms occupied as a percentage of rooms
available to let
Bed Occupancy Total number of beds occupied as a percentage of beds
available
Average Guest rate Total revenue divided by number of guests
Revenue Utilisation Actual revenue as a percentage of maximum revenue from
available rooms
Average cost per Total cost divided by number of beds occupied
occupied bed

REQUIREMENT:
Prepare a table containing the following statistics, calculated to one decimal place:

i. room occupancy (%)

ii. bed occupancy (%)
iii. average guest rate (RWF)
iv. revenue utilisation (%)
v. cost of cleaning supplies per occupied room per day (RWF)
vi. average cost per occupied bed per day (RWF)
Solution
Total number of rooms occupied
(i) room occupancy= x 100
Rooms available to let

= 200 + 30 x 100
240 + 40

= 82.1%

Total number of beds occupied

(ii) bed occupancy = x 100
Total number of beds available
= 6,450 guests x 2 days per guest
((240 x 2) + (40 x 1)) x 30 days

= 82.7%

(iii) average guest rate = Total revenue

No. of guests

= RWF774,000
6,450

= RWF120

CPA EXAMINATION F2.1 Management Accounting 113

STUDY MANUAL
(iv) revenue utilisation = actual revenue x 100
maximum revenue from available rooms

= RWF774,000 x 100
((240 x RWF110) + (40 x RWF70)) x 30 days

= 88.4%

(v) Cost of cleaning supplies per occupied room per day

= RWF5,000
(200 + 30) x 30 days

= RWF0.72
(vi) Average cost per occupied bed per day
= Total Cost
Number of beds occupied

= RWF100,000 + RWF5,000 + RWF22,500
6,450 x 2
= RWF9.90

2. DLN Limited is a transport company which operates a regular delivery service from its
warehouse in Kigali to a destination near Bukavul. The total annual mileage covered (including
100 outward and return journeys) being 18,000 miles per 10-ton vehicle.

For the outward journey, the vehicle is always fully loaded and in addition there is a regular
demand for return loads of 400 tons per vehicle per annum. The standard charge to customers is
24 rwf per ton/mile. The costs of operating this service are as follows:

Vehicle fixed charges RWF5,400 per annum

Drivers’ wages, including normal overtime RWF10,260 per annum
Vehicle running costs RWF 0.33 per mile

The company is willing to pay a bonus to drivers of up to 30% of any additional profit for obtaining
additional return loads.

REQUIREMENT:
(a) What annual profit would be earned per vehicle without any additional return loads?

(b) What annual bonus would be payable to a driver who consistently obtained an additional
5-ton return load?

(c) What annual bonus would be payable if the additional 5-ton return load involved a detour
of 20 miles (on which no income would be earned) and a RWF2 additional overtime pay on
each occasion?

114 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Solution
(a) Annual Profit per vehicle under existing conditions:

Annual cost per vehicle: RWF

Fixed charges 5,400
Drivers wages 10,260
Running Costs (18,000 miles x 33rwf / mile) 5,940
21,600
Income: Ton / miles
100 outward journeys
(9,000 miles x 10 tons) 90,000

Return journey
(9,000 mile / 100 journeys)
= 90 mile x 400 tons 36,000
126,000 x RWF24 = 30,240

Annual profit per vehicle 8,640

(b) Annual bonus on regular route RWF

5 tons x 9,000 miles = 45,000 ton / miles x RWF 10,800
Bonus at 30% 3,240

(c) Annual bonus on detour route RWF RWF

Additional income per above 10,800
Less:
20 mile x 100 journeys
= 2,000 miles x RWF33 660

Overtime
100 journeys x RWF2 200
860
Net additional income 9,940
Bonus at 30% 2,982

Application
Until now we have been considering organisations with a cost unit which can be segregated,
and have direct expenses wholly attributed to it. Other types of organisation produce output in
which a unit cannot be easily separated, so that the output requires to be treated in bulk. It is
then necessary to use the technique known as process costing.

Process costing is applicable in the chemical, paint, carpet, food processing and textiles
industries.

CPA EXAMINATION F2.1 Management Accounting 115

STUDY MANUAL
General Method
The method is essentially one of averaging, whereby the total costs of production are
accumulated under the headings of processes in the manufacturing routine, and output figures
are collected in respect of the various processes. The total process cost is divided by the total
output of the process, so that an average unit cost of manufacturing is arrived at for each process.

Where there are several processes involved in the production routine, it is usual to cost each
process and to build up the final total average cost, step by step. The output of one process may
be the raw material of a subsequent one, thus making it necessary to establish the process
cost at each stage of the manufacturing operation.

The way to do this is to regard each process carried out as a cost centre, and to collect information
regarding the usage of materials, costs of labour and direct expenses exclusively attributable to
individual processes. Each process will be charged with its share of overhead expenses and the
procedure of building up cost rates per process or cost centre is carried out in accordance with
the rules given previously.

Need to Record Losses and Good Production

We have said that an average cost per unit is obtained for each process. This average cost is
arrived at by dividing the cost of each process by the number of “good” units of production
obtained from it. Hence it is necessary to set up a recording scheme to find the number of units
produced by each process. Since it is unlikely that all material entering a process will emerge
in the form of good production, the recording scheme should provide records of losses from
each process in addition to records of good production achieved.

B. BUILDING UP PROCESS COSTS

Material
The method of charging material usage will depend on the factory layout and organisation. If
there is only one input of raw material at the stage of the initial process, the problem is simplified
and material usage can be computed from the stores requisitions. In a case such as this, the
output of the first process becomes the raw material of the second, and so on.

If further raw material is required at a subsequent process, it may be convenient to establish raw
material stores adjacent to the point of usage.

In many cases material may be used which is of low value, e.g. nails, and the volume of paperwork
required to record each issue would be prohibitive. In such cases the method of charging would
be to issue the anticipated usage for a costing period at one time, the issue being held for use at
the point of manufacture. A physical stock-taking at the end of the period would establish actual
usage of material, which could be compared with the theoretical usage expected for the output
achieved. With all such items the requirement is to maintain some degree of physical control
rather than accurate cost allocation.

Labour
Accounting for labour where process costing is in operation is normally straightforward
because fixed teams of operatives are associated with individual processes, and the
interchange of labour between processes is not normal from the point of view of efficiency. It is
often as simple as collating names on the pay sheets to establish the wages cost for a process.

116 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Where process labour is interchangeable, labour charges per process may be established by
issuing job cards to employees to record the time spent on each process.

Direct Expenses
All expenses wholly and exclusively incurred for one particular process will be given the
proper process number and attributed to the cost centre on this basis.

Overhead
The indirect material, labour and expenses not chargeable to one particular process must be
borne eventually by production. Absorption rates are used as before, and it is necessary that we
establish rates in advance for each cost centre. This means that the total overhead expenses
of the business must be estimated and apportioned to the processes in terms of the rules which
we have already explained. As we have seen, it is necessary to assess the output expected at
each cost centre. Then the absorption rates for the cost centres can be calculated by dividing the
costs associated with them by the estimated output per cost centre.

In this way we establish a relationship between overhead cost and activity. At the close of
each period the actual activity achieved by the cost centre is multiplied by the predetermined
rate to give the charge for overheads. However, where marginal costing techniques are being
followed (see later study units), overhead costs are not included but are dealt with in total as is
fundamental to marginal costing.

Conversion Costs
These are the costs of converting material input into semi-finished or finished products, i.e.
additional direct materials, direct wages, direct expenses and absorbed production overhead.
They do not include the costs of original new material inputs. The term “conversion costs”
is often referred to in examination questions on process costing and you should understand
what the term means.

C. EXAMPLES OF PROCESS COSTING

• Value of opening and closing WIP

• Equivalent units
• FIFO method
• Average method
The techniques used in process costing can be demonstrated with the aid of a series of examples.
You should follow them through carefully, making sure that you understand each stage and can
follow the double entries in the accounts.

Example 1: Demonstration of Process Accounts and Stock Accounts When the

Value of Opening and Closing Work-in-Progress is Given
In this example an organisation produces an item which requires two processes, and it is normal
for stocks of goods completed by Process I to be held for some time before being used in
Process II. It is therefore necessary to open process stock accounts. (In future examples we
shall assume that output from one process is used immediately in the next process, making it
unnecessary to keep stock accounts.)

CPA EXAMINATION F2.1 Management Accounting 117

STUDY MANUAL
The following information has been collected for costing period no. 3.

Process I Process II
Direct materials used RWF2,000 RWF1,400

Direct labour cost RWF2,000 RWF2,100

Production overhead RWF1,150

Opening Stocks: Process I 1,000 units valued at

RWF0.50 each

Finished 1,111 units valued at

Good RWF0.90 each
Opening Work-In-Progress: Process I 1,400 units valued at
RWF0.25 each

Process II 644 units valued at

RWF0.155 each

Closing Work-In-Progress: Process I 600 units valued at

RWF0.25 each

Process II 200 units valued at

RWF0.50 each

Closing Stocks: Process I 1,600 units valued at

RWF0.50 each

Process II 555 units valued at

RWF0.90 each

Units completed during Period 3: Process I 9,600 units

Process II 9,444 units

Sales 10,000 units at RWF1.10 each

Production overhead is absorbed at the rate of RWF0.50 per machine hour for Process I and
RWF0.25 per machine hour for Process II.

Machine hours worked during Period 3:

Process I 1,200

Process II 2,000
Process II used 9,000 units of Process 1 output

118 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Solution
(*The asterisked items are those which are found as the balancing figure on the account.)

PROCESS I ACCOUNT
Units Unit Total Units Unit Total
Cost Cost Cost Cost

RWF RWF RWF RWF

Opening WIP 1,400 0.25 350 9,600 0.50* 4,800*
Process I stock
Material 8,800* 2,000 600 0.25 150
WIP c/d
Labour 2,000

Overhead

(1,200 × 0.5) 600

10,200 4,950 10,200 4,950

WIP b/d 600 0.25 150

Notice that both the “Units” and the “Total Cost” columns must balance.

PROCESS I STOCK ACCOUNT

Units Unit Total Units Unit Total
Cost Cost Cost Cost

RWF RWF RWF RWF

Balance b/f 1,000 0.50 500 Process II 9,000 0.50 4,500
Process I 9,600 4,800 Balance c/f 1,600 0.50 800
10,600 0.50 5,300 10,600 0.50 5,300
Balance b/f 1,600 0.50 800
As the opening stock had the same value as the units transferred from Process I during the
period (50rwf per unit), there is no problem over valuing the 9,000 units issued to Process II.
If the unit costs had been different, either the FIFO method or the averaging method would have
been used to value the units issued to Process II, and the closing stock.

CPA EXAMINATION F2.1 Management Accounting 119

STUDY MANUAL
PROCESS II ACCOUNT

Units Unit Total Units Unit Total

Cost Cost Cost Cost

RWF RWF RWF RWF

Opening WIP 644 0.155 100 Finished stock 9,444 0.90* 8,500*
Process I WIP c/d 200 0.50 100
Stock 9,000 0.50 4,500
Material 1,400
Labour 2,100
Overhead
(2,000 × 0.25) 500
9,644 8,600 9,644 8,600
WIP b/d 200 0.50 100

FINISHED STOCK ACCOUNT

Units Unit Total Units Unit Total

Cost Cost Cost Cost

RWF RWF RWF RWF

Balance b/f 1,111 0.90 1,000
Profit & loss
Process II 9,444 0.90 8,500 a/c Cost of 10,000 0.90 9,000
sales Balance 555 0.90 500
c/f
10,555 0.90 9,500 10,555 0.90 9,500
Balance b/f 555 0.90 500

PRODUCTION OVERHEAD ACCOUNT

RWF RWF
1,150 Absorbed: Process I 600
Actual expenditure
Absorbed: Process II 500

Profit and loss a/c:

under-absorbed overhead 50

1,150 1,150

120 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
PROFIT AND LOSS ACCOUNT

RWF RWF
Cost of sales 9,000 11,000
Sales

Production/overhead
Under-absorbed 50

Profit 1,950
11,000 11,000

Example 2: Introduction to “Equivalent Units” - Work-in-Progress at End of

Period Only In Process I the costs incurred during January were:

RWF
Materials 2,000
Labour 2,700
Overhead 1,600
6,300
There was no opening work-in-progress. 1,100 units were introduced into the process. 700
were completed during January and the remaining 400 were:

75% complete as to materials,

50% complete as to labour,
25% complete as to overhead.

Calculate: cost per unit, total value of finished production, value of closing work-in-
progress.

Draw up the process account.

Solution
Note: “Equivalent units” or “effective units” are a notional quantity of completed units substituted
for an actual quantity of incomplete physical units in progress, when the aggregate work content
of the incomplete units is deemed to be equivalent to that of the substituted quantity of completed
units.

The idea of equivalent units is that 200 units half-complete are equivalent to 100 units fully-
complete, in terms of cost. In the above example we have different degrees of completion for the
different elements of cost. The meaning is that the units comprising the closing WIP have had
75% of the required material incorporated in them; this has taken 50% of the labour processing
time necessary to complete a full unit and the overhead content is put at 25% of that for a full unit
(e.g. the units concerned have had 25% of the necessary machine time).

The layout shown on the next page is recommended for all questions where percentage completion
is given.

CPA EXAMINATION F2.1 Management Accounting 121

STUDY MANUAL
Since there is no mention of overhead absorption rates in this question, we assume that overhead
is charged to production as it is actually incurred, rather than by the use of predetermined
absorption rate.

CALCULATION OF EQUIVALENT UNITS AND COST PER UNIT

Material Labour Overhead
% Com- Equiv % Com- Equiv % Com Equiv
pletion alent pletion alent pletion alent
Units Units Units
Completed units
(700) transferred
A to next process 100 700 100 700 100 700

WIP c/d (400) 75 300 50 200 25 100

B Total equivalent
units
1,000 900 800
Costs incurred
RWF 2,000 2,700 1,600
Cost per
equivalent unit
(B/A) 2 3 2

Valuations
Total cost per equivalent unit = RWF7 (RWF2 + RWF3 + RWF2) Value of finished production
= RWF7 × 700 = RWF4,900

Value of closing WIP (ascertained by reference to no. of equivalent units for each category of
cost):

RWF
Material 300 × RWF2 = 600
Labour 200 × RWF3 = 600
Overhead 100 × RWF2 = 200
RWF1,400

PROCESS I ACCOUNT
Units RWF Units RWF
Material 1,100 2,000 Process II 700 4,900
Labour 2,700 WIP c/d 400 1,400
Overhead 1,600
1,100 6,300 1,100 6,300
WIP b/d 400 1,400

122 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Example 3: Work-in-Progress at Both Beginning and End of the Period: FIFO Method
Process No. 2 had opening work-in-progress of 200 units valued at RWF1,692, completed as to:

Previous process 100%

Added materials 80%
Labour 60%
Overhead 75%

During the month a further 2,200 units were received from the previous process, valued at
RWF4 per unit (total RWF8,800). The following costs were incurred:
RWF
Materials added 5,060
Labour 5,450
Overhead absorbed 3,906

At the end of the month 400 units were still in process, completed as to: Materials added 90%
Labour 75% Overhead 80%
Calculate the division of costs incurred during the month between: completion of opening work-
in-progress, units started and completed during the month, and closing work-in- progress, and
draw up the process account.

Solution
The implication in this question, where we are told the percentage completion of the opening
work-in-progress (and can therefore see how much work remains to be done on it this month
in order to complete it), and are asked to show the cost of completing the opening work-in-
progress, is that FIFO is to be used. That is, we are to assume, for costing purposes, that the
opening work-in-progress is completed first, before any new units are worked on. (It does not
matter whether or not that is what happens in practice: it is a reasonable assumption to make for
costing purposes.)

The method is very similar to that illustrated in Example 2. Because of our FIFO assumption, we
can say that the output from Process 2 must be:

200 units - opening work-in-progress, now complete

1,800 units - started and finished this period.

CPA EXAMINATION F2.1 Management Accounting 123

STUDY MANUAL
CALCULATION OF EQUIVALENT UNITS AND COST PER EQUIVALENT UNIT (PROCESS 2)

Material Labour Overhead

% Com- Equiv- % Com- Equiv- % Com- Equiv-
pletion alent pletion alent pletion
alent

Units Units Units

Completion of
opening WIP (200) 20 40 40 80 25 50

Units started and

A finished this

month (1,800) 100 1,800 100 1,800 100 1,800

Closing WIP (400) 90 360 75 300 80 320

B Total equivalent
units
2,200 2,180 2,170
Costs incurred this
month RWF 5,060 5,450 3,906

Cost per equiv.

unit (b/a) RWF 2.3 2.5 1.8

Division of this month’s costs

(1) Completion of opening WIP:

RWF

Material added 40 × RWF2.3 = 92

Labour 80 × RWF2.5 = 200

Overhead 50 × RWF1.8 = 90

RWF382

124 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
(2) Units fully processed this period:

Total cost per unit = RWF2.3 + RWF2.5 + RWF1.8 = RWF6.60

cost of 1,800 units = 1,800 × RWF6.60 = RWF11,880

(3) Closing WIP:

RWF
Material added 360 × RWF2.3 = 828
Labour 300 × RWF2.5 = 750
Overhead 320 × RWF1.8 = 576
RWF2,154
Valuation of Closing WIP
RWF
Process 2 costs incurred on closing WIP
(from above) 2,154
Add: Cost b/f from Process I (400 @ RWF4) 1,600
Total value of closing WIP 3,754
Calculation of Cost Transferred to Process 3
RWF
Opening valuation of opening WIP 1,692
Add: cost of completing opening WIP (from above) 382
Total cost of the first 200 units of output 2,074
Cost of the remaining 1,800 units:
Cost b/f from Process I (1,800 × 4) 7,200
Processing cost this month (from above) 11,880

Total cost of output RWF21,154

PROCESS 2 ACCOUNT
Units RWF Units RWF
WIP b/f 200 1,692 Transferred to
Transferred from Process 3 2,000 21,154
Process 1 2,200 8,800 WIP c/f 400 3,754
Materials added 5,060
Labour 5,450
Overhead 3,906
2,400 24,908 2,400 24,908

CPA EXAMINATION F2.1 Management Accounting 125

STUDY MANUAL
Example 4: Work-in-Progress at Both Beginning and End of Period: Average Method
At the beginning of March the work-in-progress in Process I was 7,000 units, valued as follows:

RWF
Materials 29,600
Labour 7,600
Overhead 6,000
43,200

During March a further 32,000 units were introduced and additional costs during the month were:

RWF

Materials 110,800
Labour 33,650
Overhead 31,950
176,400

At the end of the month 30,000 units had been fully processed and passed to the next process
and 9,000 units remained in Process I, completed as follows:

Material 100% complete

1
Labour 33 % complete
3

Overhead 33 1 % complete
3

Make the necessary calculations and draw up the process account.

Solution
In this example it is impossible to use the FIFO method just described, because we do not
know how much work remains to be done to complete the opening WIP.

The average method is therefore used, in which the costs incurred in previous months on the
opening WIP and the costs incurred in March are averaged over the total number of units
processed (30,000).

126 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
CALCULATION OF EQUIVALENT UNITS AND COST PER EQUIVALENT UNIT

Material Labour Overhead

% Com- Equiv- % Com- Equiv- % Com- Equiv-
pletion Alent pletion alent pletion
alent
Units Units Units
Units transferred
to next process

Closing WIP 100 30,000 100 30,000 100 30,000

(30,000)

1 1
(9,000) 100 9,000 33 3 3,000 33 3 3,000
A Total equiv. units 39,000 33,000 33,000

Costs incurred in
previous periods
(value of opening

B WIP) RWF 29,600 7,600 6,000

Costs incurred
in March RWF 110,800 33,650 31,950
Total cost RWF 140,400 41,250 37,950
Cost per
equivalent
unit (B/A) RWF 3.60 1.25 1.15

Cost of units transferred to next process

Total cost per equivalent unit = RWF3.60 + RWF1.25 + RWF1.15 = RWF6
Cost of completed units = 30,000 × RWF6 = RWF180,000

Valuation of closing work-in-progress

RWF
Material 9,000 × 3.60 = 32,400
Labour 3,000 × 1.25 = 3,750

Overhead 3,000 × 1.15 = 3,450

39,600

CPA EXAMINATION F2.1 Management Accounting 127

STUDY MANUAL
PROCESS I ACCOUNT

Units RWF Units RWF

WIP b/f 7,000 43,200 Transferred
Materials 32,000 110,800 to Process II 30,000 180,000
Labour 33,650 WIP c/f 9,000 39,600
Overhead 31,950
39,000 219,600 39,000 219,600

WIP b/f 9,000 39,600

Essential Differences Using FIFO and Average Methods

It is important to understand the essential differences between the FIFO and average methods,
and when each may be used. Although the average method may appear somewhat easier, in
examinations you are recommended to use FIFO whenever possible, i.e. when the percentage
completion is given for both opening and closing WIP.

In practice FIFO is used when the costs do not fluctuate significantly from month to month, and
the average method is used where there are larger fluctuations.

The essential differences you will see between the two methods are:

• The equivalent units calculation under FIFO shows percentage of work required to complete
opening WIP, whereas under the average method, opening WIP and units fully processed
(started and finished) this period are grouped together.
• Under FIFO only one cost (the cost incurred this period) is used to work out the cost per
equivalent unit. The value of opening WIP is not brought in until later. In the average method
the value of opening WIP is added to the cost incurred this period.
• In Example 3, we were looking at Process 2 and consequently had a cost brought forward
from Process 1. By leaving this element until the very end of the calculations, no difficulties
were encountered. This element is slightly more difficult to introduce in the average method.
The best way is to have a four-column instead of a three-column layout for the calculation of
equivalent units, treating the units transferred from the previous process as “Material 1” and the
material introduced in the present process as “Material 2”. All units, whether fully complete at
the end of the period or closing WIP, are of course 100% complete in respect of “Material 1”.

This technique can also be applied to the FIFO method, and is illustrated by the following
alternative solution to Example 3 (using the FIFO method).

128 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Example 5: Alternative Layout Where a Process Other Than the First is Involved - The layout
is shown below.

CALCULATION OF EQUIVALENT UNITS AND COST PER EQUIVALENT UNIT

“Material 1” Materials Labour Overhead

(Transfer from Added
Process 1)

% Equiv. % Equiv. % Equiv. % Equiv.

Units Units Units Units

Completion of
opening WIP - - 20 40 40 80 25 50
(200)
Units started and

finished this
period (1,800) 100 1,800 100 1,800 100 1,800 100 1,800
A Units started this
period and in
process at close
(400) 100 400 90 360 75 300 80 320

B Total equivalent
units
2,200 2,200 2,180 2,170
Costs introduced
this month RWF 8,800 5,060 5,450 3,906

Cost per
equivalent unit

RWF 4 2.3 2.5 1.8

Division of Costs
(a) Completion of opening WIP - as before.
(b) Units fully processed this period:

RWF
Process 1 Cost 1,800 × 4 = 7,200
Process 2 Cost 1,800 × 6.60 = 11,880

19,080

(c) Closing WIP - as before.

CPA EXAMINATION F2.1 Management Accounting 129

STUDY MANUAL
D. LOSSES IN PROCESS COSTING – NORMAL LOSSES AND ABNORMAL LOSSES
Losses - The Terminology
You should familiarise yourself with the following CIMA terminology. Make sure you
understand the difference between scrap and waste.

(a) Scrap
Discarded material which has some recovery value and which is usually either disposed of without
further treatment (other than reclamation and handling), or re-introduced into the production
process in place of raw material.

(b) Waste
Discarded substances having no value.

Normal Loss
All loss, theoretically, is avoidable, and it can be said that inefficiency exists wherever waste
occurs. However, no factory ever completes its manufacturing programme without
producing some loss, so loss up to a certain level must be expected and regarded as normal.
Every effort must be made to reduce it to an absolute minimum by the proper use of
materials, machines, methods and effective controls.

The normal loss in processes is usually readily recognisable, and can be expressed as a
percentage of the total input of material. The cost of normal loss is borne by the process,
less any incoming credit in respect of the sale of loss. Where there is no sale value of the normal
loss, then of course in the examples which follow, normal loss value would be nil.

Example
Cost of process RWF2,000

Number of units entering process 1,000

Percentage of input regarded as normal loss 10% Value of loss per unit 25rwf
The process account will be written as follows:

PROCESS ACCOUNT

Units RWF Units RWF

Input in units 1,000 Normal loss 100 25
Cost of process 2,000 Cost of normal
Output 900 1,975
1,000 RWF2,000 1,000 RWF2,000

Calculations:
(a) Normal loss - 10% of input = 100 units
(b) Credit value of (a) above, 100 units at 25rwf per unit = RWF25
(c) Cost of normal output per unit = rwf 2,000 25 = RWF2.19
900

130 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
From this example you can see that the cost of normal loss is written into the cost of good
production, but that credit is given for scrap value, if any.

Abnormal Loss or Gain

If losses are greater than normal, there is said to be an abnormal loss, while if losses are less
than normal there is an abnormal gain. Normal loss is treated in exactly the same manner as
above, i.e. its scrap value is credited to the process account and the cost per unit of normal output
is found. Abnormal losses or gains are valued at the same value as good production and
transferred to abnormal loss or gain account and thence to profit and loss account, after making
any adjustments for the income from the sale of abnormal loss. This procedure highlights
any abnormalities so that any necessary explanations may be incorporated in the periodic
management accounts, thus facilitating the taking of corrective action.

Examples

Example 1
Total cost of process = RWF7,385
No. of units input = 700
Normal loss = 5% of input
Actual loss = 40 units

Scrapped units are sold at RWF2 each

Show the process account, abnormal loss account and scrap account.

Solution

Workings
Normal loss: 5% of 700 = 35 units

Scrap value of normal loss = 35 × RWF2 = RWF70

Actual loss = 40 units

Abnormal loss = 5 units

Normal output expected = 700 – 35 = 665 units
(rwf 7,385 70)
Cost per unit of normal output =
665

(allowing credit for scrap value of normal loss)

= RWF11 per unit

i.e. abnormal loss and good production are each valued at RWF11/unit.

Cost of abnormal loss = 5 × RWF11 = RWF55

Cost of good production = 660 × RWF11 = RWF7,260

CPA EXAMINATION F2.1 Management Accounting 131

STUDY MANUAL
PROCESS I ACCOUNT
Units RWF Units RWF
Input 700 7,385 Normal loss
(scrap value) 35 70
Process II 660 7,260
Abnormal loss 5 55
700 7,385 700 7,385

NORMAL LOSS ACCOUNT

Units RWF Units RWF

Process I a/c 35 70 Scrap a/c 35 70

ABNORMAL LOSS ACCOUNT

Units RWF Units RWF

Note (a) Scrap a/c 5 10 (b)
Process I a/c 5 55 Profit & loss a/c - 45 (c)
5 55 5 55

SCRAP ACCOUNT
Units RWF Units RWF
Note (d)
Normal loss a/c 35 70 40 80 Note (e)
Cash

Note (b)
Abnormal loss 5 10
a/c
40 80 40 80

Notes on Abnormal Loss Account and Scrap Account

(a) This is the double entry of the “abnormal loss” appearing in the process account.
(b) These are the two halves of a double entry and represent the scrap value of abnormal loss
(5 units @ RWF2).
(c) This is the loss to be transferred to profit and loss account, arising from the abnormal loss.
It is found as the balancing figure on the account.
(d) This is the double entry of the normal loss entry in the process account.
(e) This is the cash which would be received from sale of both normal and abnormal loss
(40 units @ RWF2).

132 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Example 2
Same data as Example 1 except that the actual loss is 30 units.

Solution
Calculation of cost per unit of normal output - as before (RWF11 per unit).

Actual loss = 30 units; normal loss = 35 units

Abnormal gain = 5 units

Abnormal gain and good production are each valued at RWF11 per unit. Value of abnormal gain
= 5 × RWF11 = RWF55
Cost of good production = 670 × RWF11 = RWF7,370

In the process account, the abnormal gain must appear on the opposite side of the account to
the losses. (It is like having an extra input to the process.)

PROCESS I ACCOUNT
Units RWF Units RWF
Input 700 7,385 Normal loss -
Abnormal loss 5 55 35 70
(scrap value)

Process II
660 7,260
705 7,440 705 7,440

NORMAL LOSS ACCOUNT

Units RWF Units RWF
Process I a/c 35 70 Abnormal gain 5 10
a/c 30 60 Note
(b)
Scrap a/c
35 70 35 70

ABNORMAL GAIN ACCOUNT Note (a)

Units RWF Units RWF
Normal loss a/c 5 10 Process I a/c 5 55

Profit & loss a/c 45

5 55 5 55

SCRAP ACCOUNT
Units RWF Units RWF
Normal loss a/c 30 60 Cash 30 60

CPA EXAMINATION F2.1 Management Accounting 133

STUDY MANUAL
Notes on the Abnormal Gain Account, Normal Loss Account and Scrap Account
(a) The entries made in the abnormal gain account are as follows:

Credit the abnormal gain account with the difference between the actual output and normal
output at full cost.

Debit the abnormal gain account with the variance in units at their scrap value, e.g. 5 units at
RWF2 each = RWF10. These units and value are then credited to the normal loss account to
reduce the normal loss to the actual loss.

Debit the abnormal gain account with the difference in value between the abnormal gain at
full cost and the foregone scrap value of the gain, i.e. RWF55 – 10 = RWF45.

This amount is credited to the profit and loss account.

If an abnormal gain arises, remember to make the above accounting entries in the order shown.

(b) This entry is transferred to the scrap account and represents the actual loss in units at their
scrap value, e.g. 30 units at RWF2 each = RWF60.

B. PROCESS COSTING INVOLVING BOTH LOSSES AND WORK-IN-PROGRESS

To further explain process costing and to help your overall understanding, here are some examples
of process costing where both work-in-progress and abnormal loss/gains are involved.

Example 1

Process No. 1
Opening work-in-progress: 300 units valued at RWF1,380
Degree of completion: materials 80%, labour 60%
overheads 40%.

During the month 4,300 units were introduced and costs incurred were: RWF
Materials 11,885
Labour 9,400
Overheads 7,540
RWF28,825
Normal loss = 10%, actual loss = 500 units.

Losses are ascertained by inspection at the end of the process. Scrapped units can be sold for
RWF1 each.
Closing work-in-progress 500 units;
Degree of completion: materials 75%, labour 50%, overheads 40%.
Carry out the necessary calculations and draw up the Process 1 account, abnormal loss/gain
account and scrap account.

134 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Solution
Since the percentage completion is given for both opening and closing work-in-progress, the
FIFO method is the appropriate one.

The comment that losses are ascertained by inspection at the end of the process means that
we do not simply take 10% of input - the closing work-in-progress must be excluded since, not
being finished, it will not form part of the inspection.

Opening WIP 300

Add units introduced 4,300
4,600
Less closing WIP Units 500
available for
Inspection 4,100
Normal loss 10% 410 Total loss = 500 units, i.e.
Expected good units 3,690 abnormal loss = 90 units
Abnormal loss 90
Actual output 3,600
This output of 3,600 units consists of the opening 300 units WIP, now completed, and a
further 3,300 units started and finished this period.

Cost per Equivalent Unit

Material Labour Overhead
% Equiv. % Equiv. % Equiv.
Units
Units Units
Completion of
opening WIP (300) 20 60 40 120 60 180

Units started and finished this

period

(3,300) 100 3,300 100 3,300 100 3,300

Abnormal loss (90) 100 90 100 90 100 90
Closing WIP (500) 75 375 50 250 40 200

A Total equivalent units 3,825 3,760 3,770

Less scrap value of 11,885 9,400 7,540
Cost RWF

normal loss RWF 410 - -

B Net cost 11,475 9,400 7,540
Cost per equivalent unit
B RWF 3 2.5 2
A

CPA EXAMINATION F2.1 Management Accounting 135

STUDY MANUAL
Note that normal loss does not appear in the equivalent units calculation (except for the credit for
scrap value).

Cost of completing opening WIP

RWF

Material (60 × RWF3) 180

Labour (120 × RWF2.50) 300
Overhead (180 × RWF2) 360
840

Cost of units fully processed this period

Cost per equivalent unit = RWF3 + RWF2.50 + RWF2 = RWF7.50

of fully processed units = 3,300 × RWF7.50 = RWF24,750

Cost transferred to next process

RWF
Cost of units fully processed this period 24,750
Cost of completing opening WIP 840
Add opening value of WIP 1,380
Transferred to Process 2 RWF26,970

Cost of abnormal loss

90 units @ RWF7.50 = RWF675

Value of closing WIP

RWF Material (375 x RWF3) 1,125
Labour (250 x RWF2.50) 625
Overhead (200 x RWF2) 400
RWF2,150

PROCESS I ACCOUNT
Units RWF Units RWF
WIP b/d 300 1,380 Process 2 3,600 26,970
Material 4,300 11,885 Abnormal loss 90 675
Labour 9,400 Normal loss -
Overheads 7,540 scrap value 410 410
WIP c/d 500 2,150
4,600 30,205 4,600 30,205
WIP b/d 500 2,150

136 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
ABNORMAL LOSS ACCOUNT
Units RWF Units RWF
Process 1 90 675 Scrap 90 90
Profit and loss 585
90 675 90 675

NORMAL LOSS ACCOUNT

Units RWF Units RWF
Process 1 A/c 410 410 Scrap A/c 410 410

SCRAP ACCOUNT

Units RWF Units RWF

Abnormal loss 90 90 Cash 500 500
Normal loss 410 410
500 500 500 500

Example 2

Process No. 1
Opening work-in-progress 1,500 units valued at RWF4,120.

Degree of completion: materials 70%, labour and overheads 60%. During the month 10,300 units
were introduced and costs incurred were:

RWF
Materials 13,945
Labour 13,250
Overheads 8,800

RWF35,995
Normal loss = 10%. Losses are ascertained by inspection at the end of the process. Scrapped
units are sold for 40rwf each.
At the end of the month, 9,200 units had been passed to the next process and 1,800 units were
still in process, complete as follows:

Materials 60%, labour and overheads 40%.

Make the necessary calculations and prepare the process account.

CPA EXAMINATION F2.1 Management Accounting 137

STUDY MANUAL
Solution

Opening WIP 1,500

Units introduced 10,300
11,800
Less closing WIP 1,800
Units available for 10,000 Normal loss 10% = 1,000 units
Inspection Expected output = 9,000 units
Units passed to 9,200 1,500 units opening WIP
next process 7,700 units started and finished this period

Actual loss 800 Abnormal gain 200 units

Calculation of Equivalent Units and

Cost per Equivalent Unit

Material Labour and Overheads
% Equiv. % Equiv.
Units Units

Completion of opening WIP

(1,500) 30 450 40 600

Units started and finished this

period (7,700)
100 7,700 100 7,700

Abnormal gain (200) 100 (200) 100 (200)

A
Closing WIP (1,800) 60 1,080 40 720

Total equivalent units 9,030 8,820

Cost RWF 13,945 22,050

Less scrap value of normal loss 400 -

RWF
B Net cost RWF 13,545 22,050

Cost per equiv. unit (B ÷ 1.5 2.5

A) RWF

138 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Cost of completing opening WIP

RWF
Material (450 × RWF1.50) 675
Labour and overhead (600 × RWF2.50) 1,500
2,175

Cost of units started and finished this period

Total cost per unit = RWF4
Cost of fully processed units = 7,700 ×
RWF4 = RWF30,800

Cost transferred to next process

RWF
Cost of units fully processed this period 30,800
Cost of completing opening WIP 2,175
Add opening value of WIP 4,120
Cost transferred to next process 37,095
Cost of closing WIP
Material (1,080 × RWF1.50) 1,620
Labour and overhead (720 × RWF2.50) 1,800
3,420
Value of abnormal gain

200 units @ RWF4 = RWF800

PROCESS 1 ACCOUNT

Units RWF Units RWF

WIP b/f 1,500 4,120 Normal loss -
Material 10,300 13,945 1,000 400
scrap value
Labour 13,250 9,200 37,095
Overhead 8,800 Process 2 1,800 3,420

WIP c/f

Abnormal gain 200 800

12,000 40,915 12,000 40,915

CPA EXAMINATION F2.1 Management Accounting 139

STUDY MANUAL
ABNORMAL GAIN ACCOUNT

Units RWF Units RWF

Normal loss 200 80 Process 1 200 800
Profit and loss 720
200 800 200 800

NORMAL LOSS ACCOUNT

Units RWF Units RWF

Process 1 a/c 1,000 400 Abnormal gain 200 80
a/c 800 320
1,000 400 Scrap a/c
1,000 400

SCRAP ACCOUNT

Units RWF Units RWF

Normal loss a/c 800 320 Cash 800 320
Further Complications
Further complications might arise, for instance, units being rejected part-way through a
process instead of at the end. This is covered in the next example.

Example

1,000 units of material, at a cost of RWF9,000, are input to Process 1. Normal loss is 10% of
input. Normal loss is discovered at the end of the process and has no scrap value. During Period
2, labour costs of RWF3,750 and overhead costs of RWF4,000 were incurred. Due to a fault
on one of the machines, there was an exceptional amount of faulty work, i.e. 250 units. These
were discovered half-way through processing. The material content of these units was salvaged
and will be re-input to the process in the next period. 150 other units were lost at the end of
processing.

Prepare the process account.

Solution
Material Labour/Overhead


% Completion % Completion

Fully processed
units (600) 100 600 100 600
Abnormal loss (250) 100 250 50 125
Abnormal loss (50) 100 50 100 50
Total equivalent units 900 775

140 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Material Labour/Overhead
RWF RWF
Costs: period 2 9,000 7,750
Cost per equivalent unit 10 10

Cost of abnormal loss:

loss half-way through 2,500 1,250

loss at end 500 500
RWF4,750
PROCESS ACCOUNT

Units RWF Units RWF

Input 1,000 9,000 Normal loss 100 Nil
Labour 3,750 Abnormal loss 300 4,750
Overhead 4,000 Finished goods 600 12,000
1,000 16,750 1,000 16,750

ABNORMAL LOSS ACCOUNT

Units RWF Units RWF
Process 300 4,750 Process account
account next period
(material
salvaged 250
@ RWF9) 250 2,250
Waste 50 Nil
P& L 2,500
300 4,750 300 4,750

NORMAL LOSS ACCOUNT

Units RWF Units RWF

Process a/c 100 Nil Waste 100 Nil

CPA EXAMINATION F2.1 Management Accounting 141

STUDY MANUAL
TOPIC 4
COSTING TECHNIQUES
A. DEFINITION OF MARGINAL COST
The Chartered Institute of Management Accountants defines marginal cost as: “The variable
cost of one unit of a product or a service;i.e.a cost which would be avoided if the unit was not
produced or provided.”

From the above descriptions of fixed, variable and semi-variable cost, it should be clear to youth
at producing one item less does not avoid any fixed cost or any of the fixed element of semi-
variable costs.

A statement of cost on a marginal basis will therefore contain only the variable cost, built up as
follows:

Cost per unit

RWF RWF
Direct material x
Direct labour x
Direct expenses x
Prime cost x
Add: Variable overheads:

Factory x
Selling x x
Marginal cost x

B. THE MARGINAL COST EQUATION: TERMINOLOGY OF MARGINAL COSTING

When the total variable (or marginal) cost of a number of products is deducted from the total
sales revenue, the amount that is left over is called the contribution. Since fixed costs have
not yet been taken into account, this contribution has to cover fixed costs and then any amount
remaining is profit. (That is why it is called the contribution-it is a contribution towards fixed costs
and then profit.) We can write this symbolically as S – V = F + P. This is the basic equation of
marginal costing. (Sales revenue – Variable cost = Fixed cost + Profit.)

The term“contribution”is defined as the difference between sales value and the variable cost of
those sales, expressed either in absolute terms or as a contribution per unit.
Contributions not profit, it is sales less variable cost.

RWF
Sales x
Less Variable Costs x
=Contribution x

142 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
We can also talk about the contribution per unit of a product: this is simply the selling price
minus the variable (marginal) cost. It should be clear to you that under marginal costing we
cannot talk about the profit from any one product, since fixed costs are only considered into land
are not apportioned to the individual products. However, a number of decisions can be made by
looking at the contribution-clearly if a company maximizes its contribution it is also maximising its
profit, provided fixed costs are truly fixed.

A profit statement for the three products,A,B and C in our first example in this study unit, built up
on a marginal costing basis, would have been:

Total Product Product Product

A B C

Sales 48,000 21,000 18,000 9,000

Direct wages 12,000 3,000 4,000 5,000

Direct material 14,000 6,000 6,000 2,000

Variable overhead
Factory 1,500 600 600 300
Selling 3,000 2,000 700 300

Marginal cost 30,500 11,600 11,300 7,600

Contribution 17,500 9,400 6,700 1,400

Fixed overhead

(Factory Selling) 7,500

Profit 10,000

With this layout of the profit statement, management would have been able to determine that
Product C, whilst not the best product to produce ,nevertheless made a contribution towards
Covering fixed costs of RWF1,400. Note that itisthislostcontributionofRWF1,400which reduced
the profit figure from RWF10,000 to RWF8,600 in the first example.

At this point it is worth considering what is the best product to produce. By calculating the
contribution per RWF of sales for each of the three products, we can rank the mas to their relative
ability to cover fixed costs and generate profits:

Product A provides RWF 9,400 contribution from RWF 21,000 sales,i.e.RWF0.4476 per RWF1 of
sales.
Product B provides RWF6,700 contribution from RWF 18,000 sales,i.e.RWF0.3722 per RWF1
of sales.

Product C provides RWF 1,400 contribution from RWF 9,000 sales,i.e.RWF0.1556 per RWF1 of
sales.

CPA EXAMINATION F2.1 Management Accounting 143

STUDY MANUAL
Clearly the ranking is A-B-C and with no production or sales limitations, total production and
sales of Would maximise contribution and therefore profit.

MARGINAL PROFIT AND LOSS ACCOUNT

Advantages
In the orthodox trading and profit and loss account, the opening and closing stocks
are debited and credited respectively, and the valuations placed upon them include a share of
production fixed overheads. Accountants who believe in using marginal costing take the
view that all fixed costs should be written off in the period in which they are incurred and that
there can be no justification for carrying part of one period’s costs forward to the next period in
closing stock. They argue that fixed costs are incurred on a time basis, regardless of the level
of production or sales in any period. They claim, therefore, that a closing stock valuation which
excludes any element of cost is more “accurate”. The exclusion of fixed costs does ensure
that the writing off of fixed costs is not deferred until a later period. The main advantage of the
marginal form of profit and loss account is, therefore, that the profit will not be affected simply
because of a significant change in the stock figures: profit is clearly related to the level of sales.

Example of Layout Total Product A Product B

Sales revenue xxxx xxx xxx
Less Variable costs of goods sold:
Direct material xxx xx xx
Direct labour xxx xx xx
Variable overheads xxx xx xx
Total variable cost xxx xxx xxx
Contribution xxx xxx xxx
Less Fixed costs xxx
RWFxxx

Layout When Some Fixed Costs Can Be Allocated

If some of the fixed costs can be directly associated with a particular product or department,
then clearly these costs should be shown separately and not grouped with the general fixed
costs. This is best illustrated by an example.

Example
A company manufactures goods in three separate factories. The projected figures for the next
year are as follows:

Edinburgh York Gloucester

RWF RWF RWF

Sales 440,000 400,000 700,000

144 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Branch expenses:
Salaries 42,000 38,000 62,000
Advertising 8,000 15,000 10,000
Other 10,000 8,000 11,000

There is a central office in London which is estimated to cost RWF154,000. Variable costs
amount to 75% of sales for each factory.
The marginal profit and loss account for this company would appear as follows:

Edinburgh York Gloucester Total

RWF RWF RWF RWF

Sales 440,000 400,000 700,000 1,540,000

Less variable cost of sales 330,000 300,000 525,000 1,155,000

Gross contribution 110,000 100,000 175,000 385,000

Less branch fixed costs 60,000 61,000 83,000 204,000

Contribution to

central expenses and profit 50,000 39,000 92,000 181,000

Less central expenses 154,000
Profit RWF27,000

Comparison of Absorption and Marginal Costing Methods

Example
The Melody Radio Co. Ltd which manufactures the “Melody” radio receiver, commenced
trading on 1 April last. The company’s budget for each four-week period is as follows:

RWF RWF

Sales - 20,000 receivers 400,000

Manufacturing cost of goods sold:

Variable costs 240,000

Fixed overhead 60,000 300,000

Gross profit 100,000

Selling and distribution costs (fixed) 20,000

Net profit
80,000

CPA EXAMINATION F2.1 Management Accounting 145

STUDY MANUAL
The following data relates to the first two trading periods:

Period 1 Period 2
Production 24,000 18,000
Sales 18,000 21,000

REQUIREMENT:
(a) Prepare operating statements for each of the two periods:

• Where fixed manufacturing overhead is absorbed into product costs at the budgeted
rate and selling and distribution costs are treated as period costs.
• Where all fixed costs are treated as period costs.

You may assume that the selling price, fixed costs, and unit variable costs for the two periods
are in line with budget.

(b) Comment upon the results revealed by your statements.

Solution
Workings

Variable costs = RWF 240,000 = RWF12 per unit

20,000
60,000
Fixed overhead absorption rate = RWF = RWF3 per unit
20,000
400,000
Selling price = RWF = RWF20 per unit
20,000

Stock figures
Period 1 Period 2

Units Units
Opening stock 0 6,000
+ Production 24,000 18,000
24,000 24,000
– Sales 18,000 21,000
Closing stock 6,000 3,000

Fixed overheads are fully absorbed by production of 20,000 units.

In Period 1, fixed overheads will be over-absorbed by 4,000 × RWF3 = RWF12,000.
In Period 2, fixed overheads will be under-absorbed by 2,000 × RWF3 = RWF6,000.
The wording of the question is taken to mean that closing stock should be valued at the budgeted
rate (RWF15 per unit) and under- or over-absorption written off in the relevant period.
The alternative would be, taking Period 1 as an example, to value closing stock as: Variable cost:
6,000 × RWF12 =RWF72,000

Fixed cost: ¼ of RWF60,000 =RWF15,000 (since closing stock is ¼ of the period’s

production) RWF87,000

146 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
(i) Absorbing Fixed Manufacturing Overhead at the Budgeted Rate

Period 1 Period 2
RWF RWF RWF RWF
Sales 360,000 420,000
Opening stock (@ RWF15/unit) 90,000

Production (@ RWF15/unit) 360,000 270,000

360,000 360,000

Less closing stock (@ RWF15/unit) 90,000 45,000

270,000 315,000
Fixed manufacturing

overhead over- absorbed (12,000) Fixed

manufacturing

overhead under- absorbed 6,000

Total manufacturing
cost of goods sold 258,000 321,000
Gross profit 102,000 99,000
Less selling and
distribution costs 20,000 20,000
Net profit 82,000 79,000

(ii) All FixedCosts Treatedas PeriodCosts (Marginal Costing)

Period1 Period2

RWF RWF RWF RWF

Sales 360,000 420,000
Openingstock(@RWF12perunit) - 72,000
Production (@RWF12 perunit) 288,000 216,000
288,000 288,000
Closingstock(@RWF12 perunit)72,000 36,000
Marginalcostofsales 216,000 252,000
Contribution 144,000 168,000
Fixed manufacturingcost 60,000 60,000
Grossprofit 84,000 108,000
Sellingand distributioncost 20,000 20,000
Netprofit 64,000 88,000

CPA EXAMINATION F2.1 Management Accounting 147

STUDY MANUAL
(b) Comments

The marginal costing statement relates profit clearly to sales: when sales rise, profit rises.
The absorption costing statement shows a lower profit in Period 2, despite the rise in sales,
because of the change in the stock position.

The profits under the two methods may be reconciled as follows:

Period 1 Closing stock valuation - absorption costing - RWF90,000

Closing stock valuation - marginal costing - RWF72,000
Difference in closing stock valuation = difference in profit

between the two methods RWF18,000

Period 2 Fall in stock during period = 3,000 units
Valuation - absorption costing - 3,000 @ RWF15 = RWF45,000
Valuation - marginal costing - 3,000 @ RWF12 = RWF36,000
Difference = difference in profit between the two methods
RWF9,000
Taking the two periods together
Total profit – absorption costing RWF161,000
Total profit – marginal costing RWF152,000
Difference = difference in Period 2 closing stock valuation
RWF 9,000
It should be clear that over several periods taken together such that stock at the beginning of
the first period and at the end of the last period was nil, the absorption and marginal costing
methods would give the same total profit, but the amount of profit in each individual period
would be different under the two methods.

L. MARGINAL AND ABSORPTION COSTING COMPARED

Most management accounting theorists agree that marginal costing is more useful in
decision-making, where a choice has to be made between alternatives. Marginal costing would
provide information about differential costs, which would be most relevant to the situation.
However, a choice has to be made between marginal and absorption costing in the routine
internal cost accounting system. There is no straightforward answer as to which system should
be used. The system designer must consider all the advantages and disadvantages and what is
required from the system, before making a decision.
Remember these points if you are given a scenario in the examination and need to decide on
the best option.

Arguments in Favour of Absorption (Full) Costing

• When production is constant but sales fluctuate, absorption costing will cause fewer profit
fluctuations than marginal costing in periods when stocks are being built up to match future
increased sales demand (see the example in Section C).

• No output could be achieved without incurring fixed production costs, and it is

therefore logical to include them in stock valuations.

148 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
• If managers continually use marginal cost pricing, there is a danger that they may lose sight
of the need to cover fixed costs. Absorption costing values all production at full cost, so that
managers are always aware of fixed costs.
• SSAP 9 Stocks and Long-term Contracts states that in order to match costs
and revenues, the cost of stock should include all costs incurred in bringing the stock
to its present condition. These costs should include all related production overheads,
even if they accrue on a time basis (i.e. do not fluctuate with the level of activity - fixed
overheads).

Arguments in Favour of Marginal Costing

• When sales are constant but production fluctuates, marginal costing will give a more logical,
constant profit picture.
• Since fixed costs accrue on a time basis, it is logical to charge them against sales in the
period in which they are incurred. The recommendations of SSAP 9 are for external profit
reporting purposes, but the internal costing system simply has to meet the information needs of
managers. The marginal costing system will also give a better indication of the actual cash
flow of the business.
• Under- or over-absorption of overheads is not a problem with marginal costing, and managers
are never working under a false impression of profit being made, which could be totally altered
by an adjustment for under- or over-absorbed overheads in absorption costing.

Further Points
It is important to remember that the difference between absorption and marginal costing
arises from the treatment of the fixed costs of production. As direct material cost and direct labour
cost will always vary with production, it is the overhead cost which creates the difficulties.

In absorption costing all the overheads are absorbed using various logical bases. It is
essential to prepare an overhead summary prior to a period, dividing anticipated overheads
into production and service departments. The overheads allocated or apportioned to service
departments are then apportioned to production using the most logical basis; an absorption
rate is calculated on the basis of whether the production departments are labour, machines or
material intensive.

In marginal costing, direct cost of production is calculated by adding direct material cost, direct
labour cost and overheads which can be related to one unit of production. By deducting this
marginal cost of production (cost to produce one extra unit) from the sales revenue, a contribution
towards fixed overheads from each unit of production is calculated. Total fixed overheads divided
by contribution per unit establishes the breakeven point. This is where all fixed overheads are
recovered and the business starts making contribution towards profit.

Limitations of absorption costing:

• In absorption costing the main difficulty arises in dividing overhead expenses between production
and service departments. If they relate to one department they can be easily allocated; but if
they need to be apportioned between departments then the most logical basis of apportionment
has to be established.

CPA EXAMINATION F2.1 Management Accounting 149

STUDY MANUAL
• The cost of production is calculated after the production has taken place. The profit or loss is
therefore calculated after the event, reducing any opportunity for the management to take
action to control the cost in order to improve profitability.
• Because the absorption rate is calculated on the basis of anticipated production, and the
overheads themselves are estimated, at the end of the period there will always be over- or
under-absorption of overheads as actual production or actual overheads will be more or less
than the estimate.
• Absorption costing does not assist management by giving accurate information that helps
in preparing quotations for future contracts or in establishing a correct selling price. This is
because the overheads in the following period may be different and they may change in their
variability.

Limitations of marginal costing:

The main difficulty in marginal or direct costing is to establish variability of overhead expenses.
In reality most overheads are semi-variable. They are neither strictly variable with
production nor strictly fixed for any level of production. Their variability can be calculated by
techniques such as scatter graphs etc. Therefore the basic argument in favour of marginal
costing is flawed.

• In the case of a business producing more than one product, it is difficult to calculate
breakeven points for each product. The best we can achieve is usually to calculate an overall
breakeven point based on level of activity or total sales revenue. This again reduces the
usefulness of marginal costing.

Absorption costing is useful to management because it is easy to operate. Once the basis of
apportionment and rates of absorption are agreed, adjustments can be made annually to bring
them in line with the current situation. Marginal costing is very useful to management in
making decisions, e.g. on make or buy, levels of production, pricing of products.

In conclusion, both methods can and should be used by management - absorption costing for
the benefits it gives in cost accumulation and cost control, and marginal costing to assist in
managerial decisions.

Example 2
The following information relates to product J for quarter three, which has just ended:

Production Sales Fixed VariableCosts

Overheads
(units) (units) RWF000

RWF000
Budget 40,000 38,000 300 1,800

Actual 46,000 42,000 318 2,070

150 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
The selling price of product J was RWF72 per unit.
The fixed overheads were absorbed at a predetermined rate per unit.

At the beginning of quarter three there was an opening stock of product J of 2,000 units
valued at RWF25 per unit variable costs and RWF5 per unit fixed overheads.

REQUIREMENT:

(a) (i) Calculate the fixed overhead absorption rate per unit for the last quarter, and
Present profit statements using FIFO (first in, first out) using:
(ii) Absorption costing, and
(iii) Marginal costing, and
(iv) Reconcile and explain the difference between the profits or losses.

(b) Using the same data, present similar statements to those required in part (a), using the
AVECO (average cost) method of valuation, reconcile the profit or loss figures, and comment
briefly on the variations between the profits or losses in (a) and (b).

Answer
(a) (i) Fixed overhead absorption rate per unit:

Budgeted fixed overheads rwf 300,000

= RWF7.5
Budgeted production 40,000

(ii) Absorption Costing (FIFO) Profit Statement

RWF000 RWF000

3,024
Sales (42000 RWF72)
Less Cost of sales:
Opening stock (2,000 RWF30) 60
Add Production (46,000 RWF52.5) 2,415
(W1)
2,475

315 2,160
Less Closing stock (6,000 RWF52.5)
864
Add Over-absorption

(W2)
Profit 891
Workings Per unit

RWF (1) Variable cost 45

Fixed overhead 7.5

52.5

CPA EXAMINATION F2.1 Management Accounting 151

STUDY MANUAL
(2) Fixed overhead absorbed 345,000
46,000 RWF7.5 =
Less Actual 318,000
RWF27,000
27
(iii) Marginal Costing (FIFO) Profit Statement

RWF000 RWF000
Sales 3,024
Less Cost of sales
Opening stock (2,000 RWF25) 50
Add Production (46,000 RWF45) 2,070
(W1)
2,120
Less Closing stock (6,000 RWF45) 270 1,850
Contribution 1,174
Less Fixed overheads (actual) 318
Profit 856

(iv) Reconciliation Profit

Absorption 891

Marginal 856
35
Fixed overheads in closing stock

45
(6,000 RWF7.50)

10
Less Opening stock (2,000 RWF7.50)
35
The difference is due to fixed overheads being carried forward in stock valuations. The figures
under absorption give a higher profit because more of the fixed overheads are carried forward
into the next accounting period than were brought forward from the previous one. The fixed
overhead absorption rate depends on estimates of both production units and fixed overheads,
and actual figures may vary. The over- absorption of fixed overheads is adjusted for at the
end of the period.

Under marginal costing fixed overheads are treated as period costs and not carried forward in
stock valuations; under- or over-absorption does not arise. Marginal costing, by taking only
the variable costs, shows how much contribution is being made, and is regarded as giving more
useful figures for decision-making

152 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
(b) Absorption Costing (AVECO) Profit Statement

RWF000 RWF000
Sales 3,024
Less Cost of sales
Opening stock plus production (48,000 2,475
RWF51.56)
Less Closing stock (6,000 RWF51.56) 309 2,166
858
Plus Over-absorption 27
Profit 885

Marginal Costing (AVECO) Profit Statement

RWF000 RWF000
Sales 3,024
Less Cost of sales
Opening stock plus production
(48,000 at RWF44.17) 2,120
Less Closing Stock (6,000 RWF44.17) 265 1,855
Contribution 1,169
Less Fixed overheads 318
Profit 851
Reconciliation:
Difference in profits 34
Absorption closing stock 309
Less Marginal closing stock 265 44
Less Fixed costs in absorption opening stock 10
34

The variations in the profits in (a) and (b) of RWF6,000 and RWF5,000 respectively are caused
by using different methods of valuation (FIFO and AVECO). The valuation method can affect
profit/loss for both absorption and marginal approaches, and could lead to much wider variations
than here.

CPA EXAMINATION F2.1 Management Accounting 153

STUDY MANUAL
M. USES OF MARGINAL COSTING
Deciding on a Selling Price
Marginal costing is useful when a company has carried out some market research to ascertain
the likely sales of a product at different selling prices.

Example 1
The variable costs of Product A are RWF10 per unit. The company has undertaken market
research which indicates that the likely sales at each of a number of possible selling prices
would be:

Selling price RWF12 RWF15 RWF20

Sales (thousands) 20 10 4.5

The company wishes to know which selling price it should adopt.

Solution

(a) Contribution per unit

Selling Price
RWF12 RWF15 RWF20
(Selling price – Variable cost) RWF2 RWF5 RWF10

(b) Sales (thousands) 20 10 4.5

Total contribution (a) × (b) RWF40,000 RWF50,000 RWF45,000
Clearly the company should sell the product at RWF15 each as this maximises the
contribution it will make.

Example 2
DPS Ltd is experiencing a recession in trade. As a result, the Board of Directors is very
anxious to obtain all possible business.

A request for a quotation is received from RLY and Co. for a special type of machine. The
costing department of DPS Ltd has estimated the following costs for the machine:

Direct material cost RWF30

Direct labour cost RWF25 (100 hours) Overhead costs:
Variable - RWF0.50 per direct labour hour; Fixed – RWF1 per direct labour hour.

Special jigs and other equipment required to produce the machine are estimated to cost
RWF100. There is no possibility of further use for these in the future.
You are required to calculate the lowest price which should be quoted for the order.

154 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Solution
Quotation for Machine for RLY& Co.
RWF

Direct material 30
Direct labour100 hours 25
Direct expense (special equipment) 100

155
Variableoverhead costs:
100 hours @ 50RWFperdirect labourhour 50
Marginal cost RWF205

The marginal cost of the machine is, therefore, RWF205. This represents the lowest possible
price and it may be quoted when the factory is being operated even though not covering fixed
costs, e.g. as a policy of keeping workers employed.

Normally an addition would be made to the RWF205, thus allowing some contribution to be made
towards reducing fixed costs. If working at normal capacity, the fixed cost content of the job
would be found by multiplying the number of direct labour hours by the rate per hour, i.e.
100 hours × RWF1 = RWF100.

In the circumstances envisaged, the company may perhaps attempt to recover half the fixed costs,
i.e. RWF50, thus making a total price of RWF255. However, this figure is purely hypothetical
in that the percentage of total fixed costs to be taken is determined by reference to the degree
of urgency involved. If there is no possibility of further orders then a low contribution should be
included to ensure that DPS Ltd’s price is competitive, giving them a good chance of winning the
order. On the other hand, if there is a reasonable possibility of further orders, a higher recovery
of fixed overhead should be attempted.

Deciding Whether to Accept an Additional Contract

In times when it is short of work, a firm can accept additional work provided that the sales
revenue is more than the marginal cost of that work and any additional fixed costs incurred.
This is because, although the new work might not show a profit on an absorption full cost basis
(where it was given a share of the total fixed costs), it will provide an additional contribution and
so reduce any overall loss (or increase overall profit). In the long term, of course, a firm will not
survive unless it covers all its fixed costs.

Example 1
A company manufactures articles for RWF6 each (variable cost) and normally sells them at
RWF10 each. Fixed costs are RWF10,000 per month. The firm is currently short of work - it
is only selling 2,000 units a month. It has the chance of an additional contract for 500 units a
month for four months if it will accept a reduced selling price of RWF8 per unit. Fixed costs will
not be increased if the contract is accepted. Advise the company whether or not to accept
the contract.

CPA EXAMINATION F2.1 Management Accounting 155

STUDY MANUAL
Solution
The contribution per unit on the additional contract would be RWF2 (RWF8 – RWF6).
Since this is positive (i.e. selling price is greater than marginal cost) the contract should be
accepted (but see below).

Demonstration that this will reduce the loss

On present sales of 2,000 units the contribution is RWF4 per unit (RWF10 – RWF6).
Total contribution is 2,000 × RWF4 =RWF8,000 (per month)
Fixed costs RWF10,000 “ “
Loss RWF 2,000 “ “
If the new contract is accepted, the additional contribution is 500 × RWF2 = RWF1,000 per
month. Therefore the loss is reduced by RWF1,000, to RWF1,000.

Note: Since the contract is for four months, the company would have to take into account the
likelihood of sales at the normal selling price picking up within that time. Obviously, if sales are
likely to pick up, the company would prefer full price sales rather than being tied to a reduced
price contract. But if sales are unlikely to improve, the reduced price contract is better than
nothing!

Example 2
A company manufactures articles at a variable cost of RWF5 each, which it usually sells for
RWF10 each. It has the chance of an additional contract for 600 articles at RWF9 each but is
unsure whether to accept, as fixed costs would be increased by RWF1,500.

What is your advice?

Solution
Contribution per unit on the extra sales = RWF4Total additional contribution = 600 × RWF4
=RWF2,400

Additional fixed costs incurred RWF1,500

Additional profit RWF 900
Therefore the company should accept the contract.

Setting a Selling Price for Additional Work

In the long run, of course, a company must set selling prices which ensure that all its costs are
covered. However, in the short term, it will accept work at lower prices than normal, rather than
lose the work altogether, if it is short of work. Marginal costing can be used to determine
the minimum price which should be charged for such additional work.

Example
A company manufactures articles at a marginal cost of RWF12 each, which it sells for
RWF20. It has been approached by a charity who would purchase 2,000 articles if a mutually
acceptable reduced price could be negotiated. Fixed costs are expected to increase
by RWF6,000 if the extra 2,000 articles are produced. What is the minimum price which the
company should quote for the contract?

156 F2.1 Management Accounting CPA EXAMINATION

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Solution
The contribution from the extra 2,000 articles must at least cover the extra fixed costs
incurred, i.e.
extra contribution needed is RWF6,000 minimum.
6,000
extra contribution needed per unit is RWF minimum
2,000
= RWF3 minimum.

minimum price to be quoted is marginal cost + RWF3 = RWF15 each.

minimum price for whole order is 2,000 × RWF15 = RWF30,000.

Deciding Whether to Cease Production of Unprofitable Items

Our very first example in this study unit, B Bloggs & Co., is an example of this use of
marginal costing.

G. ARGUMENTS AGAINST MARGINAL COSTING

The above examples have illustrated situations where marginal costing must be used for
better decision-making. There are, however, some arguments against marginal costing.

Inadequate Sales Mixture

A company which is short of work will accept reduced-price work provided the selling price
covers marginal cost and any additional fixed costs incurred. This was illustrated in Section F of
this study unit. Indeed, in the short term, a firm might even accept work at a price below marginal
cost, if it wanted to avoid laying off workers. However, if a company takes on too much reduced-
price work, it will be unable to take on more profitable work which becomes available at a later
date. Therefore, the indiscriminate use of marginal costing techniques can lead to an inadequate
sales mixture, with the firm being unable to concentrate on its most profitable product.

Price-Fixing Policy
We have studied an example where marginal costing was used to establish a short-term price
(see Section F of this study unit). However, as already pointed out, such a method could not be
used for fixing long-term prices.

Where a total cost system is in operation, selling prices can be fixed by finding the total cost of
each product and adding on a percentage to give the desired level of profit. If marginal costing is
used, however, the percentage added on has to cover fixed costs as well as profit, and this makes
the selling price very difficult to calculate.

This is a serious objection to marginal costing for those businesses which do one-off jobs to
customers’ specifications, and where a price must be worked out for each order individually. For
businesses which have a ready market for their product, however, the objection is not quite
as serious. This is because in practice few companies are entirely free to determine their
own selling price. It is in part determined for them by the extent of the competition and what the
market will bear. They will lose sales if they charge much more than their competitors and/or
more than people are willing to pay. Therefore many businesses must take the selling price
as given, and concentrate on keeping their costs down in order to make a profit.

CPA EXAMINATION F2.1 Management Accounting 157

STUDY MANUAL
Stock Valuation
When marginal costing is used, valuations of the closing stock of finished goods or work-in-
progress exclude any element of fixed cost. This is contrary to the IAS International Accounting
Standard No. 2 which says that these stock valuations should include a fair share of production
overheads.

H. ASSUMPTIONS OF MARGINAL COSTING

• Fixed expenses will remain unchanged over the relevant period. In the short term it may be
valid but over the longer term unforeseen circumstances may arise which will require additional
fixed expenses being incurred (e.g. renting of additional premises). This can create stepped
fixed expenses with multiple break even points.
• Selling price will remain constant. A drop in demand may lead to a reduction in the selling price
to maintain a reasonable share of the market. Some goods may be sold below normal selling
price to attract customers who will then buy more profitable goods (loss leaders).
• The contribution percentage will remain constant. This ignores economy of scale which
enables variable costs to be reduced. It also assumes that materials will be available at
the same price during the relevant period. The recent fluctuations in the price of fuel due to
political instability and regional conflicts are a very good example of circumstances, which can
completely invalidate break even assumptions.
• Only one product is sold. For multiple products break even analysis is very complicated
and assumptions are made that the ratio of sales of the different products will remain constant.
An average contribution is calculated. This assumption may prove to be inaccurate over an
extended period of time.
• Expenses can be categorized into variable and fixed. There are a number of grey areas and
different firms will treat some expenses as variable whereas others may treat them as fixed.

WORKED EXAMPLE
You will be aware of both types of costing, so we can usefully start by refreshing your
memory with a practical exercise. Try the following.

Question
Using the information given below, prepare profit statements for the months of March and
April using:

(a) Marginal costing

(b) Absorption costing

Per unit: RWF

Sales price 50
Direct material cost 18
Direct wages 4
Variable production overhead 3
Per month:

158 F2.1 Management Accounting CPA EXAMINATION

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Fixed production overhead 99,000
Fixed selling expenses 14,000
Fixed administration expenses 26,000
Variable selling expenses 10% of sales value
Normal capacity was 11,000 units per month.
March units April units

Sales 10,000 12,000

Production 12,000 10,000

Answer
The valuation of units of production and stock will be different with each of the methods:
(a) Marginal Costing
All units will be valued at the variable production cost of RWF25:

RWF
Direct material cost 18
Direct wages 4
Variable production overhead 3
Total variable production cost 25
PROFIT STATEMENTS FOR MARCH AND APRIL USING MARGINAL COSTING

March April

Units RWF000 Units RWF000

Sales @ RWF50 10,000 500 12,000 600

Less Cost of sales:

Opening stock @ RWF25 - - 2,000 50
Variable cost of production @ 12,000 300 10,000 250
RWF25
12,000 300 12,000 300
Less Closing stock @ RWF25 2,000 50 - -
10,000 250 12,000 300
Variable selling expenses 50 60
Total variable cost of sales 300 360
RWF000 RWF000
Contribution 200 240
Less Fixed costs:
Production overhead 99 99

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STUDY MANUAL
Selling expenses 14 14
Administration expenses 26 139 26 139
Net profit 61 101

Total net profit for March and April = RWF162,000

(b) Absorption Costing

The valuation of units of production and stock will include a share of the fixed production
overhead for the month.
SSAP 9 Stocks and Long-term Contracts states that the allocation of overheads in the valuation of
stocks must be based on the company’s normal level of activity. The cost of unused capacity (i.e.
under-absorbed overheads) should be written off in the current year. In this example, therefore,
the rate for absorption of fixed production overheads should be based on an activity level of
11,000 units per month.
rwf 99,000
Fixed production overhead absorption rate: = RWF9 per unit
11,000

Full production cost for one unit, to be used in stock valuations:

RWF per unit Variable cost 25 (as before)

Fixed production cost 9
34
PROFIT STATEMENTS FOR MARCH AND APRIL USING ABSORPTION COSTING

March April

Units RWF000 Units RWF000

Sales @ RWF50 10,000 500 12,000 600

Less Cost of sales:
Opening stock @ RWF34 - - 2,000 68
Production cost absorbed @ 12,000 408 10,000 340
RWF34
12,000 408 12,000 408
Less Closing stock @ RWF34 2,000 68 - -
10,000 340 12,000 408
Gross profit 160 192
Adjustment for over/(under)
absorption of overheads (Note
1) 9 (9)

169 183
RWF000 RWF000
Less
Variable selling expenses 50 60

160 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Fixed selling expenses 14 14
Fixed administration expenses 26 90 26 100

Net profit 79 83

Total net profit for March and April = RWF162,000

Note 1: Calculation of over/(under) absorption of fixed production overheads

Production Overhead Total Overhead Over/

absorbed overhead incurred (under
(units) per unit absorbed ) absorption

March 12,000 RWF9 RWF108,000 RWF99,000 RWF9,000

April 10,000 RWF9 RWF90,000 RWF99,000 (RWF9,000)

Notice that the net profits for March and April together are the same using both methods,
RWF162,000. This is because all of the stock is sold by the end of April, and therefore all costs
have been charged against sales.

The net profit figure for March is RWF18,000 higher using absorption costing, due to
RWF18,000 of fixed production overhead being carried forward in stock, to be charged
against the sales revenue for April. (Stock = 2,000 units RWF9 = RWF18,000.)

Having reminded yourself of the technique, you can now go on to look at a problem that the
examiner might set. In which circumstances would you use marginal costing; in which absorption
costing?

J. WHEN PRODUCTION IS CONSTANT BUT SALES FLUCTUATE

Absorption costing is usually considered more suitable in these circumstances.

Example
MC Ltd manufacture and sell a single product. Cost and revenue details of the product are as
follows:

Per unit: RWF

Sales price 20
Variable cost of production 6

Per month:

Fixed production overhead 5,000

Fixed selling and administration 3,000
overhead

It is MC’s policy to maintain a constant production output at the normal capacity of 1,000 units per
month, despite fluctuations in monthly sales levels. Sales achieved for the months of January
to April were as follows:

CPA EXAMINATION F2.1 Management Accounting 161

STUDY MANUAL
Units
January 400
February 500
March 1,400
April 1,700
You are asked to prepare profit statements for January to April using:

Absorption costing
Marginal costing

Answer A Absorption costing

162 F2.1 Management Accounting CPA EXAMINATION

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Answer B Marginal costing

CPA EXAMINATION F2.1 Management Accounting 163

STUDY MANUAL
rwf 5,000
(b) Fixed production overhead absorption rate = = units
1,000
= RWF5 per unit

Full production cost = RWF5 + RWF6 variable cost per unit

= RWF11 per unit
Note that there will be no over- or under-absorption of fixed production overheads, because
the production for every month is equal to the normal capacity of 1,000 units.

You can see, therefore, that when production is constant but sales fluctuate each month, absorption
costing will cause fewer profit fluctuations than marginal costing. Managers could have been
caused unnecessary concern if marginal costing had been used because of the losses which
this method would show in January and February. With absorption costing, the fixed production
overheads were carried forward in stock to be matched against the relevant revenue when it
arose in March and April.

Be prepared to explain to an examiner why a particular method should be used.

K. WHEN SALES ARE CONSTANT BUT PRODUCTION FLUCTUATES

This is not very likely to occur in practice, but in this situation marginal costing would show a
constant level of profit linked to the constant sales.

Example
Consider again the previous example of MC Ltd, and prepare profit statements using (a)
marginal costing and (b) absorption costing for January to April, based on the same cost data,
and the following activity levels:

Sales Units Production Units

January 1,000 1,900
February 1,000 1,000
March 1,000 600
April 1,000 500
Note:1,000 units permonth is still considered to benormal capacity.

164 F2.1 Management Accounting CPA EXAMINATION

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CPA EXAMINATION F2.1 Management Accounting 165
STUDY MANUAL
Calculation of over/(under)-absorption of fixed production overheads
P r o d u c t i o n Overhead Total Overhead Over/(under)
(units) absorbed overhead incurred absorption
per unit absorbed

RWF RWF RWF RWF

January 1,900 5 9,500 5,000 4,500
February 1,000 5 5,000 5,000 -
March 600 5 3,000 5,000 (2,000)
April 500 5 2,500 5,000 (2,500)

166 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
TOPIC 5
INFORMATION FOR DECISION MAKING
A. FIXED,VARIABLE AND SEMI-VARIABLECOSTS
Before going any further, it is necessary to recall the definitions of fixed, variable and semi-
variable cost given in an earlier study unit.

Fixed Cost (See diagram in Study Unit 3: Cost behaviour Patterns )

A fixed cost is one which tends to remain fixed regardless of the level of production.
Examples are rent, rates, salary of the production manager. It should be clear that any expense
classified as “fixed” is only fixed for a certain time period and only within certain levels of production.

For instance, the uniform business rate is likely to increase once a year or once every few years,
so clearly rates are not fixed for ever. However, within the year, they are fixed regardless of
the level of production at the factory. If, though, production increased so greatly that it was
necessary to acquire a new factory, clearly there would be additional rates to pay. Therefore a
fixed cost can only be regarded as fixed over a certain period of time and only within certain levels
of production.

Variable Cost
This is a cost which tends to follow (in the short term) the level of activity. Consider a
selling expense such as travellers’ commission. If the organisation makes no sales, no
payment or expense will arise; but as sales begin to rise from zero the cost of commission will
increase according to the level of sales achieved. This is an example of variable cost.

Semi-Variable Cost (See diagram in Study Unit 3: Cost behaviour Patterns )

Between these two extremes, one of which reacts in complete sympathy with production
activity, while the other is not affected by activity, there is another type of overhead which is partly
fixed and partly variable. It is known as a semi-fixed or semi-variable cost, that is to say, a cost
containing both fixed and variable elements, and which is thus partly affected by fluctuations in
the level of activity. An example is the charge for electricity, which consists of a standing charge
per quarter (the fixed element) and a charge per unit of usage (the variable element). Any
semi-variable cost can be separated into fixed and variable components, as follows.

High-Low Method
The total cost for two different levels of output is:

Output (units) 40,000 50,000

Total cost RWF320,000 RWF360,000

The increase in total cost for the increase in output is first calculated. This is a variable cost.

High Output Low Output Increase (Variable Cost)

Units 50,000 40,000 10,000

Total cost RWF360,000 RWF320,000 RWF40,000 i.e. RWF4 per unit

CPA EXAMINATION F2.1 Management Accounting 167

STUDY MANUAL
The total cost can now be divided into its fixed and variable elements by examining either
level of output.

At 40,000 units RWF

Total cost 320,000
Variable cost 40,000 × RWF4 160,000
Fixed cost is 160,000
The variable cost per unit is calculated by dividing the increase in total cost by the increase in
output: Rwf 40,000/10,000=Rwf 4

Note: Total cost = Fixed cost + Variable cost.

B. 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.

Purpose of Estimation
It assists in estimating the future expenditure (cost prediction) as the expenditure will depend on
the cost of the respective activities

• 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.

Methods of cost estimation

We will consider following cost estimation methods commonly utilized, namely:

• Engineering method
• Accounts inspection/ Cost analysis
• High Low Activity method
• Visual Fit (Scatter graph) method
• Simple linear regression analysis

168 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
• 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.

• 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 frw1,090 variable costs, frw1,430 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 = frw.1,430 + frw. 2.18 (550) = 1,430 + 1,999 = frw.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.

• 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 2019 :

CPA EXAMINATION F2.1 Management Accounting 169

STUDY MANUAL
Labour hours Service cost (frw)

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 = frw.200,000 – frw.150,000

800 hrs – 300 hrs

= frw.50,000 = frw.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) = frw.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 = frw.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) = frw.150,000.
Therefore 150,000 = a + 100(300)
a =150,000 – 30,000 = frw.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
= frw.220,000.
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.

170 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
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
8 x
Dependant
variable 7 x x x
(Total Cost) 6 x x x
5 x x x x x
4 x
3
2 xxxxx
x x

1m x

x2 x3
0 2,000 400,000

IndependentVariable
(Output Level)

Fixed Cost = X
 0 = 1m
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

• 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

CPA EXAMINATION F2.1 Management Accounting 171

STUDY MANUAL
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 uptoxn.

b1,b2bnare 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)

BREAK-EVEN ANALYSIS
For any business there is a certain level of sales at which there is neither a profit nor a loss, i.e.
the total income and the total costs are equal. This point is known as the break-even point.
It is very easy to calculate, and it can also be found by drawing a graph called a break- even chart.

Calculation of Break-Even Point – Example

As shown in the last unit, you must be able to layout a marginal cost statement before doing
Break Even formulas.

Marginal Cost Statement

Sales x
- Variable Cost (x)
= Contribution x
- Fixed Costs (x)
= Profit/Loss xx

Let us assume that the organising committee of a dinner have set the selling price at
RWF8.40 per ticket. They have agreed with a firm of caterers that the meal would be supplied
at a cost of RWF5.40 per person. The other main items of expense to be considered are the
costs of the premises and orchestra which will amount to RWF80 and RWF100 respectively.
The variable cost in this example is the cost of catering, and the fixed costs are the amounts for
premises and orchestra.

The first step in the calculations is to establish the amount of contribution per ticket.

Contribution
RWF
Price of ticket (sales value) 8.40
Less Catering cost (marginal cost) 5.40
Contribution 3.00

Now that this has been established, we can evaluate the fixed expenses involved.

172 F2.1 Management Accounting CPA EXAMINATION

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Fixed Costs
RWF

Hire of premises 80
Orchestra fee 100

Total fixed expenses RWF180

The organisers know that for each ticket they sell, they will obtain a contribution of RWF3 towards
the fixed costs of RWF180. Clearly it is only necessary to divide RWF180 by RWF3 to
establish the number of contributions which are needed to break even on the function. The
break-even point is therefore 60, i.e. if 60 tickets are sold there will be neither a profit nor a loss
on the function. Any tickets sold in excess of 60 will provide a profit of RWF3 each.

Formulae
The general formula for finding the break-even point in volume is:

Fixed costs
Contribution per unit

(this is, of course, exactly what we did in the example).

If the break-even point is required in terms of sales value, rather than sales volume, the
formula that should be used is as follows:
Fixed costs
Break-even point =
C / s ratio

The C/s ratio is Contribution x 100

Sales

For example, the contribution earned by selling one unit of Product A at a selling price of
RWF10 is RWF4.
RWF 4
C/s ratio = × 100 = 40%
RWF10
In our example of the dinner-dance, the break-even point in revenue would be:
rwf 180
3 = RWF504
rwf 8.40

The committee would know that all costs (both variable and fixed) would be exactly covered by
revenue when sales revenue earned equals RWF504. At this point no profit nor loss would
be received.

Suppose the committee were organising the dinner in order to raise money for charity, and they
had decided in advance that the function would be cancelled unless at least RWF120 profit
would be made. They would obviously want to know how many tickets they would have to sell
to achieve this target.

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Now, the RWF3 contribution from each ticket has to cover not only the fixed costs of RWF180,
but also the desired profit of RWF120, making a total of RWF300. Clearly they will have to sell
100 tickets (RWF300 divided by RWF3).
To state this in general terms:

Volume of sales needed to achieve a given profit =

Fixed costs + Desired profit
Contribution per unit

Suppose the committee actually sold 110 tickets. Then they have sold 50 more than the
number needed to break even. We say they have a margin of safety of 50 units, or of
RWF420 (50 × RWF8.40), i.e.

Margin of safety = Sales achieved – Sales needed to break even.

The margin of safety is defined as the excess of normal or actual sales over sales at break- even
point.
It may be expressed in terms of sales volume or sales revenue.
Margin of safety is very often expressed in percentage terms:

Sales achieved Sales needed to break even

x 100
Sales achieved

i.e. the dinner committee have a percentage margin of safety of 50/110 × 100% = 45%.
The significance of margin of safety is that it indicates the amount by which sales could fall before
a firm would cease to make a profit. Thus, if a firm expects to sell 2,000 units, and calculates
that this would give it a margin of safety of 10%, then it will still make a profit if its sales are at
least 1,800 units (2,000 – 10% of 2,000), but if its forecasts are more than 10% out, then it
will make a loss.

The profit for a given level of output is given by the formula: (Output × Contribution per unit) –
Fixed costs.
It should not, however, be necessary for you to memorise this formula, since when you have
understood the basic principles of marginal costing, you should be able to work out the profit from
first principles.

Consider again our example of the dinner. What would be the profit if they sold
(a) 200 tickets
(b) RWF840 worth of tickets?

(a) We already know that the contribution per ticket is RWF3.

Therefore, if they sell 200 tickets, total contribution is 200 × RWF3 = RWF600.
Out of this, the fixed costs of RWF180 must be covered: anything remaining is profit. Therefore
profit = RWF420. (Check: 200 tickets is 140 more than the number needed
to break even. The first 60 tickets sold cover the fixed costs; the remaining 140 show a profit of
RWF3 per unit. Therefore profit = 140 × RWF3 = RWF420, as before.)

174 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
(b) RWF840 worth of tickets is 100 tickets, since they are RWF8.40 each.

RWF Total contribution on 100 tickets = 300

Less fixed costs 180
Profit RWF120

BREAK-EVEN CHART
Information Required
(a) Sales Revenue
When we are drawing a break-even chart for a single product, it is a simple matter to
calculate the total sales revenue which would be received at various outputs.

As an example let us take the following figures:

Output (units) Sales revenue (RWF)

0 0

2,500 10,000

5,000 20,000

7,500 30,000

10,000 40,000
(b) Fixed Costs
We must establish which elements of cost are fixed in nature. The fixed element of any
semi-variable costs must also be taken into account.
Let us assume that the fixed expenses total RWF8,000.

(c) Variable Costs

The variable elements of cost must be assessed at varying levels of output.

Output (units) Variable costs (RWF)

0 0
2,500 5,000
5,000 10,000
7,500 15,000
10,000 20,000

Plotting the Graph

The graph is drawn with level of output (or sales value) represented along the horizontal axis
and costs/revenues up the vertical axis. The following are the stages in the construction of
the graph:

(a) Plot the sales line from the above figures.

(b) Plot the fixed expenses line. This line will be parallel to the horizontal axis.

CPA EXAMINATION F2.1 Management Accounting 175

STUDY MANUAL
(c) Plot the total expenses line. This is done by adding the fixed expenses of RWF8,000 to
each of the variable costs above.

(d) The break-even point (often abbreviated to BEP) is represented by the meeting of the
sales revenue line and the total cost line. If a vertical line is drawn from this point to
meet the horizontal axis, the break-even point in terms of units of output will be found.

The graph is illustrated in Figure 1.

Note that, although we have information available for four levels of output besides zero, one
level is sufficient to draw the chart, provided we can assume that sales and costs will lie on
straight lines. We can plot the single revenue point and join it to the origin (the point where
there is no output and therefore no revenue). We can plot the single cost point and join it to the
point where output is zero and total cost = fixed cost.

In this case, the break-even point is at 4,000 units, or a revenue of RWF16,000 (sales are at
RWF4 per unit).

This can be checked by calculation:

Sales revenue = RWF4 per unit

Variable costs = RWF2 per unit

Contribution = RWF2 per unit

Fixed costs = RWF8,000
Break-even point = Fixed costs
Contribution per unit
= 4,000 units.

176 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Figure 1

Break-even Chart for More Than One Product

Because we were looking at one product only in the above example, we were able to plot
“volume of output” and straight lines were obtained for both sales revenue and costs. If we wish
to take into account more than one product, it is necessary to plot “level of activity” instead of
volume of output. This would be expressed as a percentage of the normal level of activity, and
would take into account the mix of products at different levels of activity.

Even so, the break-even chart is not a very satisfactory form of presentation when we are
concerned with more than one product: a better graph, the profit-volume graph, is discussed in
the next study unit. The problem with the break-even chart is that we should find that, because
of the different mixes of products at the different activity levels, the points plotted for sales
revenue and variable costs would not lie on a straight line.

CPA EXAMINATION F2.1 Management Accounting 177

STUDY MANUAL
Assumptions and Limitations of Break-Even Charts
Apart from the above point about the difficulty of dealing with more than one product, you
should bear the following points in mind:

• Break-even charts are only accurate within fairly narrow levels of output. This is because
if there were to be a substantial change in the level of output, the proportion of fixed costs could
change.
• Even with only one product, the income line may not be straight. A straight line implies
that the manufacturer can sell any volume he likes at the same price. This may well be untrue:
if he wishes to sell more units he might have to reduce the price. Whether this increases or
decreases his total income depends on the elasticity of demand for the product. Therefore
the sales line may curve upwards or downwards, but in practice is unlikely to be straight.
• Similarly, we have assumed that variable costs have a straight line relationship with level
of output, i.e. variable costs vary directly with output. This might not be true. For instance, the
effect of diminishing returns might cause variable costs to increase beyond a certain level of
output.
• Break-even charts only hold good for a limited time-span. Nevertheless, within these limitations
a break-even chart can be a very useful tool. Managers who are not well- versed in accountancy
find it easier to understand a break-even chart than a calculation showing the break-even point.

General Points on the Interpretation of Break-Even Charts

The skeleton break-even chart (Figure 2) illustrates the following points:

(a) Margin of Safety

The margin of safety - i.e. the extent by which sales could fall before a loss was
incurred - is easily read from the graph.

Figure 2

178 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
(b) Angle of Incidence
The angle a marked on the chart is referred to as the angle of incidence. This shows the rate at
which profits increase once the break-even point is passed. A large angle of incidence means
a high rate of earning (equally it means that if sales fell below break- even point, the loss would
increase rapidly). This is also illustrated by the size of the profit and loss wedges.

Changes in Cost Structure

If costs increase, the break-even point will be reached at a higher level of sales. The break-
even chart (Figure 3) illustrates the effect of changes.

Example
A long-distance coach company expects 80,000 tickets to be sold on a particular route in a
three-month period at a price of RWF30 each. Fixed overhead for the period is budgeted at
RWF412,500 and expected net profit is RWF247,500.

REQUIREMENT:
Calculate:
(a) the contribution/sales ratio;
(b) the total contribution;

CPA EXAMINATION F2.1 Management Accounting 179

STUDY MANUAL
(c) the contribution per ticket;
(d) the additional profit arising from selling a further 1,250 tickets;
(e) the additional sales required to earn the same profit as that shown above if the price per
ticket is reduced to RWF27.75.

Solution
(a) The contribution must first be calculated.
Fixed costs + Profit: RWF412,500 + RWF247,500 = RWF660,000. Contribution/sales ratio
rwf 660,000
× 100 = 27.5%
80,000 tickets RWF 30
(b) Total contribution = RWF660,000.
(c) Contribution per ticket: this is the total contribution divided by the number of tickets to be
sold

RWF 660,000
80,000 = RWF8.25

(d) Additional profit arising from selling a further 1,250 tickets: as the company is already
trading at above its break-even point, any additional contribution earned by additional
sales will be profit.
The additional profit is 1,250 × RWF8.25 = RWF10,312.50
(e) The additional sales required to produce a profit of RWF247,500 if the selling price per
ticket is reduced to RWF27.75 is calculated as follows:

Target contribution RWF660,000

Selling price per ticket RWF30
No. of tickets sold 80,000
Revised position
Target contribution RWF660,000

Selling price per ticket RWF27.75

Fixed costs remain the same. Therefore the reduction in selling price reduces
contribution by the same amount:
RWF30 – RWF27.75 = RWF2.25. This reduces contribution per ticket from RWF8.25 to RWF6.00.
To earn a target profit of RWF660,000, sales must now be
rwf 660,000
rwf 6 = 110,000.

This means that an additional number of 30,000 (110,000 – 80,000) tickets must be sold.

180 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Contribution Break-Even Chart
An alternative form of break-even chart is one which shows the contribution earned. Instead
of starting by measuring the fixed costs from the base line, the variable costs are taken. The
fixed costs are then shown above the variable costs.

Example
Variable costs RWF2 per unit

Fixed costs RWF80,000

Maximum sales RWF200,000

Selling price per unit RWF20

REQUIREMENT:
Prepare a contribution break-even chart. (See Figure 4)

Figure 4

CPA EXAMINATION F2.1 Management Accounting 181

STUDY MANUAL
THE PROFIT VOLUME GRAPH
The profit volume graph provides an alternative presentation to the break-even chart
discussed in the previous study unit. It may be more easily understood by managers who are
not used to accountancy or statistics.

In this graph, sales revenue is plotted on the horizontal axis, against profit/loss on the vertical
axis. It is therefore necessary to work out the profit before starting to plot the graph. This is done
using the marginal costing equation.
Sales revenue – Variable cost = Fixed cost + Profit

or Profit = Sales revenue – Variable cost × Fixed cost

or Profit = Contribution per unit × No. of units – Fixed cost
The general form of the graph is illustrated in Figure 6.

Figure 6
The distance AO on the graph represents the amount of fixed cost, since when no sales are
made there will be a loss equal to the fixed cost.

182 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
USE OF THE PROFIT VOLUME GRAPH FOR MORE THAN ONE PRODUCT
In order to draw a profit volume graph for several products it is necessary to calculate:

• Sales revenue for each product and cumulative sales revenue.

• Contribution for each product, cumulative contribution and hence profit.

The graph is easiest to draw and interpret if the products are taken in order, starting with the most
profitable and working back to the least profitable, “profitability” in this context being measured by
the relationship which contribution bears to sales revenue.

Example
The Works Director of XY Ltd, a company manufacturing and marketing a number of
different products, considers that the profit could be increased by restricting the number of
products. He wishes to eliminate production of the two lines which contribute
proportionately least, and he is satisfied that the output and sale of the remaining products would
be increased proportionately so that the total value of sales is unaffected.

He asks you to help him by preparing from the following data a suitable graph which would
indicate the products which should be eliminated, and would assist him in presenting his point
of view to his colleagues on the Board.

Product Variable Cost Profit Sales

RWF RWF RWF

A 11,000 3,000 (Loss) 12,000
B 18,000 3,000 22,000

C 17,000 500 20,000

D 21,500 9,500 44,000

E 6,000 8,000 23,000

F 8,000 2,000 (Loss) 10,000

131,000
Fixed expenses are at a level of RWF33,500.

Solution
The first step is to establish the contribution made towards fixed expenses by the individual
products. The second is to calculate the contribution as a percentage of sales revenue. At
this stage we will be able to eliminate the least profitable lines.

CPA EXAMINATION F2.1 Management Accounting 183

STUDY MANUAL
Product Sales Variable Contribution Contribution as
Percentage of
Cost
Sales Revenue
RWF RWF RWF %
A 12,000 11,000 1,000 8.3
B 22,000 18,000 4,000 18.2
C 20,000 17,000 3,000 15.0
D 44,000 21,500 22,500 51.1
E 23,000 6,000 17,000 74.0
F 10,000 8,000 2,000 20.0

It is clear that A and C are proportionately the two least profitable products, and should be
eliminated.

Since the question states that the total value of sales will remain the same, we must gross up
the sales of the remaining items.

Product Former Sales Share of Increase Revised Sales

RWF RWF RWF

E 23,000 7,440 30,440
D 44,000 14,220 58,220
F 10,000 3,230 13,230
B 22,000 7,110 29,110
RWF99,000 RWF32,000 RWF131,000

We must now calculate revised contributions for each product.

Product Sales Percentage Revised Contribution

Contribution
RWF % RWF
E 30,440 74 22,500
D 58,220 51 29,750
F 13,230 20 2,650
B 29,110 18.2 5,300
The method of obtaining the points to be plotted is as follows:

184 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Present
Basis
Product Sales Contribution Profit
(Contribution Less
Fixed Costs)
RWF RWF RWF
E 23,000 17,000 –16,500
D 44,000 22,500
67,000 39,500 + 6,000
F 10,000 2,000
77,000 41,500 + 8,000
B 22,000 4,000
99,000 45,500 +12,000
C 20,000 3,000
119,000 48,500 +15,000
A 12,000 1,000
RWF131,000 RWF49,500 +16,000

Revised
Basis
Product Sales Contribution Profit

(Contribution Less
Fixed Costs)
RWF RWF RWF
E 30,440 22,500 –11,000
D 58,220 29,750
88,660 52,250 +18,750
F 13,230 2,650
101,890 54,900 +21,400

B 29,110 5,300

RWF131,000 RWF60,200 +26,700

The graph is shown in Figure 7.

CPA EXAMINATION F2.1 Management Accounting 185

STUDY MANUAL
Figure 7
From the graph we can read:

(a) Revised profit is RWF26,700.

(b) Present profit is RWF16,000.
(c) Revised BEPis RWF72,900.
(d) Present BEPis RWF88,700.

186 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
THE PROFIT/VOLUME OR CONTRIBUTION/SALES RATIO
Calculation
In the calculations for the profit graph in the previous example, we made use of the ratio
“contribution: sales” (expressed as a percentage). This ratio has historically been referred to as
the “profit: volume ratio”. This is not a very sensible name, because it does not describe what the
ratio actually is. In fact, examiners now call it by the more descriptive name of “contribution
: sales ratio” (C/S ratio) but you should watch out for the alternative terminology P/V ratio
in older textbooks.

The ratio may be calculated as either:

Selling price per unit Variable cost per unit
Selling price per unit
or
Total sales revenue Total variable cost
Total sales revenue
Alternatively, it may be calculated when variable costs are not known, provided the sales
revenue and profit figures are known for two different levels of output.

Example
Calculate the contribution: sales (C/S) ratio from the following information:
Sales Figures Profit Figures
RWF RWF
3,500 625
Activity Level I
Activity Level II 3,000 500

The calculation of the ratio is as follows:

(a) Variation in profits: Level I - Level II is RWF625 – RWF500 = RWF125.

(b) Variation in sales: Level I - Level II is RWF3,500 – RWF3,000 = RWF500.
This means that for additional sales of RWF500 there is an additional profit of RWF125.

(a) 125 = 0.25

(c) Contribution: sales ratio (b) or
500

This figure can be checked by drawing up profit statements for the two activity levels, bearing
in mind that if the ratio is 0.25, i.e. contribution is 0.25 per RWF of sales, then variable costs
will be 0.75 per RWF of sales. We must also remember that fixed cost = contribution – profit,
and that the fixed cost will by definition be the same at each of the two activity levels.

Level I Level II

RWF RWF
Sales 3,500 3,000
Less marginal cost (0.75 per RWF1) 2,625 2,250
Contribution 875 750
Less fixed expenses 250 250
Profits 625 500

CPA EXAMINATION F2.1 Management Accounting 187

STUDY MANUAL
Use of Ratio
(a) Profit at Different Levels of Sales
Using the data in the last example, what would be the profit on RWF2,000 sales?
What sales level would be required to produce a profit of RWF1,000?
(i) Sales of RWF2,000

a. Sales as above RWF2,000

b. C/S percentage as calculated 25%

c. Contribution on RWF2,000 sales,

25% of RWF2,000 RWF500
d. Fixed expenses as calculated RWF250
e. Profit on RWF2,000 sales (c. – d.) RWF250

(ii) Profit Requirement of RWF1,000

a. Profit requirement as above RWF1,000

b. Fixed expenses as calculated RWF250
c. Total contribution required (a.
+ b.)
C/S percentage as calculated RWF1,250
d. 25%
100
e. Sales required RWF1,250 × 25 RWF5,000

(b) Calculation of Break-Even Point

We saw earlier that the formula for calculating the break-even point in sales value is:
Fixed cost
C / s ratio
This gives the breakdown point in terms of sales value. Using the same data again, break-even
point will be
250 100
= 250 × 25 = 1,000
0.25

i.e. the break-even point occurs when sales are RWF1,000.

Typical Examination Question

(a) Define and illustrate by means of simple arithmetical examples:

(i) Contribution/sales ratio;

(ii) Margin of safety.

(b) Demonstrate the relationship between a firm’s contribution/sales ratio, its percentage
margin of safety, and its profit/sales ratio.
(c) What is the significance of a firm’s margin of safety?
(d) The following details relate to Product X:

188 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
RWF RWF
Selling price 120
Costs:
Material 60
Labour 15
Variable overhead 5
Fixed overhead 10 90
Profit RWF30

During the forthcoming year it is expected that material costs will increase by 10%, wages by
1
33 3 % and other costs by 20%.

You are required to calculate the percentage increase in the selling price of X which would
maintain the firm’s contribution/sales ratio.

Solution
(a) (i) The contribution/sales ratio is the contribution that is sales revenue - variable
cost, expressed as a proportion of sales.
For example, if selling price = RWF100 and variable cost/unit = RWF75, the
contribution/unit is RWF25 and the C/S ratio 0.25 or 25%.
(ii) The margin of safety is the difference between a firm’s actual or expected sales,
and the sales which would be needed to break even. It may be expressed as
a percentage of the actual sales.

For example, using the data above and supposing fixed costs to be RWF2,500, the sales
2,500
volume required to break even would be 100 units ( ).
If the firm’s actual sales were 200 units, its margin25of safety would be 100 units or
100
200 × 100% = 50%.

(b) A firm’s profit/sales ratio can be obtained by applying its percentage margin of safety to
its C/S ratio. This is illustrated using the above data:

RWF

Actual sales (200 units @ RWF100) 20,000

Marginal cost of sales (200 @ RWF75) 15,000
Contribution (= 25% of revenue) 5,000
Less fixed costs 2,500
Profit (= 12½% of revenue) 2,500

CPA EXAMINATION F2.1 Management Accounting 189

STUDY MANUAL
Contribution/sales ratio × percentage margin of
safety

= 25% × 50% = 12½%

which is the profit/sales ratio, as required.

(c) A firm’s margin of safety shows its ability to withstand adverse trading conditions: for
instance, in the above example the firm can afford for sales to drop by up to 50% before it will be
in real difficulties.

(d) Present Increase Expected

Costs Costs
RWF % RWF
Material 60 10 66
1
Labour 15 33 3 20
Variable overhead 5 20 6
Marginal cost 80 92

Since current sales revenue is RWF120 per unit, the current C/S ratio is 40/120 or
1 2
33 3 %. The variable cost: sales ratio is 66 3 %.

If the C/S ratio is to remain the same, the variable cost : sales ratio will also remain the same,
2
i.e. 66 3 % of the new selling price is RWF92. Therefore the new selling price must be
RWF138
92
( × 100).
66 2 3

RWF

Check:Selling price 138

Less variable cost 92
1
Contribution RWF46 which is 3 of sales revenue, as
required.

The two most important points to notice about this part of the question are:

• The examiner gave the fixed cost per unit as a “red herring”. In marginal costing we are only
interested in the fixed costs in total; fixed cost per unit is relevant only to absorption costing.
As it transpired, in this question we did not need any information at all about fixed costs.
• The variable (marginal) cost to sales ratio and the contribution to sales ratio are complementary
ratios, i.e. when expressed as percentages they add up to 100%, and if one of them remains
constant, then so does the other.

190 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
RELEVANT COSTS
Accountants have an important role in the preparation of relevant data for decision making
purposes.

For decision making purposes information is required which is relevant to the particular decision
under consideration. In all decisions there must be a “status quo” (or position the decision
making entity will be in if no decision is taken) and an alternative position (or several
alternative positions) which will result as a direct consequence of the decision to be taken.
Relevant information is that which relates to the differences between the basic, or status
quo outcome and the alternatives. Therefore the decision should be appraised by making a
comparison of the financial effects between the two sets of outcomes. Information concerning
events which are common to all outcomes possibilities may be ignored as such events are not
decision variables. The decision variables are not to be measured by the historic costs utilised
in regular management accounting reports as the historic costs relate to past transactions and
not, therefore, decision variables for the purpose of any current decision. Past transactions
are common to all future or current actions and as such are events which are common to all
outcomes hence they may be ignored. Relevant information concerns future incremental
(or avoidable) costs and revenues (as these can be altered by the current decisions) as well as
current opportunity values of existing assets.

Hence the figures incorporated in regularly produced management accounting reports are
generally based on past actions and are not to be used for decision making which is
concerned with current and future alternative actions. However, frequently, the figures used in
the regularly produced statements will be a good first approximation for the values which should
be attributed to the relevant decision variables – but this cannot be relied upon to be always the
case.

Relevant costs for decision making purposes are:

• Opportunity costs of existing assets or past expenditure.

Assets currently held as a result of past expenditure bestow benefits to the owner. It is not the past
expenditure which bestows the benefits but the current ownership of the asset and benefits can be
measured only by considering the uses to which the asset can be put. Hence for decision making
purposes the historic cost is irrelevant as it is the measurement of a past transaction and it does
not measure the current benefit derivable from the asset. If a current asset is used for one purpose
then its alternative use will be foregone – for the purposes of deciding whether it is worthwhile
to forego this alternative use then the benefits which would be derived from that use should be
attributed to the asset as its opportunity cost. Opportunity cost is therefore the net revenue which
avoidable as a result of the decision.
• Incremental, attributable future costs.
Future costs may be relevant but the essential point is that the future costs be avoidable as a result
of the decision. If accepting a decision incurs (or saves) a cost and rejecting the decision does incur
(or saves) a cost and rejecting the decision does incur (or save) that cost then the cost is a decision
variable. However care must be taken to ensure that only truly avoidable costs are included as
relevant, and all truly avoidable costs are treated as relevant – apportioned fixed overhead is not
relevant but actual changes in total fixed overhead are relevant to the decision which would cause
the change.

CPA EXAMINATION F2.1 Management Accounting 191

STUDY MANUAL
These are the types of cost which are relevant for decision making but the actual application of
the concept depends upon the precise decision to be made. There is no such thing as the costs for
decision purposes which can be applied to an asset on a regular basis – there are instead a variety
of relevant costs depending upon the nature of the decision to be made. Thus figures used in
routinely produced statements are not useful for decision making purposes as relevant information
is situation dependant.

THE PRACTICAL USE OF RELEVANT COSTS

There are a number of specific areas where accountants can use the concept of relevant costs
and these will be illustrated now: -

• Make or buy decisions

• Joint product decision i.e. sell or reprocess
• Special orders
• Key factor decisions
• Addition/discontinuance of products
• Pricing
• Continue/close down decisions

(a) Make or Buy Decisions

A common type of decision is a make-buy decision in which the decision maker chooses
between buying an item or manufacturing it e.g. should a furniture manufacturer buy in seat
cushions or should they try and manufacture them themselves.

The decision may not simply be for tangible products but could be a service facility e.g. sub
contract out computer services of use own personnel. Regardless of the type of make-buy
decisions the analytical process is the same. Managers attempt to isolate the costs relevant to
the decision at hand.

To illustrate let us assume, KA Tractors Limited manufacture a line of garden tractors. Currently
the company purchases sub-assemblies for RWF80 a unit which is expected to rise to RWF90
next year. The company is currently operating at 70% capacity and has the ability to manufacture
the sub-assemblies itself. This would incur additional leasing costs of RWF25,000 per annum.
Current requirements are 5,000 units.

192 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
The current costs of manufacturing are as below: -

RWF
Direct material 25
Direct labour 30
Variable overhead 20
Additional fixed overhead 5
Allocated fixed overhead 12

Total manufacturing cost 92 X 5,000 = RWF460,000

Purchase alternative 90 X 5,000 = RWF450,000

2 RWF10,000

Manufacturing appears to cost RWF2 more per unit. However the figures contain costs which are
not relevant to the decision i.e. allocated fixed overhead RWF12 which will be incurred whether
manufactured or purchased. These SUNK COSTS should be disregarded because they are
already committed and the decision will not alter them.

The relevant cost is only RWF92 - RWF12 = RWF80 and the company can save
RWF10 a unit by manufacturing.

However let us assume that the company is operating at full capacity and therefore by producing
the sub assemblies it will have to forego the use of the space for alternative production. This
alternative may be to produce engine blocks selling at a contribution (i.e. Sales less variable cost
of manufacturing) of RWF15 per unit. The decision will therefore be altered so it is better to earn
a contribution of RWF15 rather than save RWF10 and thus the company should sub-contract out.
The alternative income of the engine blocks are known as the OPPORTUNITY COSTS of
the manufacturing decision.

(b) Joint Product Decision I.E. Sell Or Reprocess

In general joint product decisions can be categorised as those affecting single products and those
affecting the entire group. Allocated joint costs are not relevant to the former decision but are to
the latter.

Let us examine AG. Brewing Limited which produces 2 joint products lager and beer and we
use 2 of the most common methods of joint cost allocation i.e. physical units and gross profit
methods. The schedule of total product costs is as follows: -
Physical Units Method

Product Sales Production Joint Post Total Cost Per unit

Price Costs Split off cost
RWF RWF Costs RWF
RWF RWF
Lager 20 50,000 (G) (5/6) 625,000 180,000 805,000 16.1
Beer 50 10,000 (G) (1/6) 125,000 120,000 245,000 24.5

60,000 (G) 750,000 300,000 1,050,000

CPA EXAMINATION F2.1 Management Accounting 193

STUDY MANUAL
Gross Profit Method

Product Sales Production Joint Post Total Cost Per unit

Price Costs Split off cost
RWF RWF Costs RWF
RWF RWF

Lager 20 50,000 (G) (82/120) 520,000 180,000 700,000 14

Beer 50 10,000 (G) (38/120) 230,000 120,000 350,000 35
60,000 (G) 750,000 300,000 1,050,000

We can now assume a competitor SUPERBEER comes on to the market at RWF32.50. What
decision do we make as the physical units methods says we should continue in production
whereas the gross profit method leaves us with a closure decision as the cost of RWF35 exceed
revenue by RWF2.50 per unit. Which is correct?

The answer lies in disregarding the joint costs as they are SUNK and are committed anyway. The
relevant cost is the costs incurred after split off of RWF120,000 or RWF12 per gallon produced
and compare this with the additional (incremental) income generated of RWF32.5 therefore the
company should continue production. A contribution of RWF20.5 is earned towards recovering the
joint costs which represents increased profit of RWF205,000 from the alternative of discontinuing
the line.

Taking this further let us assume that lager can be sold for RWF10 a gallon without processing
beyond the split off point. Revenue falls by RWF10 and costs by RWF3.60 (RWF180,000 ÷
50,000 gallons). Since loss in revenue exceeds costs saved by RWF6.40 the decision must
be to continue the product to completion as there would be an overall fall of RWF320,000 in the
years profits.

However if instead we can assume that Beer can be sold for RWF27.50 at split off or at RWF32.50
on full completion then the fall in income at split off is only RWF5 a gallon compared with cost
savings of RWF12 (RWF120,000 ÷ 10,000 gallons). A net saving of RWF7 a gallon would result
increasing profits by RWF70,000.

Joint costs become relevant when an alternative is to discontinue production of all the joint
products in the group. For example the company may have a target gross profit on its joint
products of say 25% then the following are the relevant costs: -

RWF

Joint Costs 750,000

Post split-off costs 300,000
Target gross profit (25% x RWF1,325,000) 331,250

1,381,250
*Sales 1,325,000

Shortfall (56,250)

194 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
*Lager 50,000 gallons at RWF20 = RWF1,000,000

Beer 10,000 gallons at RWF32.5 (competitor) = RWF325,000

RWF1,325,000

(c) Special Orders

Often a company is faced with a decision to take on special orders or “one off” orders which have
different characteristics than on going orders. Each order should therefore be evaluated based
on costs relevant to the situation.

Let us assume the CL Toy Co is currently operating at only 60% capacity. A national toy company
approaches the company with a proposal that the firm should produce
200,000 assorted toys at RWF7 each (normal price RWF10).

The firms accountant produces the following information: -

RWF
Direct materials 2
Direct labour 3
Variable selling and distribution costs 1
Manufacturing overhead allocated 2

It would appear that the company would lose RWF1 for each toy sold but manufacturing
overhead is already “sunk” therefore it cannot be relevant to the decision being taken. The
additional costs are only RWF6 and therefore each unit sold will make a positive RWF1
contribution towards recovery of fixed overheads and towards profits.

However it would be wrong simply to judge the special order on its quantitative merits along.
There are a number of side effects which should be carefully considered in conjunction with the
above?

• Will acceptance result in further orders from this customer and if I charge this price of
RWF7 am I stuck to it?
• What effect will this reduced price have on other customers. Will they demand price
decreases or are they likely to turn elsewhere for their business?
• By accepting the special order could I be losing out on other more profitable work elsewhere?
• How long will this spare capacity last?

These are just a few of the problems created by this decision and these may very well in the
end outweigh the financial advantages computed as per above.

CPA EXAMINATION F2.1 Management Accounting 195

STUDY MANUAL
(d) Key Factor Decisions
Contribution Per Key Factors
Sometimes a decision has to be made on whether to produce one product or another. This
happens when a multi-product plant is operating at capacity and a decision has to be made as
to which orders to accept i.e. the production capacity is the limiting factor.

The contribution approach supplies the data for a proper decision, because the decision is
determined by the product that makes the largest total contribution to profit. The objective
is to maximise total profits which depend on getting the highest contribution margin per unit of
the constraining factor.

A company has two products:

Product A Product B
Selling Price 10 15
Variable Expense 7 9
Contribution Margin 3 6
P/V ratio 30% 40%
B seems more profitable than A.
But if there are only 1000 hours of capacity available and that: A - takes ⅓ hours to
produce and
B - takes 1 hour to produce

It follows

A B
Units per hour 3 1
Contribution Margin per hour 9 6

Product A should be produced because it contributes the greater contribution per hour. We can
prove this by calculating the profits under both decisions: -
Product A

1000 Hours maximum capacity 1000 Hours maximum capacity

⅓ Hours required for each unit 1 Hour required for each unit
3000 Total production 1000 Total production possible
RWF3 Unit contribution RWF6 Unit contribution
Total contribution Total contribution
RWF9000 RWF6000

A is clearly the better product to produce despite the fact that each unit is only earning half that of
product B. However, the important factor is that product A takes ⅓ of the time to produce as B and
therefore with a limiting factor of 1000 hours this outweighs any contribution/unit disadvantage.

196 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Constraining Factor is Labour

1 Unit of A takes 2 hours to produce and a unit of B takes 3 hours

A B

Direct material .25 .15

Direct labour at .05 per hour .10 .15
Variable overhead at .03 per hour .06 .09

.41 .39
Contribution .59 .81

Selling Price 1.00 1.20

P/V ratio 59% 67%

Contribution per hour .30 .27

Product A becomes more important when labour is the constraining factor.

Very often where labour is the constraining factor one is asked to indicate possible methods of
providing the estimated missing productive capacity which would include the following:

• Recruit and train additional personnel.

• Resort to employing existing labour on an overtime basis. During the overtime periods,
a premium would be paid which would have to be more than offset by the additional
contribution. Also to be considered is whether fixed costs and variable overhead will change
as a result of the extended use of personnel and facilities. In addition, the effect of the
overtime on labour efficiency should be considered.
• The production might be contracted out to another manufacturer. In this case the main factor
would be the external contract price which would have to be included in the contribution
analysis.
• Install a second shift.
• Addition/Discontinuance Of Products

The various reasons for adding or discontinuing products to a company’s range are usually to
increase profits or reduce the losses. Provided that no fixed investment is required then the
incremental analysis should provide a solution.

Let us assume that the firm has spare capacity. An opportunity arises for regular turnover
of 10,000 units/month of a new product “x” at a price of RWF1 each. No investment is
required. If we assume material and labour to cost 75rwf per unit, additional fixed overheads to
cost RWF1,500 per annum then provided there are no better alternatives available the project
should go ahead: -

CPA EXAMINATION F2.1 Management Accounting 197

STUDY MANUAL
RWF RWF
Sales 10,000
Variable costs 7,500
Additional fixed costs 1,500
9,000
Increased contribution RWF1,000

If facilities were not idle and there were other possibilities then in addition to the above costs
OPPORTUNITY COSTS should be considered.

In relation to the decision to discontinue a product the only relevant costs are those which are
AVOIDABLE as a result of the decisions. For example a product profitability report could
well look as follows: -

RWF RWF
Sales 2,500
Variable costs 2,000

Fixed costs 700

2,700

Net Loss RWF(200)

It would appear that the product should be discontinued but we may find that we can only reduce
our fixed overheads by say RWF400 in which case the cost savings are RWF2,400 only which
would be less than the RWF2,500 revenue lost. It is therefore essential to analyse expenses
to identify how much could be avoided if the product were dropped and ascertain whether any
other costs would be incurred e.g. redundancy costs.

(f) Pricing
Pricing Decisions: Long Run And Short Run

Pricing a product is one of the most difficult areas for management decision. There are basically
two aspects of the problem: -

• Long-run pricing policy and

• Short-run pricing policy.
• Long-run pricing policy
The objective in the long run of a company is to maximise profit. Basically this boils down to
maximising the difference between: -

• Total Revenue = units x price and

• Total costs = (units x variable costs) + fixed costs.

In many firms today the pricing policy is quite often simply to add a margin to total cost giving a
sales figure. This COST PLUS PRICING can be seriously in error for it fails to take into account
the effect of that decision on sales volume. It may be possible to reduce prices and increase
profits if the volume is sufficiently elastic in relation to price changes or it may not affect volume

198 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
and therefore decrease profits. Sufficient to stress that pricing policies should not be reviewed
in isolation.

When comparing the effect on unit sales of varying prices what is critical is the contribution
margin since fixed costs are unaffected by volume changes. The aim of contribution pricing is to
maximise contribution and therefore profits at the same time.

Example
CP Limited prices products at cost plus 50%. Its cost structure and current activity level
are as follows: -

Volume Capacity Per Unit Total

(units) Usage
RWF RWF
Variable costs 6,000 60% 5 30,000
Fixed costs 50,000

Total cost 80,000

Mark-up (50%) 40,000

Sales 6,000 60% RWF20 RWF120,000

Market research indicates that a 10% price reduction would increase sales volume by 25%. A
contribution approach to the pricing problem clearly shows that profit is higher after the price
change than before.

Volume Per Unit Total

Before After Before After Before After

(units) Sales
6,000 (units) RWF RWF RWF RWF

7,500 20 18 120,000 135,000

Capacity 60% 75%

Usage
Variable 6,000 7,500 5 5 30,000 37,500
costs

Contribution 6,000 7,500 15 13 90,000 97,500

Fixed costs 50,000 50,000

Operating profit RWF40,000 RWF47,500

CPA EXAMINATION F2.1 Management Accounting 199

STUDY MANUAL
However, there are a number of dangers inherent in this approach: -

• Fixed costs are only fixed within the RELEVANT RANGE OF ACTIVITY. Once
outside this range then we must take account of the impact of the pricing decision on fixed
costs. (Example below illustrates this point in a short run context.)
• In the long run all costs will vary.

These two dangers should lead to caution in using a rigid classification of costs.

• By concentrating on contribution management could lose sight of the long term problem of
covering fixed costs. This often happens when management allow a short run price
which slightly exceeds marginal cost to become the long run price. (See (c) Special Orders
above).

(b) Short run pricing policy

In the short term a company can accept orders at a price above marginal cost but below normal full
cost provided there is surplus capacity available in the factory and that it does not displace other
more profitable work or affect the relationship that the company has with its present customers
who may well ask for price reductions as well. This type of marginal cost pricing is used in the
public sector a great deal e.g. railway cheap fares in off-peak periods, electricity cheaper off peak
usage etc.

Let us now look at an example dealing with varying levels of activity.

Example:
AY Limited is a manufacturing company. At present it is operating at 60% level of activity at which
level its sales (at RWF20 per unit) are RWF120,000.

Variable costs are RWF5.00 per units.

Fixed costs amount to RWF50,000 but it is estimated that to achieve 80% - 90%
activity level would cause fixed costs to increase by RWF10,000.

The sales manager of the company has proposed that the price of the product should be reduced
by 25% so as to reach a wider sales market. As a result the board of directors require a statement
showing:

• The operating profit of the company at activity levels of 60%, 70%, 80% and 90% assuming:
• No change in price is effected
• A reduction in selling price of 25% is effected and
• The percentage increase on present output which will be required to maintain the
present profit if the company reduces the selling price.

200 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Solution
(i) Statement of Operating Profit
(a) (b)
Present Policy New Policy
RWF RWF
Selling Price per unit 20 15
Variable costs per unit 5 5
Contribution cost per unit 15 10

Activity level 60% 70% 80% 90% 60% 70% 80% 90%

Sales units 6,000 7,000 8,000 9,000 6,000 7,000 8,000 9,000

Contribution 90,000 105,000 120,000 135,000 60,000 70,000 80,000 90,000

(RWF)

Fixed Costs 50,000 50,000 60,000 60,000 50,000 50,000 60,000 60,000
(RWF)

Operating 40,000 55,000 60,000 75,000 10,000 20,000 20,000 30,000

Profit
(RWF)

(ii) Increase in Production Required:

To maintain the present profit level, one must ascertain the change in contribution i.e. at
60%

Contribution at selling price of RWF20 = 90,000

Contribution at selling price of RWF15 = 60,000
Change 30,000

To offset this falling contribution production must be increased by:

30,000
or 50%
60,000

The production would have to be increased by 3,000 units. Unfortunately, this represents 90%
activity level at which level (in fact any level above80%) fixed costs are increased by RWF10,000
thus reducing profit by the same amount. Therefore, to maintain its existing profit level, the company
must cover this extra RWF10,000 by increased contribution from extra units produced.
Increased Fixed Costs 10,000
i.e. = 1,000 units
Contribution per unit 10

CPA EXAMINATION F2.1 Management Accounting 201

STUDY MANUAL
Thus in order to maintain its existing profit level the company must produce an extra 4,000 units
to offset the effect of its reduced selling price i.e.

6,000 + 4,000 units 10,000 @ New Contribution = 100,000

=

Less Fixed Costs 60,000

Net Profit 40,000
The above example illustrates how marginal costing may be used to simplify complicated pricing
and production decisions, by concentrating on the effect on contribution but at the same time care
must be taken that all “relevant” costs are taken into consideration e.g. the increase in fixed costs
of RWF10,000 is a “relevant” cost for this decision.

The conclusion should not be reached that all variable costs are relevant and that all fixed
costs are irrelevant. This approach over-simplifies the problem as all costs become variable in
the long run.

Certain costs may be variable but because of the nature of the decision to be made become
irrelevant. Furthermore fixed costs are often affected by a decision. For example the
decision to buy (or not to buy) a second car is usually influenced by the fixed costs that go with
the second car.

If the length of time under consideration is long enough no cost is fixed. Yet decisions often have
to be made in conditions where the length of time is short enough for costs to be fixed.

Fixed costs should therefore, be considered when they are expected to be altered either
immediately or in the future by the decision at hand.

MARKET VULNERABILITY ANALYSIS

Price Competition and Volume Shortfalls
A simple examination of a firm’s cost structure will show how vulnerable it is to market changes
in the downward direction.

In particular a businessman with a high variable cost is vulnerable to price competition from
competitors who have a low variable cost per unit. They will still be generating a
contribution at a price below his variable cost, so that he must sell each unit at a gross loss to
compete.

However in conditions of low demand for the product where the price is maintained (i.e.
where price reductions will not generate increased demand) the business with the low
variable costs and high fixed costs will fare worse. This is because volume shortfalls at a
high contribution per unit have a greater impact on profit than at a low contribution per unit. The
business with the low variable cost will usually have high fixed costs with the result that volume
shortfalls quickly give rise to losses.

Example
Two businesses, A Limited and B Limited, sell the same type of product in
st the same type of
market. Their budgeted Profit and Loss Accounts for the year ending 31 December 19X6
are as follows:

202 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
A Limited B Limited

RWF RWF RWF RWF

Sales (10,000 units) 150,000 150,000
Less:

Variable costs 120,000 60,000

Fixed costs 15,000 135,000 75,000 135,000

Net Profit RWF15,000 RWF15,000

When one considers: -

(a) The break-even points of each business:
(b) The minimum selling price each business can sustain without incurring a gross loss.
(c) The profit (loss) of each business in the event of sales falling to 5,000 units per annum.
These points as to price and volume vulnerability are clearly illustrated.

CONTINUE/CLOSE DOWN DECISIONS

A similar decision to the addition/discontinuance of products is the decision whether to continue or
close down a department/business. Again the relevant costs in the decision are the AVOIDABLE
COSTS.

Let us examine a simple department store with 3 departments whose results are as follows:
Total Groceries Hardware Furniture

RWF RWF RWF RWF

Sales 490,000 100,000 180,000 210,000

Variable costs 332,000 80,000 126,000 126,000

Contribution 158,000 20,000 (20%) 54,000 (30%) 84,000 (40%)

Fixed costs 76,000 21,000 20,000 35,000

82,000 (1,000) 34,000 49,000

At first glance we should close down the grocery departments as there is a loss of RWF1,000.
However this assumes that all RWF21,000 of fixed costs will be save. This is unlikely as there
are a number of COMMON COSTS which have been apportioned to all 3 products.
As well as that there are a number of other considerations: -

• Will I have customers for my other two departments if I close groceries down i.e. groceries
are a loss leader.
• Are there alternatives for other new departments which might make a larger
contribution.
• Could I expand on hardware and furniture in the space now occupied by groceries and earn
a higher contribution.

CPA EXAMINATION F2.1 Management Accounting 203

STUDY MANUAL
Let us assume that after further analysis of the fixed costs we discover that of the RWF21,000 fixed
costs, RWF6,000 are unavoidable. Thus the decision to close down the grocery department would
result in a net revenue loss of RWF5,000 (100,000 – 95,000). However, taking this further we
could assume that the idle space now left, could be used by the expanding hardware department
when sales could increase of RWF150,000 which at a contribution of 30% should result in
RWF45,000 additional contribution. In order to do this, however, additional capital investment of
RWF10,000 is essential together with an additional member of staff costing RWF6,000. The net
effect of all this is to increase contribution from the original by RWF24,000 as follows:

Original Close Groceries Difference

Extend Hardware

RWF RWF RWF

Sales 490,000 540,000 50,000

Variable costs 332,000 357,000 (25,000)

Contribution 158,000 183,000 25,000

Fixed costs 76,000 77,000 (1,000)

82,000 106,000 24,000

MARGINAL COSTING IN DECISION MAKING

Question 1
You are consulted by XYZ and Company Ltd to advise on the sales policy which they should
adopt. The following information is available from the system of total costing in operation for
the year end 30 June.

Expense Element
Product Classifications

A B C D
RWF RWF RWF RWF

Material costs 2,000 4,000 1,000 3,000

Labour costs 1,000 1,500 500 1,250
Fuel and power costs 300 500 100 200
Direct expenses 400 800 700 500
Sales Levels 10,000 14,000 6,000 12,000
You evaluate the cost structure of the expense elements and find it to be as follows:
Material costs - 100% variable
Labour costs - 20%
fixed Fuel and power costs - 10%
fixed Direct expenses - 10% variable

204 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
The overhead expenses are established at the following figures, and your assessment of the
cost structure is also shown:

Factory overheads - 10% variable RWF6,500

Admin. overheads - 80% fixed RWF2,000
Sales overheads - 60% fixed RWF10,000

The administration overheads should be spread equally between factory and sales overheads.
The variable sales overheads are directly related to sales value, and the factory overheads of a
variable nature are related to direct labour costs.

Prepare a statement which shows management in the clearest possible fashion which product
is most profitable, and also a statement to show the effect of two proposals made by the sales
manager:

• That the sale of C can be increased by 10% if a better grade of material is used. This will
increase the variable material cost by 5% per unit.
• That A and D are similar in market appeal, and if A were eliminated the sales of D would
rise by 50%

Solution
XYZ & CO. LTD
Profit Statement - Year End 30 June
A B C D Total

RWF RWF RWF RWF RWF

Direct material - 100% 2,000 4,000 1,000 3,000 10,000
“ labour - 80% 800 1,200 400 1,000 3,400
“ fuel and power - 90% 270 450 90 180 990
“ expenses - 10% 40 80 70 50 240
3,110 5,730 1,560 4,230 14,630

Add Variable works cost

25% on direct labour 200 300 100 250 850
Variable selling cost
10% on sales value

1,000 1,400 600 1,200 4,200

Marginal cost 4,310 7,430 2,260 5,680 19,680

Sales value 10,000 14,000 6,000 12,000 42,000
Contribution 5,690 6,570 3,740 6,320 22,320

Less fixed expenses 16,570

RWF5,750
Net profit for half year

CPA EXAMINATION F2.1 Management Accounting 205

STUDY MANUAL
Calculations
(a) Statement of Fixed Expenses
RWF
Labour costs - 20% 850

Fuel and power - 10% 110

Salaries and expenses - 90% 2,160

Works overheads - 90% 5,850

Admin. overheads - 80% 1,600

Selling overheads - 60% 6,000

RWF16,570

(b) Calculations of Overhead Absorption Rates

(i) Direct labour costs - variable RWF3,400

(ii) Variable factory overheads - 10% RWF650
Share of admin. variable
overheads - 50% of 20% RWF200 RWF850
(iii) Overhead absorption rate =
Cost 850 100
x 100 = = 25% on direct labour
Activity 3400

(iv) Total sales value RWF42,000

(v) Variable selling overheads
- 40% RWF4,000
Share of admin. variable
overheads - 50% of 20% RWF200 RWF4,200
(vi) Overhead absorption rate =

Cost 4,200
Activity × 100 = x 100 = 10% on sales value
420,000

Revised Profit Statement

Giving Effect to Sales Manager’s Proposals

B C D Total
RWF RWF RWF RWF

Direct materials 4,000 1,155 4,500 9,655

“ labour 1,200 440 1,500 3,140
“ fuel and power 450 99 270 819

206 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
“ expenses 80 77 75 232
5,730 1,771 6,345 13,846
Add Variable works cost 300 110 375 785
Variable selling cost 1,400 660 1,800 3,860
Marginal cost 7,430 2,541 8,520 18,491
Sales value 14,000 6,600 18,000 38,600
Contribution 6,570 4,059 9,480 20,109
Less Fixed expenses 16,570

Revised net profit RWF3,539

Conclusion
The suggestion that the grade of material used in Product C should be improved is worth
pursuing, since the contribution made by that product will be increased.

However, the suggestion that Product A be dropped is not worthwhile, since the extra
contribution gained by Product D does not compensate for the contribution lost on Product A.

Question 2
The XL Co. Ltd manufactures four products, “Mainline”, “Trimline”, “Exline” and
“Superline”. The costs and revenues are as follows:

XL CO. LTD.
Mainline Trimline Exline Superline
RWF RWF RWF RWF
Revenue for year 10,000 15,000 30,000 15,000

* Variable costs 5,000 6,000 20,000 9,000

Fixed costs 6,000 4,000 5,000 8,000

Total costs 11,000 10,000 25,000 17,000

PROFIT RWF5,000 RWF5,000

LOSS RWF(1,000) RWF(2,000)

* Note that variable costs include prime costs and variable overhead costs.
The directors are considering whether or not to eliminate the products on which losses are
being incurred and concentrate only on the products earning profits. The sales of these latter
products, they are advised, are unlikely to increase and this fact makes the problem more
difficult.
You, as management accountant, are required to present the information in the most appropriate
manner and advise the board of directors on the best course to follow.

CPA EXAMINATION F2.1 Management Accounting 207

STUDY MANUAL
Answer
(a) Marginal Profit and Loss Statement

Product Sales Value Marginal Cost Contribution

RWF RWF RWF
Mainline 10,000 5,000 5,000
Trimline 15,000 6,000 9,000
Exline 30,000 20,000 10,000
Superline 15,000 9,000 6,000
70,000 40,000 30,000

Less Fixed costs 23,000

Net Profit RWF7,000

(b) Position when Trimline and Exline Only are Produced

Product Sales Value Marginal Cost Contribution
RWF RWF RWF
Trimline 15,000 6,000 9,000
Exline 30,000 20,000 10,000
45,000 26,000 19,000

Less Fixed costs 23,000

Loss RWF4,000
Clearly the position portrayed (RWF4,000 loss) shows that the elimination of Mainline and
Superline will result in a loss instead of a profit.

(c) Position when Superline Only is Eliminated

Product Sales Value Marginal Cost Contribution
RWF RWF RWF
Mainline 10,000 5,000 5,000
Trimline 15,000 6,000 9,000
Exline 30,000 20,000 10,000
55,000 31,000 24,000

Less Fixed costs 23,000

Profit RWF1,000

208 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
(d) Position when Mainline Only is Eliminated
Product Sales Value Marginal Cost Contribution
RWF RWF RWF
Trimline 15,000 6,000 9,000
Exline 30,000 20,000 10,000
Superline 15,000 9,000 6,000
60,000 35,000 25,000

Less Fixed costs 23,000

Profit RWF2,000

(e) Recommendations

• If sales volumes of the four products cannot be increased, then all four should be produced as
at present. In this way the total possible net profit of RWF7,000 per annum is earned.
• “Mainline” makes a contribution of RWF5,000, so it is worth continuing.
• “Superline” makes a contribution of RWF6,000, so that too is worth continuing.
• If apportionments of fixed overheads are felt to be essential, then a more accurate basis for the
calculation may have to be found.
• A market research investigation into the potentialities of the products is recommended. Possibly
a sales campaign may allow larger volumes to be produced which, in turn, would result in a
larger total contribution.

DECISION MAKING INVOLVING A SINGLE LIMITING FACTOR

“A limiting factor is any factor that is in scarce supply and that prevents the organisation from
expanding its activities further, i.e. it limits the organisation’s activities”

For many organisations, the limiting factor is sales because they simply cannot sell as many units
as they would like. Therefore, their ability to expand is restricted or limited.

But other factors may also be limited (and this is especially the case in the short term). For
example, machine capacity, raw materials or the supply of skilled labour may be limited for the
period (or until some remedial action resolves the situation)

If an organisation is facing a situation involving a single limiting factor (i.e. where only one resource
is in short supply), then it must ensure that a production plan is established that maximises the
organisation’s profit using the available capacity of this resource.

Assuming that fixed costs remain constant, this is the same as saying that that the
contribution must be maximised from the use of the scarce resource. The profit of an
organisation in this situation will be maximised by maximising the contribution per unit of the
limiting factor. This is the decision rule that must be followed.

CPA EXAMINATION F2.1 Management Accounting 209

STUDY MANUAL
Example 1
NT Ltd manufactures three products; X, Y and Z. All three products use two materials A and
B. Due to adverse weather conditions and poor growth yield, the supplier of the materials has
informed NT that the supply of A and B will be limited to the following quantities for the next
period:

Material A 1,030 kg
Material B 1,220 kg
No other source of supply can be found for the next period.
Information relating to the three products manufactured by NT Ltd is as follows:
X Y Z

Quantity of material used per unit manufactured:

Material A (kg) 2 1 4
Material B (kg) 5 3 7
Maximum sales demand (units) 120 160 110
Contribution per unit sold (RWF) 15.00 12.00 17.50
Because the products are perishable, no finished goods stocks are held

REQUIREMENT:
(a) Recommend a production mix that will maximise the profits of NT Ltd for the
forthcoming period
(b) NT Ltd has a valued customer to whom they wish to guarantee the supply of 50 units of
each product next period. Would this alter your recommendation?

Solution
(a) The first step is to check whether the supply of each material is adequate or whether
either or both of them represent a limiting factor.
X Y Z Total
MAXIMUM SALES DEMAND (UNITS) 120 160 110
Material A required per unit (kg) 2 1 4
Total Material A required (kg) 240 160 440 840
Material B requires per unit (kg) 5 3 7
Total Material B required (kg) 600 480 770 1,850
It can be seen that there will be sufficient material A to satisfy the maximum demand for the
products but material B will be a limiting factor.

Thus, we employ the decision rule mentioned earlier, i.e. maximise the contribution per unit of
limiting factor. Rank material B in this order and then allocate according to this ranking.

X Y Z
Contribution per unit sold RWF15 RWF12 RWF17.50
Material B per unit (kg) 5 3 7
Contribution per kg of material RWF3 RWF4 RWF2.50
B Ranking 2 1 3
Therefore, NT Ltd. should produce as much of Product Y as possible. Then, when maximum
demand for Y has been met, produce Product X and finally, with any material B leftover,
produce product Z.

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The optimal production plan for the next period will be:

Recommended Material B Total

Product Production Utilised Contribution
(units) (kg) (RWF)

Y 160 480 1,920

X 120 600 1,800
1,080 3,720
Z 20* 140(balance) 350
1,220 4,070
* After satisfying the demand for X and Y, 140 kg of Material B will be available for the production
of Product Z. Since Product Z requires 7 kg of Material B per unit, a maximum 20 units of Product
Z can be produced.

(b) The recommended production plan in part (a) does not include sufficient Product Z to satisfy
the requirements of 50 units for the valued customer. Some of the material allocated to Product
X (second in the ranking) must be allocated to Product Z. The recommended production plan will
now be as follows:

Recommended Material B Total

Product Production Utilised Contribution

(units) (kg) (RWF)

Y 160 480 1,920
X 78* 390(balance) 1,170
870 3,090
Z 50 350 875
1,220 3,965
* since the original production plan did not meet the needs of the valued customer, it will be
necessary to divert resources so that sufficient Product Z will be produced.

Then the maximum amount of Product Y will be produced (first in the ranking) and the remainder
of Material B will be used to produce Product X

It can be seen that the total contribution will be lower than the production plan in part (a). But
the altered plan makes the best use of the available material B within the restriction of market
requirements. Failure to meet the requirements of the valued customer might lead to loss of
future business as this customer may take their business elsewhere.

Example 2
ELG Ltd. manufactures three products A, B and C. The products are all finished on the same
machine. This is the only mechanised part of the process. During the next period, the
production manager is planning an essential major maintenance overhaul of the machine.
This will restrict the available machine hours to 4,200 hours for the next period.

CPA EXAMINATION F2.1 Management Accounting 211

STUDY MANUAL
Data for the three products is:

A B C
RWF per unit RWF per unit RWF per unit

Selling price 90 51 63.00

Variable Cost 39 18 27.00
Fixed Production Cost 30 24 18.00
Other fixed cost 6 3 10.50
Profit 15 6 7.50
Maximum demand (units per 750 420 390
period)

No stocks are held.

Fixed production costs are absorbed using a machine hour rate of RWF6 per machine hour.

REQUIREMENT:
Determine the production plan that will maximise profit for the forthcoming period.

Solution
Firstly, calculate how many machine hours are required for each product:

A B C
Total
Fixed production costs per
unit at RWF6 per hour RWF30 RWF24 RWF18
Machine hours per unit 5 4 3
Maximum demand (units) 750 420 390
Maximum hours required 3,750 1,680 1,170 6,600
Since 6,600 machine hours are required and only 4,200 are available, machine hours are a
limiting factor. To maximise profit for the period, it is necessary to maximise the contribution
per unit of scarce resource. In other words, maximise the contribution per hour of machine time

(Note: Do not allocate hours according to profit per hour or profit per product)

Now, calculate the contribution per machine hour from each of the products:

A RWF B RWF C RWF

Selling price per unit 90 51 63

Variable cost per unit 39 18 27
Contribution per unit 51 33 36
Machine hours per unit 5 4 3
Contribution per hour RWF10.20 RWF8.25 RWF12.00
Ranking 2 3 1

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The available hours can be allocated according to this ranking.

Product Units to be produced Machine Hours

C 390 (maximum demand) 1,170

A 606 (balance)* 3,030
4,200
* After producing the maximum number of Product C, there will be 3,030 machine hours left
available. Product A is the second ranking product, requiring 5 machine hours per unit. Therefore,
only 606 can be produced in the available time. This is less than the maximum market demand
of 750 units. Consequently, no units of Product B will be produced as there is no machine time
available.

CPA EXAMINATION F2.1 Management Accounting 213

STUDY MANUAL
TOPIC 6
INFORMATION FOR PLANNING AND CONTROL
Budget (A plan in money)
A budget is defined as:

“A plan quantified in monetary terms, prepared and approved prior to a defined period of time,
usually showing planned income to be generated and/or expenditure to be incurred during
that period and the capital to be employed to attain a given objective.”

A budget is therefore an agreed plan which evaluates in financial terms the various targets
set by a company’s management. It includes a forecast profit and loss account, balance sheet,
accounting ratios and cash flow statements which are often analysed by individual months to
facilitate control.

Budgets are normally constructed within the broader framework of a company’s long-term strategic
plan covering the next five to ten years. This strategic plan sets out the company’s long-term
objectives, whilst the budget details the actions that must be taken during the following year to
ensure that its short and long-term goals are achieved.

Budgetary Control
A definition of budgetary control is:
“The establishment of budgets relating the responsibilities of executives to the requirements
of a policy, and the continuous comparison of actual with budgeted results, either to secure by
individual action the objective of that policy or to provide a basis for its revision.”

Companies aim to achieve objectives by constantly comparing actual performance against

budget. Differences between actual performance and budget are called variances. An
adverse variance reduces profit and a favourable variance improves profitability.
Budgetary control therefore allows management to review variances to identify aspects of the
business that are performing better or worse than expected. In this way a company will be able
to monitor its sales performance, expenditure levels, capital expenditure projects, cash flow, and
asset and liability levels. Corrective action will be taken to reduce the impact of adverse trends.

Financial budgets are prepared in the same format as the company’s profit and loss, balance
sheet and cash flow statements. In this way it is easy to compare actual and budgeted results
and calculate variances.
Here is a typical statement comparing actual and budgeted results:

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PROFIT AND LOSS ACCOUNT - MAY

MONTH YEAR TO DATE

Description Budget Actual Variance Budget Actual Variance

R % R % RWF R % R % RWF
W W W W
F F F F
Sales

Tickets
Catering
Souvenirs
Other
Total
Gross Profit
Tickets
Catering
Souvenirs
Other
Total
Overheads
Staff costs
Rent & local authority tax
Electricity
Gas
Cleaning
Repairs
Renewals
Advertising
Entertainment
Commissions
Laundry
Motor expenses
Total overheads
NET PROFIT

You can see that this statement details the month’s performance together with that for the year
to date. It covers the whole company; in order to obtain even greater control it is necessary to
prepare operating statements evaluating the contribution from each area of the business. These
additional statements usually cover the activities of individual managers to identify which of them
are failing to achieve their targets. A typical operating statement is as follows:

CPA EXAMINATION F2.1 Management Accounting 215

STUDY MANUAL
OPERATINGSTATEMENT Maintenance Department
Month of May . . . .

Month Cumulative

Description Budget Actual Variance Budget Actual Variance

RWF RWF RWF RWF RWF RWF
Salaries 16,000 15,500 500 70,000 67,000 3,000
Wages 51,000 53,000 (2,000) 250,000 255,000 (5,000)
Indirect materials 2,000 1,900 100 10,000 12,000 (2,000)
Maintenance 6,000 6,000 - 24,000 23,900 100
Electricity 8,000 10,000 (2,000) 40,000 39,000 1,000
Gas 6,500 7,000 (500) 26,500 28,000 (1,500)

Total 89,500 93,400 (3,900) 420,500 424,900 (4,400)

This statement includes all expenditure under the control of the maintenance manager. It
details expenditure for the month of May and the cumulative position for the year to date. The
statement identifies the month’s main areas of overspend as wages, electricity and gas. For the
year to date the main problem areas are wages, indirect materials and gas.

Under a system of budgetary control the maintenance manager will be asked to prepare a report
explaining all variances and the action being taken to bring the department back onto budget.
These actions will be monitored in the following months to ensure that the corrective measures
have been taken.

ADVANTAGES OF BUDGETARY CONTROL SYSTEMS

Agreed Targets
Budgets establish targets for each aspect of a company’s operations. These targets are set in
conjunction with each manager. In this way managers are committed to achieving their
budgets. This commitment also acts as a motivator.

Problems Identified
Budgets systematically examine all aspects of the business and identify factors that may
prevent a company achieving its objectives.
Problems are identified well in advance, which in turn allows a company to take the
necessary corrective action to alleviate the difficulty. For example, a budget may indicate that
the company will run short of cash during the winter period because of the seasonal nature
of the service being provided. By anticipating this position the company should be able to take
corrective action or arrange additional financing.

Scope for Improvement Identified

Budgets will identify all those areas that can be improved, thereby increasing efficiency and
profitability.

Positive plans for improving efficiency can be formulated and built into the agreed budget. In
this way a company can ensure that its plans for improvement are actually implemented.

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Improved Co-ordination
All managers will be given an outline of the company’s objectives for the following year.
Each manager will then be asked to formulate their own plans so as to ensure that the
company’s overall objectives are achieved.
All the managers’ plans will be combined and evaluated so that a total budget for the
company can be prepared. During this process the company will ensure that each individual plan
fits in with the company’s overall objectives.

Control
It is essential for a company to achieve, if not exceed, its budget.
Achievement of budget will be aided by the use of a budgetary control system which
constantly monitors actual performance against the budget. All variances will be monitored
and positive action taken in order to correct those areas of the business that are failing
to perform.

Raising Finance
Any provider of finance will want to satisfy itself that the company is being managed
correctly and that a loan will be repaid and interest commitments honoured.

The fact that a company has established a system of budgetary control will help to
demonstrate that it is being managed correctly. The budget will also show that the company is
able to meet all its commitments.

TYPES OF BUDGET
There are a number of different types of budget covering all aspects of a company’s operations.
These can be summarised into the following categories.

Operating Budgets
Master budgets cover the overall plan of action for the whole organisation and normally
include a budgeted profit and loss account and balance sheet.
The master budget is analysed into subsidiary budgets which detail responsibility for generating
sales and controlling costs. Detailed schedules are also prepared showing the build-up of the
figures included in the various budget documents.

Capital Budgets
These budgets detail all the projects on which capital expenditure will be incurred during the
following year, and when the expenditure is likely to be incurred. Capital expenditure is money
spent on the acquisition of fixed assets such as buildings, motor cars and equipment.

The capital budget enables the fixed asset section of the balance sheet to be completed and
provides information for the cash budget.

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

CPA EXAMINATION F2.1 Management Accounting 217

STUDY MANUAL
PREPARATION OF BUDGETS
Timetable
Each company prepares its budgets at a specific time of the year. The process is very time-
consuming and allowance must be made for:

• Each manager to prepare his estimates

• The accumulation of the managers’ estimates so that a provisional budget can be built up for
the whole company
• The provisional budget to be reviewed and any changes to be agreed

A large company with a January to December financial year will therefore probably commence
its budget preparation in August of the preceding year. This will allow 4-5 months for the
work to be completed. If it is to be completed successfully, it is essential that a timetable is
prepared detailing what information is required and the dates by which it must be submitted.
The preparation of budgets is a major project and it must be managed correctly.

Organisation
As we have just said, the preparation of budgets is a very important task which is given a
high level of visibility within the company. The overall co-ordination of the budgeting process is
therefore handled at a high level.

Budgeting may be the responsibility of the Finance Director, who will have responsibility for
bringing together the directors and managers’ initial estimates. The Finance Director will
specify the information that is required and the dates by which it is required. S/he will also
circulate a set of economic assumptions so that all directors and managers are preparing their
forecasts against the same economic background.

The Financial Director will eliminate most of the obvious inconsistencies from the initial estimates
and submit a preliminary budget to the Chairman of the company and its Board of Directors. The
Board will consider the overall framework of this preliminary budget so as to ensure that the
budget is acceptable and that it gives the desired results.
The Board must also ensure that the budget is realistic and achievable. If the Board does not
accept any part of the budget then it will be referred back to the relevant managers for further
consideration.

Some companies set up a budget committee to co-ordinate the budgeting process. This
committee carries out similar functions to those we described earlier, but will involve more of the
company’s senior directors and managers. This committee will probably be chaired by the
Chairman of the company.

The final budget must be accepted by the Board of Directors. It will then form the agreed plan
for the following year against which performance will be monitored and controlled.

Profit and Loss Account

(a) Limiting Factors
A company’s financial performance will be constrained by what are known as limiting
factors, which may include:

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• Demand for products
• Supply of skilled labour
• Supply of key components
• Capacity or space

Each of these constraints limit the company’s ability to generate sales and profits. Sales
cannot exceed the demand for products, and production cannot exceed the limits imposed by
labour and material availability and capacity.

It is essential that a company recognises the fact that it may have a limiting factor, as this will
govern the overall shape of its budget.

(b) Sales
Sales budgets are normally prepared by the company’s marketing department. The
sales budget of a small company may be set by its managing director working in conjunction with
his sales team. The sales budget will take into account the following factors:

• What is the sales trend for each product/service? Are sales increasing or decreasing
and why?
• Will any new product/service be launched and when?
• Will any of the existing products/services be phased out?
• What price increases can be obtained during the year?
• What is the advertising and promotional budget likely to be?
• What will be the pattern of sales throughout the period covered by the budget?
• What will the company’s competitors be doing?
• Are they introducing new products?
• What is their pricing policy?
• Are they being aggressive in order to gain market share?
• What is their advertising expenditure likely to be?
• Are there any new competitors entering the market?

(c) Cost of Sales

Having established a preliminary sales budget, it is necessary to calculate the cost of
sales. Most companies know how much each of their products cost to produce. These costs
must be updated to allow for the forecast level of price increases and proposed changes to
specifications or methods.

(d) Labour Costs

Labour costs will be calculated by multiplying the number of people required to
complete the budget by their rates of pay. Full allowance will have to be made for any planned
wage increases.

(e) Overheads
The sales budget will be circulated to all managers with responsibility for controlling
costs. These documents will enable each manager to understand the proposed scale of the
company’s operations. Each manager will consider the items of expenditure that he must incur
in order to ensure that the company can achieve its sales targets.

CPA EXAMINATION F2.1 Management Accounting 219

STUDY MANUAL
Each manager will already understand the cost of running his area and from this information
he should be able to estimate the cost levels required for the budget year. By accumulating all
the managers’ individual estimates it is possible for the company to build up a total cost budget.

(f) Profit before Tax

Sales Cost of sales Overheads = Profit before tax
(g) Taxation
From the budgeted level of profit, the company will be able to calculate the level of
corporation tax payable.

(h) Dividends
Dividends will be budgeted based on the forecast level of profits and the company’s
overall financial policy.

(j) Retained Earnings

Profit before tax Tax Dividends = Retained earnings
Retained earnings will be added to the balance sheet reserves.

The preceding data will be converted into a budgeted profit and loss account which should be
analysed to individual months and prepared in the same format as the company’s
management accounts.

There will also be detailed operating statements which allocate costs to individual managers.
These statements are also prepared on a monthly basis so that actual expenditure can be
compared with budget.

Balance Sheet
Having completed a budgeted profit and loss account, it is then necessary to complete a
budgeted balance sheet.

(a) Fixed Assets

• Capital Budgets
Each manager will be asked to submit details of his capital expenditure
requirements, together with a brief summary of the reasons why the expenditure is necessary. A
more detailed appraisal will be required before the expenditure is actually committed.
The capital budget will include items such as:

• New buildings
• Machinery and equipment
• Office equipment
• Computers
• Commercial vehicles
• Motor cars

The sum total of all the managers’ capital expenditure requirements will form a provisional
capital budget.

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• Disposals
Fixed assets may be sold or dismantled during the year. These will be listed and
an estimate made of any sales proceeds that may arise.
If a company sells a fixed asset for more than its net book value then a profit will be made. A loss
will result if an asset is sold for less than its net book value.
• Depreciation
The first step in completing budgeted depreciation is to calculate the charge for
the year on the assets already owned by the company. This will require the company to
examine each of its assets and calculate the depreciation charge.
All companies are required to keep a fixed asset register, which includes details of all their
fixed assets. Many companies have computerised their fixed asset
registers, which considerably improves the speed with which this part of the budgeting
process can be completed.
A company must also calculate the depreciation charge on the projects included in its capital
budget. A total depreciation charge can then be derived.
• Net Book Value
We can now see how a company can complete the fixed assets section of its
budgeted balance sheet. Here is an example:

Cost Depreciation Net Book Value

RWF RWF RWF
Balances as at 1 125,000 (35,000) 90,000
Jan

Asset disposals (7,000) 6,000 (1,000)

Depreciation for (12,000) (12,000)
year
Additions 55,000 (2,000) 53,000

Balances as at 31 173,000 (43,000) 130,000

Dec

(b) Working Capital

• Stocks
Companies calculate stock turnover ratios in order to monitor their stock control
function. The formula for calculating stock turnover is:
Cost of sales
Stock turnover =
Average Stock
Companies strive for a high stock turnover, which means they are carrying low stocks and managing
the function effectively. It is therefore possible to target improved performance by setting a
higher stock turnover target for the following year, which can be converted into a stock valuation
by adopting the following formula:
Budgeted cost of sales
Budgeted average stock =
Stock turnover

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STUDY MANUAL
• Debtors
A company will also calculate debtors’ ratios in order to monitor the effectiveness
of its credit control function. From these ratios it will establish target ratios which can be used
to calculate budgeted debtors in a similar way to the above stock calculation.
Budgeted cost of sales
Debtors ratio = Stock turnover 365 days

• Cash in Hand and at Bank

In practice the budgeting process will use cash as the balancing figure in the
balance sheet. This approach may seem strange but, if you think about it, you will see that a
company’s cash position will be the result of everything else that the company does.
• Creditors
Creditors will be calculated in a very similar way to the above debtors
calculation. A target creditors ratio will be determined, which will then be applied to the
purchases figure derived from other parts of the budgeting process.

Creditors ratio = Creditors

365 days
Credit purchases

Creditors ratio Credit purchases

Budgeted creditors =
365

• Bank Overdraft
The cash budgeting process may indicate that a bank overdraft will be required.

(c) Share Capital

The value of a company’s share capital will only change if new shares are issued. This
decision will be taken at the highest level within a company.

(d) Reserves
The opening balance on reserves will be known. The final figure will be the opening
balance plus or minus the value of retained earnings taken from the budgeted profit and loss
account.

(e) Loans
The opening position will be known. The final figure will be the opening position plus
the value of any new loans less the value of loans repaid.

All the preceding data will be presented in the budgeted balance sheet in the same format as the
company adopts for its monthly accounts. This statement will also be prepared on a monthly
basis to facilitate comparison with actual results.

Budget Review
The company has now completed provisional profit and loss, capital, cash and balance sheet
budgets.

The provisional budget will be considered by the Board of Directors. The Board must satisfy itself
that the budget is achievable and consistent with the company’s overall strategy. If the Board

222 F2.1 Management Accounting CPA EXAMINATION

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accepts the budget it will become the standard by which the company will be monitored
throughout the following year. If the Board does not accept part of the budget then it will be
referred back to management for further work.

In large groups of companies, the budget will also have to be approved by the Board of the
company’s holding company.

CONTROL MECHANISM
The budget will detail all aspects of the company’s operations. The company will prepare monthly
profit and loss accounts, operating statements, cash flow statements and balance sheets. Each
of the figures in these documents will be compared with the budget. Variances will be calculated
(the differences between actual and budgeted results). Excessive costs and inadequate sales
will be highlighted and positive action will be required in order to ensure that the company
corrects any adverse variances.

Management by Exception
When a system of budgetary control is in operation, the principle of management by
exception can be applied, i.e. when presenting information on actual results to management,
attention should be given mainly to those areas where there is a deviation from budget.

Regular Presentation of Information

The accounting function should be organised to produce the actual figures for comparison
with the budgets at the earliest possible point of time. The accounts headings should be the
same as the budget headings, so that the minimum processing work is necessary on the
figures.

The expense involved in collecting the cost figures must be borne in mind. A balance should be
struck between keeping costs to the minimum and obtaining the maximum amount of useful
information.

The budget committee should be in possession of the comparison between actual and budget
expenses within two to three weeks from the close of an accounting period. Each period should
be examined in detail by the budget committee, and managerial action taken where necessary.

Prompt presentation of information is important because any adverse trends will probably be
continuing while data is being collected and analysed. If action is to be taken to contain the
results for the succeeding period, it must be taken quickly, so the time required to collect and
analyse the data must be minimised.

Variance Interpretation
Any variances shown by the budget statements should be interpreted by the budget officer.
He should give his view on whether the variance is regarded as controllable or non- controllable.

This part of the operation is most important. The skill and experience of the budget officer will be
of the greatest value to management, who wish to know not only the extent of any deviation from
plan, but more importantly, the reasons for it and any action being taken to correct it.

CPA EXAMINATION F2.1 Management Accounting 223

STUDY MANUAL
Note that the purpose of such information is not to punish any individual for not keeping to his
budget (though it may sometimes be necessary to point out that results are unacceptable) but
rather to obtain information that will assist management to ensure that future budgets are accurate
and that greater effort is made to achieve them. The budget may also need to be updated in the
light of results achieved to date, by preparing a re-forecast.

Remember that one possible cause of variances is poor initial forecasting and budgeting.
Techniques should be kept under constant review and improved over time in the light of experience.

Budget SALES/
PRODUCTION

Actual profit

Take corrective action:

COMPARATOR
alter output, sales effort
etc. and re-budget

Compare actual
CHIEF EXECUTIVE/ profit with budget
BUDGET Variance

Figure 7.1: Budgetary Control System
Example
The principles involved in presenting information, and a suggested layout, are illustrated in
the following example.

PQ Co. is operating a budgetary control system. The overhead costs for service department
X are as follows:
Flexible Budget for Dept X - January

Units of service: 10,000 12,000 14,000

RWF RWF RWF
Cleaning 300 340 380
Consumable stores 200 230 260
Depreciation 180 200 220
Insurance 150 200 250
Light and fans 200 230 260

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Power 240 260 280
Repairs 160 190 220
Wages – indirect 700 740 780
2,130 2,390 2,650
For January the units supplied were 13,000 and the costs incurred were:

RWF
Cleaning 370
Consumable stores 250
Depreciation 210
Insurance 230
Light and fans 250
Power 270
Repairs 210
Wages - indirect 750

You are required to draft an operating statement showing the variances from each type of expense.
Complete the statement by showing possible reasons for the variances.

Answer
The costs (budgeted and actual) should be compared for the actual level of activity
achieved. Accordingly, on the operating statement shown below, the actual activity of
13,000 units forms the basis of the calculation of the budgeted costs. The variability of the costs
can be seen quite clearly from the flexible budget (see next section). Thus, for example,
cleaning costs increase by RWF40 for 2,000 units of service or, in other words, RWF20 for 1,000
units. Therefore, to find the cost for 13,000 units it is necessary to take the cost for 12,000 units
(RWF340) and add the cost for 1,000 units (RWF20), making a total of RWF360.

OPERATINGSTATEMENT
X Department Month:January
Output: 13,000 units
Types of Activity Achieved Variances Reasons forVariances
Expense 13,000 units

Actual Budgeted Fav. Adverse

RWF RWF RWF RWF
Cleaning 370 360 10 Maintenancework has
brought extra cleaning

Consumable 250 245 5 Extramaterials consumed -

Stores maintenance

CPA EXAMINATION F2.1 Management Accounting 225

STUDY MANUAL
Depreciation 210 210 - -

Insurance 230 225 5 Increased premium

Light and fans 250 245 5 Extremelyhot - extra cooler

used

Power 270 270 - -

Repairs 210 205 5 Largemachinemajor
breakdown

Wages -indirect 750 760 10 Overtime anticipated not

worked
2,540 2,520
This example is very simple, but the same principles apply with more difficult problems. The
basis for the calculation of activity may be the volume of sales or production.

In problems in examinations it is not always clear what level of activity has been achieved - this
may have to be calculated from details of sales, stocks and other information.

Profit Variance
Management will be especially interested in why profit was different from budget (not just
costs). The following presentation may be adopted to compare budgeted and actual profit:

RWF

Budget profit x
Plus/minus variance due to sales )
volume/selling prices ) x
x
Plus/minus cost variance x
Actual profit x

FLEXIBLE BUDGETS
Many companies use budgeting simply to compare actual performance with the budget that was
set during the previous financial year. This directs attention towards achieving the agreed
financial targets. The budget is fixed and all variances are reported.

However, as we saw in the previous section, if sales are greater than budget then it can be
expected that cost of sales and variable overheads will also be higher. It is possible to compare
actual results with what is therefore known as a flexible budget. A flexible budget is defined as:

“A budget which, by recognising the difference in behaviour between fixed and variable costs in
relation to fluctuations in output, turnover, or other variable factors such as number of employees,
is designed to change appropriately with such fluctuations.”

Let’s take a look at another simple example:

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Budget Actual
Sales (units) 1,000 1,100
RWF RWF
Selling price 10 10
Material cost each 3 4
Labour cost each 2 2
Variable overhead each 1 1
Fixed overheads 2,000 2,000

Comparison with the original (or fixed) budget would give the following variances:

Budget Actual Variance

RWF RWF RWF

Sales 10,000 11,000 1,000

Material cost 3,000 4,400 (1,400)
Labour cost 2,000 2,200 (200)
Variable overhead 1,000 1,100 (100)
Fixed overheads 2,000 2,000 -

Profit 2,000 1,300 (700)

In this statement there are adverse labour and variable overhead variances even though their
actual cost per product is exactly the same as budget. The only genuine adverse variance is
material, where the actual cost per product is RWF1 per product greater than the budget.

This would be better highlighted by preparing a flexible budget which shows the expected level
of costs for the actual level of sales at budgeted selling prices. This would result in the following
statement of variances which more accurately reflects the control variances and highlights only
the overspend in material costs of RWF1,100:

Flexed Budget Actual Variance

RWF RWF RWF

Sales 11,000 11,000 -

Material cost 3,300 4,400 (1,100)

Labour cost 2,200 2,200 -
Variable overhead 1,100 1,100 -
Fixed overheads 2,000 2,000 -
Profit 2,400 1,300 (1,100)

We will be looking at flexible budgeting in further detail later.

CPA EXAMINATION F2.1 Management Accounting 227

STUDY MANUAL
BEHAVIOURAL IMPLICATIONS
Budgetary control is a very powerful tool which highlights all departures from the agreed budget.
It is therefore vitally important that all managers are involved in the budget-setting process so
that they feel committed to achieving their targets. It also needs to be recognised that managers
will play the ‘budget game’ and endeavour to ensure they have achievable targets. It is quite
common to find that the company’s first budget estimates show it plunging into massive losses.
Sales and marketing staff have been cautious with their sales estimates and views on price
increases, whilst line managers have been unduly pessimistic about costs and endeavour to
secure the maximum capital budget so that they can implement all their projects.

It takes time to tease out their genuine expectations, and this process must be handled very
carefully in order to avoid the appearance of imposing budgetary targets on managers. The
eventual target should be realistic but stretching - so as to provide a challenge to the people
involved.

Having constructed the budget, it is also important to recognise that some managers may attempt
to bend the system so that adverse variances are not reported in their area. It is not unknown
for managers to put incorrect codes on their purchase orders so that costs are shown in another
manager’s operating statement, or reported elsewhere on their own. Naturally this does nothing
to help define better budgets in the following years.

It is also essential that the basis of the budget-setting process is understood. In practice it is
often based on the company’s current position and then updated for changes expected in the
forthcoming year. This can lead to established inefficiencies being built into next year’s targets.
An alternative approach is called zero-based budgeting, which challenges the accepted way of
doing things and attempts to construct budgets based on the way operations would be established
if they were being set up for the first time. The budget must obviously start from the company’s
current position, but this type of analysis should encourage the company to progress towards a
better way of structuring its activities.

We will cover zero-based budgeting in detail later.

BUDGETING AND LONG-TERM OBJECTIVES

Budgetary control is important, but the correct balance needs to be maintained between the
company’s short and long-term goals. Budgetary control tends to highlight short-term financial
objectives, and this highlighting is sometimes reinforced by management incentive schemes
geared to achieving budget. Great care must therefore be exercised to ensure that decisions are
not taken which protect short-term profitability at the expense of the long-term position of the
company. For example, research and development costs can be cut without any immediate
impact on the company; however, it is likely to have a major impact on the company’s long-term
position.

PUBLIC SECTOR BUDGETS

Preparation of the Budget
This section details specific steps in the budget preparation process, as it’s one of the core
functions of the Chief Budget Manager. The budget preparation process is coordinated by the
National Budget Department at MINECOFIN and all the budget related documents are posted at
their website http://www.minecofin.gov.rw/ministry/directorates/nb.

228 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
The First Budget Call Circular
The budget preparation call circular is triggered by the issuance of the First Budget Call
Circular (BCC). The BCC is issued in accordance with Article 28 of OBL, and provides

information to guide the Chief Budget Managers in the preparation of the budget. The 1st
BCC is normally issued in October and it is important that Chief Budget Managers start using it
from October.

The 1st BCC is not intended to seek budget submissions from budget agencies but is rather
aimed at giving advance information to facilitate timely coordination and effective planning within
the sectors to allow formulation of policy based budgets within individual budget agencies at a
later stage. The 1st BCC is aimed at inducing discussions at the sector level on priority activities
to be funded through the Government budget for the following financial year. These priorities
should be reflected in joint sector review report and should be the basis for submission of the
budget requests in response to the 2nd BCC, normally issued in early December.

The Second Budget Call Circular

As indicated above, the 1st BCC issued in October is meant to provide advance information to
budget agencies to better prepare and make informed plans and budgets. The 2nd Budget Call
Circular is issued in early December requiring budget agencies to prepare detailed budget
submissions for the following financial year. The 2nd BCC, which is also prepared by National
Budget Department, includes:

(a) The total indicative resource envelope derived from the macro-fiscal framework consistent
with the broad policy objectives. The indicative ceilings are issued at high level at line ministries,
provinces and other high level government institutions. This is to allow coordination and
prioritization of activities at the high level of Government programmes. The parent institutions
(Ministries and other high level institutions) that have been allocated ceilings are required to
immediately undertake consultative process with all affiliated agencies to agree on individual
agency ceilings that shall be the basis for the detailed budget estimates to be entered in the
budget system (SmartFMS).

(b) Budget submission formats (Annexes) to be submitted by each budget agency to assist in
preparation of the Finance Law (including externally and internally financed projects, internally
generated revenues, earmarked transfers to districts, Agency MTEFs, Strategic Issues Papers
(SIPs).

Strategic Issues Papers (SIPs)

The Strategic Issues Papers (SIPs) and Agency MTEFs are prepared by line ministries after
consultation with their affiliated agencies, projects and districts. At this stage, information is
gathered regarding projects support and sector budget support.

The SIPs and agency MTEFs are submitted to MINECOFIN and analyzed by NBD. Budget
consultations are then held between line ministries and MINECOFIN (in March) to agree on final
ceilings to submit to Cabinet & Parliament.

As indicated above, budget preparation is one of the most important responsibilities for a
Chief Budget Manager. Chief Budget Managers should ensure that the contents of the guidelines
are strictly adhered to and all issues therein are addressed in their draft budget estimates.

CPA EXAMINATION F2.1 Management Accounting 229

STUDY MANUAL
Submission and approval of budgets
The procedures for preparation, presentation and approval of budgets are provided for under
Chapter III Articles 28-45.

It should be noted that no budget should be provided for urgent and unforeseen expenditures with
a budget of a central government agency as provided in article 31 of the OBL. Such a budget is
only provided under the budget of Ministry of Finance and Economic Planning. However, each
district may provide for such expenditure in its own budget as provided under article 32 of the law.

Article 35: Expenditure estimates shall be prepared by budget Agencies, based on the
available resources and the guidelines issued by the Minister. Each budget Agency shall have
a separate budgetary line (vote) in the budget. Expenditure estimates of each budget Agency
are organized in a programmatic, economic and functional classification, in line with international
classification standards.

Article 6 of the OBL obliges government institutions to reflect all the revenues including grants
and all expenditures within their budgets. Chief Budget Managers should ensure during
budget preparation that this requirement is respected.

In order to meet the constitutional obligation as per Article 79 to submit the draft budget estimates
and MTEF to parliament before commencement of the budget session, the draft estimates of
Budget Agencies should reach MINECOFIN not later than January 28th, in hard copies and
electronically through SmartFMS. This gives NBD time to analyse the budgets and conduct
Budget Hearings for all Sector Ministries. In months 8-9 (February/March), the detailed draft
budget is prepared by MINECOFIN along with accompanying Budget Framework Paper (BFP).

The BFP sets out the macroeconomic context of the draft budget as well as the key policy
choices underlying the proposed resource allocation. The BFP is discussed by Cabinet and
recommendations are incorporated. The BFP and draft Budget is discussed with donors at the
second Joint Budget Support Review. It is at this point that Development Partners make firm
commitments for the coming year.

In accordance with article 79 of the Constitution of the Republic of Rwanda of June 4,

2003 as amended to date, the Cabinet shall submit the draft budget to the Chamber of
Deputies before the beginning of the budget session. This is further elaborated in Article
th
42 of OBL. The Minister presents the draft estimates and BFP to Parliament in the 10
month of the financial year (April).

The Parliamentary Committee on Budget and State Property in collaboration with other
sectoral committees scrutinizes the BFP and the draft budget estimates and submits a report
to plenary containing recommendations to the Executive for improvement of the BFP and
draft budget estimates. This report is normally submitted before the end of May and becomes the
basis for revising the BFP and preparing the draft Finance Law.

After the approval of the draft finance law by Cabinet around the first week of June, the draft
finance is submitted to Parliament and is officially laid before the Parliament by the Minister of
Finance and Economic Planning during the second week of June. The budget is ordinarily voted
and approved by Parliament before commencement of the next fiscal year.

230 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Preparation and approval of Local Government Budgets
The Intergovernmental Fiscal Relations Unit (IGFR) in MINECOFIN acts as the coordinating unit
between the district and national budget cycle.

Districts carry out their own review of last year’s performance which is discussed at the Joint
Action Forum in month 2 (August). During budget preparation, districts participate in consultations
with line ministries on Earmarked Transfers. MINECOFIN (IGFR) sends out the District Budget
Call Circular for Districts to prepare their budgets. Following the finalization of the BFP at the
national level, districts prepare their detailed budget based on final resource envelopes agreed
at Districts’ Joint Action Forum and transfers from Central Government communicated by the
Ministry of Finance and Economic Planning.

As required under article 43 of the OBL, the draft budgets of local administrative entities shall
be submitted to the executive committee of such an entity for further analysis before submission
to the local council of such an entity for examination and approval. When the draft budget of
local administrative entities has been approved by Council, they shall make it public to the general
meeting of the residents convened by the Executive Committee of the local administrative entity,
in each sector.

Revised Budget
Article 45 of OBL provides for revision of budget after six months of implementing the budget.
The proposed changes shall be consistent with the approved medium-term strategies and budget
framework; and if they are different from the approved budget framework, the reasons thereof
shall be notified to the Parliament or to the local Council of such an entity.

Accordingly, the Chief Budget Managers are required to monitor closely the implementation of
their budget by keeping a close eye on issues that might require revision after six months of
implementing the budget. These should be the issues that cannot be handled through
budget re-allocation like information on project funds that has just been communicated by the
donor, under- spending of a project that might require some adjustment in the procurement plan
and thus budget revision etc.

Requests for budget revision should be communicated to the Ministry of Finance and Economic
Planning by the first week of December to have an informed decision of whether a budget revision
is warranted or not by the end of December.

FUNCTIONAL BUDGETS
Sample Data
VT Ltd produces two products - X and Y. The products pass through two departments -
Department 1 and Department 2. The following standards have been prepared for direct
materials and direct wages:

Product
X Y
Material A 5 kg 8 kg
Material B 4 kg 9 kg
Direct labour:
Department 1 3 hours 2 hours
Department 2 2 hours 4 hours

CPA EXAMINATION F2.1 Management Accounting 231

STUDY MANUAL
The standard costs for direct material and direct labour are:
RWF per kg
Material A 2.00
Material B 1.20

Direct wages:
RWF per hr

Department 1 3.00
Department 2 3.50

Standard selling prices are:

Product
RWF per unit

X 50.00
Y 80.00

The budgeted sales for each product for the coming year are:

Product Units

X 8,000
Y 10,000

The company plans to increase the stocks of finished goods, so that the closing stock of
product X will be 2,000 units and the closing stock of product Y will be 3,000 units.

Opening stocks of finished goods are:

Product Units

X 1,000
Y 2,000
Finished goods are valued at variable production cost.
Opening stocks of direct material are:

Material kg

A 12,000
B 15,000

232 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
The required closing stocks of materials are: material A 19,000 kg; material B 15,000 kg.

Dept 1 Dept 2 per direct

per direct labour-hour labour-hour
RWF RWF

Light, fans, power 0.20 0.20

Consumable stores, indirect materials 0.40 0.30
Indirect wages 0.30 0.50
Repairs and maintenance 0.20 0.30

Standard variable selling and distribution expenses are:

Product X Product Y

per RWF of per RWF of

sales value sales value

(%) (%)
Commission 5 5
Carriage, packing, transport 4 2.5
Telephone, postage, 2 2
stationery

Fixed production, selling and distribution, and administration overheads are budgeted to be as
follows:

Production Selling and Administratio

Distributio n
n

RWF RWF RWF

Salaries: 20,000 22,000

Dept 1 10,000 30,000

Dept 2 12,000

Selling and distribution: Product X

Product Y Administration
Depreciation:

Dept 1 20,000

Dept 2 22,000

CPA EXAMINATION F2.1 Management Accounting 233

STUDY MANUAL
Selling and distribution: Product X 5,000 6,000
Product Y Administration
Stationery, postage, telephone: 6,000

Dept 1 1,100

Dept 2 1,200

Selling and dist. product X

2,500
product Y Administration
Sundry expenses:
800
Dept 1 1,400
1,000
Dept 2 1,300

Selling and dist. product X 1,500

product Y Administration 1,200

1,500
The company’s balance sheet at the beginning of the year was:

STATEMENT OF FINANCIAL POSITION

RWF RWF

Fixed assets at cost 1,000,000

Less: accumulated depreciation 200,000
800,000
Current Assets

Stock: material 42,000

finished goods 145,100
Debtors 150,000
Cash 40,000
377,100
Current Liabilities

Creditors 110,000
Net current assets 267,100
1,067,100
Represented by:
Share capital 800,000
Reserves 267,100
1,067,100

234 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
The budgeted cash flows per quarter are:

Quarter
(1) (2) (3) (4)
RWF RWF RWF RWF
Debtors 250,000 200,000 300,000 300,000

Creditors 110,000 100,000 100,000 122,000

Wages 90,000 90,000 92,000 92,000

Expenses 83,000 84,000 87,000 88,000

You are required to prepare the following budgets:

• Sales
• Production
• Materials purchases
• Direct materials cost
• Direct labour cost
• Production overheads
• Selling and distribution overheads
• Administration overheads
• Trading and profit and loss account
• Balance sheet at year-end
• Cash

Sales Budget
The sales budget will frequently be the starting point of the budget, and it is in our example.
The sales figures will usually determine the production requirements - subject, as in this case,
to any required adjustment to the stocks of finished goods. The sales budget will be derived from
salespeople’s reports, market research, or other intelligence or information bearing on future sales
levels and demand for the company’s products. The sales budget would be analysed according
to the regions or territories involved, with monthly budget figures for territories, salespeople
and products, so that sales representatives would have specific targets against which actual
performances could be measured.

The total sales budget in terms of units and values for the two products will be:
Product Units Unit Price Sales Value
RWF RWF

X 8,000 50.00 400,000

Y 10,000 80.00 800,000
1,200,000

CPA EXAMINATION F2.1 Management Accounting 235

STUDY MANUAL
Production Budget
The purpose of this budget is to show the required production for the coming year, so that
production scheduling can be completed in advance and individual machine loading
schedules can be prepared. This will enable the production department to assess the budgeted
usage of plant, the labour requirements and the extent of any under- or over-capacity. As with
the sales budget, the total annual requirements must be analysed into monthly figures.

The total budget for the year is:

Product
X Y

units units

Sales 8,000 10,000

Plus closing stock required 2,000 _3,000
10,000 13,000
Less opening stock 1,000 2,000
Production requirement 9,000 11,000

Materials Purchase Budget

This budget sets out the purchasing requirements for each type of material used by the
organisation, so that the purchasing department can place orders for deliveries, to take place
in accordance with production requirements - the essential need being that production should
not be held up for lack of materials. Purchase orders should be placed, and deliveries phased,
according to the production schedules, care being taken that no excessive stocks are carried. The
standard for the products will also specify the quality of material required, so that the purchasing
department will be responsible for obtaining the materials required, of the standard quality.

As with other budgets, the purchasing budget should show the monthly quantities to be purchased,
allowing for any lead time in suppliers’ deliveries.

Materials

A B

kg kg

Production: Product X 45,000 36,000

Product Y 88,000 99,000
133,000 135,000
Plus required closing stock 19,000 15,000
152,000 150,000
Less opening stock 12,000 15,000
Purchases required 140,000 135,000

236 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Direct Materials Cost Budget
The figures for this budget flow from the materials purchases budget, and they show the
financial implications of the planned purchases, for purposes of financial control and cash
flow requirements.

Material A Material B
Purchases required 140,000 kg 135,000 kg

Price per kg RWF2.00 RWF1.20

Cost of purchases RWF280,000 RWF162,000

Note that the quantities for production represent the number of production units in the
production budget multiplied by the kg per unit.

Direct Labour Cost Budget

This budget shows the number of direct labour-hours required to fulfil the production
requirements and the monetary value of those hours. Departmental figures are given, so that
departmental supervisors are made aware of the labour-hours and costs over which they are
expected to exercise control. Periodic reports would be made to supervisors, showing the
output achieved and the relevant standard hours and costs for that output (and, where necessary,
the reports required on any significant variances from the standards).

Direct labour-hours:
PRODUCT
X Y

Departmen Hours Total Hours Total Combined

t Units per unit hours Units per unit hours totals
1 9,000 3 27,000 11,000 2 22,000 49,000
2 9,000 2 18,000 11,000 4 44,000 62,000

Direct labour costs:

Department Hours Rate
RWF RWF

1 49,000 3.00 147,000

2 62,000 3.50 217,000
111,000 364,000

Production Overhead Budget

The variable and fixed overheads are shown by department. The departmental supervisors
will be expected to exercise control over those items for which they are responsible, and monthly
reports, highlighting the variances from budget, will be provided to assist them. The variable
overheads are expressed as amounts per direct labour-hour - but these could also be shown in
relation to some other factor, such as machine time, units of production, materials to be consumed,
or other relevant factors. In practice a combination of these factors might be used.

CPA EXAMINATION F2.1 Management Accounting 237

STUDY MANUAL
Variable overheads:
Department 1 Department 2

(Dir. lab-hours 49,000) (Dir. lab-hours 62,000)

Per hour Per hour

RWF RWF RWF RWF

Light, heat, power 0.20 9,800 0.20 12,400
Consumable stores, indirect
materials 0.40 19,600 0.30 18,600
Indirect wages 0.30 14,700 0.50 31,000
Repairs, maintenance 0.20 9,800 0.30 18,600
53,900 80,600

Fixed overheads:
Dept 1 Dept 2

RWF RWF
Salaries 10,000 12,000
Depreciation 20,000 22,000
Stationery, postage, telephone 1,100 1,200
Sundry expenses 1,400 1,300
32,500 36,500
Selling and Distribution Overheads Budget
As with other overhead budgets, the object of this budget is to identify the overheads to be
controlled by the management - in this case the sales management. Further analyses of the
overheads would be required to show the budgeted costs on a monthly basis, and by regions
and representatives where appropriate.

Variable overheads:
Product

X Y
Sales RWF400,000 RWF800,000

% of sales RWF % of sales RWF

Commission 5 20,000 5 40,000
Carriage, packing, despatch 4 16,000 2.5 20,000
Telephone, postage, stationery 2 8,000 2 16,000
44,000 76,000

238 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Fixed overheads:
Salaries 20,000 30,000
Depreciation 5,000 6,000
Stationery, postage, telephone 800 1,000
Sundry 1,200 1,500
27,000 38,500

Administration Overheads Budget

The administration overheads are likely to be mainly of a fixed character, and not affected by
production or sales levels, except where there are wide fluctuations. These overheads will cover
the general administration and accounting services of the organisation, and they will be the
responsibility of the chief executive concerned. Separate budgets for the accounting, company
secretarial and other departments will be required in larger organisations. The budgets will be
prepared after detailed studies have been made of the level of service required to provide the
necessary accounting, secretarial and other administrative services needed. Where a complete
review is required, an organisation and methods study may be undertaken. Monthly reports
will show actual and budgeted results, as with other functions, and variances shown for further
investigation. (The costs in this problem have been assumed to be entirely fixed.)

RWF
Salaries 22,000
Depreciation 6,000

Stationery, postage, telephone 2,500

Sundry expenses 1,500

32,000

MASTER BUDGETS
(This is not examinable for Formation 2; however it is useful for information purposes)

Budgeted Trading and Profit and Loss Account

This account is part of the master budget as it brings together all the functional and subsidiary
budgets and it shows the expected trading profit or loss based on the sales and cost budgets
previously prepared. In the light of these results, the management may decide to recommend
changes to the sales and cost figures, to bring the expected results into line with a required
return on capital or gross and net profit percentages related to sales. Once the final figures have
been approved, the budgeted trading and profit figures become the target for the company as a
whole. Using the figures arising from the previous budgets, the budgeted trading and profit and
loss account would be as follows:

CPA EXAMINATION F2.1 Management Accounting 239

STUDY MANUAL
VT LTD
BUDGETED TRADING AND PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED . . . .

RWF RWF
Sales 1,200,000
Opening stock of materials 42,000
Purchases 442,000
484,000
Less Closing stock of materials 56,000
428,000
Direct wages 364,000
Variable production overheads 134,500
926,500
Opening stock of finished goods 145,000
1,071,500
Less Closing stock of finished goods 236,000 835,500
Gross profit 364,500

Overhead Expenses
Variable selling and distribution overhead 120,000

Fixed overheads:
Production 27,000
Selling and distribution 54,500
Administration 26,000
Depreciation:
Production 42,000
Selling and distribution 11,000
Administration 6,000 286,500
Net profit 78,000

Budgeted Balance Sheet

This also forms part of the master budget, and it shows the expected overall financial
position resulting from the budgets. It enables assessments to be made of the return
on capital and ratios of profitability and liquidity - for example, the current asset/current liability
position, credit collection periods, and other financial ratios. This may also be part of a review
process in which some revisions may be required before final approval is given.

240 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
VT LTD
BUDGETED BALANCE SHEETASAT. . . .
RWF RWF

Fixed assets at cost 1,000,000

Less: accumulated depreciation 259,000
741,000
CurrentAssets

Stock ofmaterials 56,000

Stock of finished goods 236,000
Debtors 300,000
592,000
CurrentLiabilities

Creditors 120,000
Bank overdraft 48,000
168,000
Net current assets 424,000
1,165,000

Represented by:
Share capital 800,000
Reserves 365,000
1,165,000

CASH BUDGET
This budget enables management to see the timing of projected cash flows and the net cash
flow position for each period. Monthly cash flow figures would be provided to show the
anticipated cash position at each point. In the light of this budget, it may be necessary to
make arrangements for overdraft facilities for short-term needs or investment of surplus
funds. In very large organisations the management of funds may require constant attention to
ensure that effective use is made of all available funds. Also separate cash budgets may be
required for operational cash flows and financing cash flows. The operational cash flows

relate to trading operations, and financing cash flows to longer-term financing with related
interest charges.

Construction of Cash Budgets

It is very important that you understand how to construct a cash budget (this topic forms a
frequent examination question).
Cash budget detail the cash effect of all transactions included in a company’s budgeted profit
and loss account and balance sheet. There are two methods of preparing them. One method
calculates receipts and payments, whilst the other looks at the change in the opening and
closing balance sheet positions.

CPA EXAMINATION F2.1 Management Accounting 241

STUDY MANUAL
We will examine a budget covering a three-month period. We will ignore the effect of VAT.

Example
Cashflow Ltd’s budgeted profit and loss account and balance sheets are as follows:

BUDGETED PROFIT AND LOSS ACCOUNT

January February March

RWF RWF RWF RWF RWF RWF

Sales 80,000 70,000 90,000
Opening stock 7,000 13,000 11,000
Purchases 30,000 19,000 30,000
37,000 32,000 41,000
Closing stock (13,000) (11,000) (14,000)
Cost of sales (24,000) (21,000) (27,000)
Gross profit 56,000 49,000 63,000

Overheads
Wages and salaries 10,000 10,000 10,000
Depreciation 4,000 4,000 4,000
Other overheads 20,000 (34,000) 18,000 (32,000) 22,000 (36,000)
Net profit 22,000 17,000 27,000

BUDGETED BALANCE SHEETS

As at 1 Jan As at 31 Mar

RWF RWF RWF RWF

Fixed Assets
Cost 175,000 200,000
Depreciation (20,000) (32,000)
Net book value 155,000 168,000

Current Assets
Stock 7,000 14,000
Debtors 100,000 90,000
Cash 10,000 117,000 81,000 185,000
Current Liabilities

Trade creditors (50,000) (52,000)

Taxation (24,000) -

242 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Dividends (7,000) (81,000) - (52,000)
Capital employed 191,000 301,000

Financed by:
Share capital 100,000 150,000
Reserves 25,000 91,000
Shareholders’ funds 125,000 241,000
Loans 66,000 60,000
191,000 301,000

Additional Notes:

• All sales and purchases are made on one month’s credit.

• Wages and salaries are paid in the same month as the expense is incurred.
• The increase in the value of fixed assets results from the purchase of equipment costing
• RWF25,000. The cash payment was made in March.
• The debtor balance as at 1 Jan will be received in January.
• The trade creditor balance as at 1 Jan will be paid in January.
• The balance sheet taxation figure shown as part of current liabilities relates to a tax
provision made on a previous year’s profits. The tax is due for payment in February.
• The balance sheet dividends figure shown as part of current liabilities relates to a
proposed dividend payable on the previous year’s profits. This dividend is payable in March.
• The increase in share capital results from the issue of new shares. Cash to the value of
• RWF25,000 is receivable in February with the balance due in March.
• A RWF6,000 loan repayment is to be made in January.

(a) Receipts and Payments Method

The cash budget prepared on the receipts and payments basis is presented below:

CASH BUDGET
Receipts
January February March

RWF RWF RWF

Cash from sales 100,000 80,000 70,000
Issue of shares 25,000 25,000
Total receipts 100,000 105,000 95,000

Payments
Purchases (50,000) (30,000) (19,000)
Wages and salaries (10,000) (10,000) (10,000)
Other overheads - (20,000) (18,000)
Purchase of fixed assets - - (25,000)
Taxation - (24,000) -

CPA EXAMINATION F2.1 Management Accounting 243

STUDY MANUAL
Dividends - - (7,000)
Loan repayment (6,000) - -
Total payments (66,000) (84,000) (79,000)
Net cash flow for month 34,000 21,000 16,000

Opening cash position 10,000 44,000 65,000

Cash inflow 34,000 21,000 16,000
Closing cash position 44,000 65,000 81,000

Explanatory notes on preparation of cash budget:

(i) Sales
All sales are made on one month’s credit. This means that January’s sales will be
paid for in February, February’s sales will be paid for in March and March’s sales will be paid for
in April.

Cash from March’s sales will be received in April, which is not covered by the cash budget. At
the end of March, RWF90,000 is owed to the company which will be shown as debtors in
March’s balance sheet.

(ii) Purchases
The company obtains one month’s credit on all its purchases. January’s
purchases will be paid for in February. February’s purchases will be paid for in
March and March’s purchases will be paid for in April.

At the end of March the company owes its suppliers RWF30,000, which will be shown as part of
creditors in March’s balance sheet.

(iii) Wages and Salaries

Wages are paid out in the same month as the expense is incurred.

(iv) Depreciation
Depreciation covers the reduction in value of a company’s fixed assets.
Depreciation is not a cash payment. It is an accounting provision which reduces profits
and the value of assets in the balance sheet.

Cash flow statements are concerned only with cash payments and cash receipts. As depreciation
does not affect cash, it will not appear in a budgeted cash flow statement.

(v) Other Overheads

Other overheads are bought on one month’s credit. The cost, included in
January’s profit and loss account, is included in February’s cash flow, and so on.

At the end of March the company owes its suppliers RWF22,000 which will be shown as part of
creditors together with the RWF30,000 owed for its other purchases.

(vi) Cash Balances

The opening cash position in January is taken from the balance sheet as at 1 Jan.

244 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
The closing cash position for January becomes the opening cash position in February.
February’s closing cash position becomes the opening cash position in March.

(b) Comparison of Opening and Closing Balance Sheets Method

It is also possible to prepare a cash budget by examining the opening and closing
balance sheet positions.

Completion of the cash budget on a receipts and payments basis will identify the level of debtors
and creditors. The debtors figure will represent sales made on credit for which payment has not
been received. The creditors figure will represent purchases made on credit that have not yet
been paid for. The statement will also establish the cash or bank overdraft position.

As an alternative, it is possible to calculate debtors and creditors by using target ratios or other
information that will always be given to you in an examination question.

Cash Flow Statement

You should be aware from your financial accounting studies that, from a budgeted balance
sheet and profit and loss account, it is possible to prepare a cash flow statement. The layout
of this type of statement is presented below. The information in this statement is taken from
Cashflow Ltd’s accounts detailed earlier.

CASH FLOW STATEMENT

RWF RWF
Operating profit 66,000
Add back depreciation 12,000
Changes in working capital:
Stocks (7,000)
Debtors 10,000
Creditors 2,000
Cash flow from operating activities 83,000
Taxation (24,000)
Capital expenditure (25,000)
Dividends (7,000)
Sources of new finance:
Share capital 50,000
Loan repayments (6,000)
Cash inflow (represented by a change in the cash 71,000
balance)

This type of statement starts with a company’s profits. It then adds back the amount of
depreciation included in the profit and loss account as this does not involve a payment of
cash. Operating profit is then further adjusted for changes in the working capital position:

CPA EXAMINATION F2.1 Management Accounting 245

STUDY MANUAL
• An increase in stocks will reduce cash.
• A reduction in debtors means that the company has received a greater value of cash than
it has invoiced out in the form of credit sales. This will benefit a company’s cash position.
• An increase in the value of creditors means that the company has paid less to its
suppliers than it has been allowed in credit. This will improve the cash position.

The effect of raising new share capital will benefit cash and the payment of tax and
dividends and repayment of a loan will obviously reduce the cash balance.

The final figure in the statement is the company’s net cash flow for the period, which is represented
by a change in the company’s cash position. The opening cash position was RWF10,000 and
the closing balance was RWF81,000. The company must therefore have generated a positive
cash flow of RWF71,000.

The advantage of this type of statement is that it clearly identifies those areas of the business that
must be controlled in order effectively to manage its cash resource:

• Profit must be maximised.

• Capital expenditure must be controlled. Investment should lead to improved levels of
profitability.
• Stock must be kept to a minimum.
• Debtors must be kept to a minimum.
• Creditors must be controlled so that the maximum benefit is obtained from this form of
finance.

We will look at cash flow statements again in a later study unit.

Benefits of Cash Budgets

The preparation of cash budgets will also generate the following benefits:

• Cash budgeting highlights the impact that all other decisions have on a company’s financial
resource.
• Cash may be a limiting factor and restrict a company’s plans. The preparation of a cash
budget will indicate if this is the case.
• Budgeting will identify any cash problems that may occur during the period covered by the
budget. Advance warning will enable a company to take corrective action.
• Cash budgets are very useful documents when talking to banks and other financial institutions.
These organisations want to see that a company is controlling its cash, and that it will be in
a position to meet its obligations as they fall due.

246 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
FLEXIBLE BUDGETS
Use of Flexible Budgets
Fixed budgets are used to plan the activity of the organisation. Cost control begins by
comparing actual expenditure with budget. Remember, though, that if the level of activity differs
from that expected, some costs will change, and the individual manager cannot be expected
to control the whole of that change. If activity is greater than budgeted, some costs will rise; if
activity is less than budgeted, some costs will fall. The question is whether the manager has kept
costs within the level to be expected, given the activity level.

A flexible budget, as we mentioned in an earlier study unit, is one which - by recognising the
difference in behaviour between fixed and variable costs in relation to fluctuations in output,
turnover, or other variable factors, such as number of employees - is designed to change
appropriately with such fluctuations. It is the flexible budget which is used for control purposes,
not the fixed budget we have discussed so far.

Cost Behaviour
In order to understand flexible budgets, we must recall our earlier definitions of fixed and
variable costs:
(a) Fixed Cost
This is a cost which accrues in relation to the passage of time and which, within certain
output and turnover limits, tends to be unaffected by fluctuations in the level of activity.
Examples are rent, , insurance and executive salaries.

(b) Variable Cost

This is a cost which, in the short term, tends to follow the level of activity. Examples
are all direct costs, sales commission and packaging costs.

(c) Semi-variable Cost

This is a cost containing both fixed and variable elements, which is, therefore, partly
affected by fluctuations in the volume of output or turnover. There are two main methods
of predicting semi-variable costs at various levels of output or turnover:

• Separation of Fixed and Variable Elements

Provided the cost is known for two different levels of output/turnover, the fixed
and variable elements can be separated, and the level of cost at any other level of output/turnover
predicted. If more than two items of data are available, the highest and lowest are selected (the
high and low point method).
Example
At output levels of 1,000 units, 1,200 units, 1,500 units and 1,800 units costs are
RWF2,000, RWF2,200, RWF2,500 and RWF2,800 respectively. Taking the low and high points
(1,000 units and 1,800 units), an extra 800 units of output causes an extra RWF800 of cost: the
variable element of the cost must be RWF1 per unit. Therefore, considering the total cost for
RWF1,000 units, the fixed element of cost must be RWF1,000.

CPA EXAMINATION F2.1 Management Accounting 247

STUDY MANUAL
• Graphical Method for ‘Curve Expenses’
The calculation made in (i) is an oversimplification of the situation that is found
in practice in respect of semi-variable costs: it was assumed that, after a certain initial expense,
incremental costs varied in direct proportion to output - in other words, that the graph of the cost
looked like that in Figure 10.1:

Figure 10.1: Cost Varying in Direct Proportion to Output

In practice, the graph of semi-variable expenses appears as a curve. The following

procedure should be adopted:

• Find the expense level for various levels of activity.

• Plot these levels of cost on a graph.
• Draw a line of best fit, so that the cost for any other activity level can be found by
interpolation.

To obtain the graph in Figure 10.2, investigation has been carried out at activity levels of 10%,
30%, 50%, 70%, 90% and 100% of the budgeted level, and the values plotted. The line of best
fit has then been drawn between them.

It has been assumed that an activity of 64% has been achieved, and the broken line projected
to find the cost which should be associated with this activity level - i.e. RWF5,000.

248 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Figure 10.2:ActivityLeveland Cost

(d) Discretionary Cost

This is a fourth category of cost, which may be incurred or not, at the manager’s
discretion. It is not directly necessary to achieving production or sales, even though the expenditure
may be desirable. Examples are research and development expenditure.

Discretionary costs such as this are a prime target for cost reduction when funds are scarce,
precisely because they are not related to current production or sales levels. This might be a very
short-sighted policy - nevertheless, it is useful to have these costs separately identified in the
budget.

(e) Controllable Costs or Managed Costs

As we know, the emphasis in budgeting is on responsibility for costs (budgetary control
is one form of responsibility accounting). The aim must be to give each manager information
about those costs he can control, and not to overburden him with information about other costs.
A controllable cost is one chargeable to a budget or cost centre which can be influenced by the
actions of the person in control of the centre.

Given a long enough time-period, all costs are ultimately controllable by someone in the
organisation (e.g. a decision could be taken to move to a new location, if factory rent became
too high). Controllable costs may, however, be controllable only to a limited extent. Fixed
costs are generally controllable only given a reasonably long time-span. Variable costs may
be controlled by ensuring that there is no wastage but they will still, of course, rise more or less
in proportion to output.

CPA EXAMINATION F2.1 Management Accounting 249

STUDY MANUAL
Preparation of Flexible Budgets
Example 1
The fixed budget for budget centre A is shown below. This is the budget based on the
expected level of output, and it will therefore be the budget used to plan the resources
needed in that department. Note that the activity level is given in standard hours. Remember that
the standard hour is a measure of output, not of time: it is the quantity of output or amount
of work which should be performed in 1 hour. This concept is used because it enables us
to compare different types of work. Instead of saying ‘400 units of X which take 2 hours per unit
plus 200 units of Y which takes 1 hour per unit’ we can simply say ‘1,000 standard hours’.

BUDGET CENTRE A

Budget - Period 3 Activity 1,000 std hrs

Fixed Variable Total

RWF RWF RWF

Process labour 2,000 2,000

Indirect labour 50 85 135

Fuel and power 450 800 1,250

Consumable stores 5 15 20
3,405

From the above figures, we can evaluate a level of expense which is appropriate to any level of
output, within fairly broad limits. The figures have been set as the total allowance of expense
which is expected to be incurred at an output level of 1,000 standard hours. Should, however, the
output not be as envisaged, the allowance of cost can be varied to compensate for the change
in level of activity. This adjustment is known as flexing a budget for activity.

We would expect that if 1,000 standard hours were produced, the cost incurred would be
RWF3,405. If the level of output changes for some reason, the level of cost usually changes. We
will assume that the levels of output attained were 750 standard hours in period 4 and
1,200 standard hours in period 5. The budgets would be flexed to compensate for the changes
which have taken place in the actual output compared with those anticipated.

BUDGET CENTRE A
Budget - Period 4 Actual output 750 std hrs
Budgeted output 1,000 std hrs
Production volume ratio 75%

250 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Basic Budget Flexed Budget Actual

F V RWF Total F V Total

RWF RWF RWF
RWF RWF RWF

Process labour - 2,000 2,000 - 1,500 1,500 1,509

Indirect labour 50 85 135 50 64 114 126

Fuel and power 450 800 1,250 450 600 1,050 986

Consumable stores 5 15 20 5 11 16 19

In this instance, the fixed expenses are deemed to have remained the same but the basic
budget variable figures have been allowed at only 75% of the full budget. We thus attempt to
show that activity has had its effect on cost. For example, we expected that only RWF1,500
would be expended on process labour for the output achieved but, in fact, we spent
RWF1,509, and we exceeded the allowed cost by RWF9.

Now consider the effect on the budget in period 5 of having gained a greater output than that
envisaged originally:

BUDGET CENTRE A
Budget - Period 5 Actual output 1,200 std hrs
Budgeted output 1,000 std hrs
Production volume ratio 120%

Basic Budget Flexed Budget Actual

F V Total F V Total

RWF RWF RWF RWF RWF RWF RWF

Process labour - 2,000 2,000 - 2,400 2,400 2,348
Indirect labour 50 85 135 50 102 152 193
Fuel and power 450 800 1,250 450 960 1,410 1,504
Consumable stores 5 15 20 5 18 23 19

Here we have used a factor of 120% as applied to the variable elements of the basic budget. For
fuel and power we observe that the fixed element has remained constant, but we have assumed
that the variable element of RWF800, having risen in sympathy with the level of output, will
have gone up by 20%, to RWF960. The flexed budget figure for fuel and power thus becomes
RWF1,410, compared with the basic budget figure of RWF1,250.

It is clearly more reasonable to compare the actual cost of fuel and power for the period - i.e.
RWF1,504 - with the flexed budget rather than with the basic budget. This explains the entire
purpose of flexible budgeting, insofar as it attempts to provide a value comparison between the
actual figure of cost and the budget figure.

CPA EXAMINATION F2.1 Management Accounting 251

STUDY MANUAL
Comment: Budget centre A involved a production budget. The flexing for activity was therefore
carried out according to different levels of output. The definition of flexible budgets given earlier
referred to fluctuations in output, turnover, or other factors. Obviously, the selling costs budget
will be flexed according to turnover (i.e. number of units sold) rather than to output levels, while
the canteen will be flexed according to number of employees.

Now work out the following problem for yourself before checking with the answer.

Example 2
From the following selected data of a department the normal and expected workload of which
is 3,000 hours per month:
(a) Compile a flexible budget for 2,000, 2,800 and 3,600 hours of work.
(b) Compile a fixed budget.
(c) Calculate the departmental hourly overhead rate for the total of the following items:

Expense Heading Behaviour of Expense

Supervision RWF250 up to 2,000 hours
An extra RWF60 for steps of 400 hours above 2,000
A further RWF30 from 3,600 hours upward
Depreciation RWF400 up to 3,000 hours
RWF550 above 3,000 hours and up to 4,200 hours
Consumable supplies RWF12 per 100 hours
Heat and fans RWF45 from 1,200 to 2,000 hours inclusive
RWF55 above 2,000 hours and RWF60 above 3,000 hours
Power RWF15 per 100 hours up to 3,200
RWF12 per 100 hours for hours above 3,200
Cleaning RWF30 up to 2,800 hours
RWF40 above 2,800 hours
Repairs RWF75 up to 1,600 hours
Additional RWF25 for steps of 400 hours up to 3,200 hours
Additional RWF40 above 3,200 hours
Indirect wages RWF20 per 100 hours
Rent RWF180

Answer

(a) FlexibleBudgetper
(b) Fixed Budgetper
Month
Month
Hours ofwork 2,000 2,800 3,600 3,000

RWF RWF RWF RWF

Expense:

252 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Supervision 250 370 490 430
Depreciation 400 400 550 400
Consumablesupplies 240 336 432 360
Heat and fans 45 55 60 55
Power 300 420 528 450
Cleaning 30 30 40 40
Repairs 100 150 215 175
Indirect wages 400 560 720 600
Rent 180 180 180 180
1,945 2,501 3,215 2,690

Budgeted expense
(c) Departmental hourly overhead rate = Budgeted hours

rwf 2,690

3,000 = RWF0.8966

Notes:

(a) Supervision
This is a semi-variable expense, and it rises only when extra hours are worked - e.g.
when the number of employees increases, or when the firm increases the number of supervisors.
The allowance for 2,001 hours to 2,400 hours would be RWF310, and between 2,801 and 3,200
the allowance would be RWF430.

Following this line of reasoning, up to and including 3,600 hours would have an allowance
of RWF490. Anything above 3,600 would have a budget of RWF580 - i.e. including the extra
RWF30.

(b) Depreciation
This is normally a fixed expense - but fixed only within certain ranges of production
activity. Remember that no expense is fixed over a long period or over a wide range of production
activities.

(c) Consumable Supplies

This is a variable expense in this example - it rises or falls in a direct ratio to the
number of hours worked.

(d) Heat and fans

This is a semi-variable expense; probably the figures are based on past experience or a
technical estimate.

(e) Power
This is a variable expense but, at certain levels of activity, power is supplied at a
cheaper rate.

CPA EXAMINATION F2.1 Management Accounting 253

STUDY MANUAL
(f) Cleaning
This is a semi-variable expense.

(g) Repairs
Again, a semi-variable expense. Presumably, when the number of hours worked
increases, more repairs will be required - but not in a direct ratio to the increase in hours.

(h) Indirect Wages

These are, in this case, a variable expense.

(j) Rent
Here, this is a fixed expense.

(k) Calculation of Departmental Hourly Overhead Rate

It is most important to realise that this rate is always calculated from the fixed budget -
not from a flexible budget. This is because the rate has to be applied throughout the budget
period as it proceeds, and the actual level of output is not known until the end of the period, so
that we would not know which flexible budget to choose. Remember that the fixed budget is
used for planning purposes, the flexible budget for control.

The difference between the flexible budget at a certain level of activity and the actual cost
incurred is, as we know, termed a variance. This may be either favourable or adverse.

Example 3
The flexible budget for the transport department of a manufacturing company contains the
following extract:

Flexible Budget for Four-weekly Period

Ton-miles to be run 80,000 100,000 120,000

Costs: RWF RWF RWF
Depreciation 240 240 240
Insurance and road tax 80 80 80
Maintenance materials 160 190 190
Maintenance wages 120 120 160
Replacement of tyres 40 50 60
Rent 110 110 110
Supervision 130 130 130
Drivers’ expenses 200 400 600
1,080 1,320 1,570

In the four-weekly period No.7, the budgeted activity was 100,000 ton-miles but the actual
activity was 90,000 ton-miles. The actual expenditure during that period was:

254 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Costs: RWF

Depreciation 240
Insurance and road tax 80
Maintenance materials 165
Maintenance wages 115
Replacement of tyres 35
Rent 110
Supervision 130
Drivers’ expenses 315
1,190

Prepare a tabulation of the variances from budget in relation to period No.7.

Answer
Budgeted Flexed Actual Expense Variance
Activity Budget Expense

Ton-miles 100,000 90,000 90,000

Expense: RWF RWF RWF RWF
Depreciation (F) 240 240 240 -
Insurance and road tax (F) 80 80 80 -
Maintenance materials (SV) 190 190 165 25 saving
Maintenance wages (SV) 120 120 115 5 saving
Replacement of tyres (V) 50 45 35 10 saving
Rent (F) 110 110 110 -
Supervision (F) 130 130 130 -
Drivers’ expenses (V) 400 300 315 15 overspending
1,320 1,215 1,190 25 saving

Maintenance materials may cause a little difficulty. There is no indication in the problem at what
level of activity the rise from RWF160 to RWF190 takes place. From the information given, it
could be taken as 80,000 ton-miles or 99,999 ton-miles. You will have to make a decision on
which to take - but remember that the level of activity taken in the solution is
80,001 ton-miles and, above this level, the budgeted expense will be RWF190.

CPA EXAMINATION F2.1 Management Accounting 255

STUDY MANUAL
ZERO-BASE BUDGETING (ZBB)
Basic Approach
Some aspects of the budget are easy to quantify. For example, if the required output is
known then the materials budget can be calculated from known data - material usage per unit of
output, wastage, planned stock changes, expected losses, etc. However, many aspects of the
budget cannot be so easily quantified - the outcome of indirect and service areas cannot easily
be related to sales and production targets. In these areas, traditionally, an incremental approach
to budgeting has been adopted. Typically, the manager starts from his current head count and
activities and estimates how much more (or, in times of hardship, less) he needs.

The advantages of this approach are:

• It is based on known factors (current expenditure).

• It is probably the least time-consuming approach to budgeting.

But:

• It encourages an easy-going, ‘live and let live’ approach.

• Considerable inertia is built into the company’s procedures. Change will be difficult to
manage.
• Existing services are accepted as necessary without question, whereas a critical eye
might see worthwhile savings.

It was to combat the disadvantages of traditional budgeting that zero base budgeting (ZBB) was
introduced. ZBB is an attempt to eliminate unnecessary expenditure being retained in budgets. It
rejects the common approach of setting budgets by taking last year’s expenditure as the starting
point for this year’s budget, and instead requires that the budget be built up from scratch. In
this way activities are rejustified each year. The CIMA defines ZBB as:

• “A method of budgeting whereby all activities are re-evaluated each time a budget is formulated.
• Each functional budget starts with the assumption that the function does not exist and is at
zero cost. Increments of cost are compared with increments of benefit, culminating in the
planned maximum benefit for a given budgeted cost.”

The way in which ZBB is implemented will vary from one organisation to another, but the following
steps may be taken:

• The organisation is divided into decision units, each representing a readily identifiable part of
the business, such as a function, division, department or section.
• Managers will be required to prepare decision packages, i.e. documents defining the
objectives, targets and resources which will be needed. It may also be necessary to prepare
alternative budgets based on different levels of production or service.
• Where different levels of budgets are set for decision units, a grading of priorities will be
required in order to assist in the final choice of packages and allocation of available resources.

The technique is most useful when applied to service and support functions such as research
and development and administration, where there is considerable discretion as to the level of
expenditure, and it has been used in non-profit-making organisations such as local government.
When funds are scarce, such a technique is the only way of introducing new projects, as otherwise
existing projects always have first claim on the scarce resources.

256 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
Expenditure may be committed (the minimum essential to meet statutory requirements, for
example for safety, or to ensure operations continue). It may also be engineered (changing with
activity levels) or discretionary (depending on management, e.g. conference costs).

ZBB exercises are very time-consuming and costly and some organisations would only carry
out a full ZBB approach, say every three to five years, and would use previous years’ costs
and revenues as a starting point in the intervening years. There may also be communication
problems in explaining ZBB to managers, and lack of co-operation as managers see ZBB as a
threat to their ‘empires’ and status.

How the System Works

Where ZBB differs from the traditional approach is that managers must scrutinise very
carefully from scratch their future requirements In other words, in principle it ignores all
previous expenditure and performance associated with the company’s activities, and looks afresh
at these activities with a view to possible cost reduction, elimination of an activity, new ways
of achieving objectives, or redistribution of resources.

A company operating ZBB demands full co-operation and participation from its managers in
producing their respective assessments of requirements. They are made fully responsible for their
decisions. The process requires each manager to justify his total budget (and, subsequently,
justify the use of resources).

(a) Decision Packages

The system requires a manager to prepare decision packages for all activities (e.g.
projects, job functions) within his responsibility, and these packages must clearly lay out the
minimum level of performance essential, and any additional costs and additional benefits linked
with these costs. Decision packages must be produced where it is considered that there may
be alternative approaches (buy-in or sub-contract, for

example) and finally an indication (cost effect) of not continuing with any particular activity.
Decision packages represent units of intended activity.

Examples of activities within the management accountant’s responsibility could be: material
control unit; payroll purchase ledger; sales ledger; data processing unit. The manager of each of
these areas would be required to produce decision packages on the basis just outlined.

(b) Ranking and Evaluation

Having produced batches of decision packages, the manager would then rank them in
order of importance, after carrying out a cost/benefit analysis for each package. All packages
would then be forwarded to top management, who would compare and evaluate the relative
organisational needs, and fund accordingly - taking due note of high and low priority packages.
Their considerations would extend to those decision packages which might cover redundant or
duplicated activities.

(c) Need for Educated Managers

In using ZBB there is a strong inference that managers are well informed in the area of
information collecting and evaluation. They must, further, be trained in cost/benefit analysis, in
order to rank the decision packages. This is a potential weakness - not in the system of ZBB
itself, but in the means of producing it.

CPA EXAMINATION F2.1 Management Accounting 257

STUDY MANUAL
(d) Comparison with Traditional Budgeting
Whereas traditional budgeting paints with a very broad brush, assuming that all
activities will continue during the budget year, ZBB paints with a thin brush, providing very
fine economic detail (and, thus, fine control of individual activities and operations within the
organisation). Because the funding of activities is considered in detail by means of decision
packages, company resources are carefully directed and monitored.

Implications and Value of ZBB

• ZBB, in principle, starts from scratch but, in practice, it would start from a minimum cost level
for each activity, and build up decision packages by changing the inputs.
• This contrasts with traditional budgeting which assumes all activities are necessary and
continuing - there is very little ‘weeding out’.
• Managers are made aware of the corporate effect of their departments’ operations.
• ZBB allows questions to be asked before committing funds, and not afterwards, as in traditional
budgeting.
• Inefficient, redundant or obsolete operations are identified before the budget is
finalised.
• Greater managerial detail is available to the top management.
• Low and middle managers are made fully aware of the smallest details of the many
activities for which they are responsible.
• Managerial education must be at a very high level, with its attendant high training cost.

Question
A manufacturing company intends to introduce zero-based budgeting in respect of its service
departments.

(a) Explain how zero-based budgeting differs from incremental budgeting and explain the
role of committed, engineered and discretionary costs in the operation of zero-based
budgeting.
(b) Give specific examples of committed, engineered and discretionary costs in the
operation of zero-based budgeting.

Answer
(a) Incremental budgeting uses the budget of the previous year as a starting point and
adjustments are made for volume, price changes and efficiency. The basic structure of the budget
is regarded as acceptable as it stands.

Zero-based budgets place the onus on the departmental manager to justify all proposed
expenditure. Nothing is accepted as being necessary expenditure. Each department will need
to consider possible options for the year, which will be ranked and used to decide total budgets
within the overall master budget of the organisation.
The role of a committed cost in zero-based budgeting is to set the minimum level of expenditure
necessary for statutory requirements to be met or for business operations to take place.
An engineered cost is one that is incurred in proportion to activity. These differ under each level
of activity projected under zero-based budgeting.

Discretionary costs are those which management decide whether to incur or not. They will be
assessed on a cost/benefit analysis and accepted or discarded depending on the result.

258 F2.1 Management Accounting CPA EXAMINATION

STUDY MANUAL
(b) The following are examples of each kind of costs. You may have suggested others
relevant to your organisation.

Committed:

• Anti-pollution measures required by law

• A minimum level of maintenance and repair costs
• Requirement of a limited company to prepare annual accounts backed by adequate
accounting records; cost of audit

Engineered:

• Machine guards for each machine used

• Routine replacement of laser printer cartridges
• Costs of invoicing per order/statement per customer

Discretionary:

• Updating conferences; attendance expenditure

• Expenditure on management accounting function

BUDGETARY CONTROL AND STANDARD COSTING - BEHAVIOURAL

CONSIDERATIONS
Throughout our studies on budgetary control and standard costing, the emphasis has been on
the economic aspect. There is, however, another - and very important - side to the concept, and
this is the effect on the human beings who will operate - and be judged by - the budgetary system.

It was only in the 1980s that the results of years of study of interpersonal relationships percolated
into the field of management accountancy. It is now recognised that failure to consider the
effect of cost control on the people could result in a lowering of morale, reducing motivation
and company loyalty. The effect of this would be a reduction in profits or cost-saving.

Control Aspects of Budgeting

In preparing budgets in the first instance, managers should be consulted in respect of
their anticipation of costs which are controlled by them. It is true that an overall objective is set
by the higher levels of management, but the actual achievement of that objective is left for the
lower levels of management to plan.

Control is achieved by continuous comparison between actual and budgeted results. Instead of
using the term ‘variances’, as used in standard costing, it may be better to call them differences.

These differences could be related to how well managers are performing their functions. It
is necessary to relate the differences in results to performance indicators.
The ultimate purpose of preparing budgets and calculating variances (differences) between
actual and budgeted results is to initiate managerial action. In the case of controllable
variances, speedy authoritative action would result in stemming adverse variances or encouraging
favourable variances. In the case of non-controllable variances, caused by external factors,
swift management action to search for alternatives would be necessary.

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Levels of Management Information
It is necessary to consider the frequency of comparative information made available to
management at different levels. Lower levels of management require information speedily,
for example weekly, to stem adverse movements, while higher levels of management, to
prevent unnecessary paperwork, could receive summarised information, for example on a
monthly basis.

The information given to management should be in units easily understood by the level to which it
is directed. The lower levels may be more interested in labour or machine- hours or kg materials
used, while higher levels would require the information in monetary values.

Motivation and Co-operation

Any system of cost control, to be fully effective, must provide for motivation and
incentive. If this requirement is not satisfied, managers will approach their responsibilities in a
very cautious and conservative manner. Praise should be forthcoming if budgets are bettered:
unfortunately, it is losses and adverse variances which attract attention and investigation.

Personal goals and ambitions are strongly linked with organisational goals; these personal
goals may include a desire for a higher social standing and a betterment of the individual’s
status. To satisfy the goals of both the organisation and the individual, there must be goal
congruence. Without this mutual understanding, the economic atmosphere of the organisation
will be much less healthy.

The success of a budget procedure depends, at all times, on people. They must work within the
system in an understanding and co-operative manner. This can be achieved only by individuals
who have a total involvement at all stages of the budgetary procedure, and who share in its
favourable as well as its adverse revelations.

Results of Goal Antagonism

Some of the most damaging and negative results of non-motivation created by a
budgetary control system are:

• Suspicion of being manipulated by the budget system: it is seen as a pressure device.

• Competition between cost centres may arise and thus diminish the unifying effect of
budgetary control.
• A discouraging atmosphere will be created by failure to commend favourable results, and
by criticism of adverse results.

Other Effects on Management Behaviour

The way standard costing and budgetary control systems are used can influence
management behaviour in a number of other ways:

• Standard costing and budgetary control systems concentrate on the short term. It must be
recognised that managers may therefore be placed in a situation whereby they make decisions
that satisfy the short-term control systems but damage the future position of the business. For
example, a manager may decide to reduce hisresearch and development costs in order to
stay within budget. This may satisfy the short-term objectives but will clearly have long-term
implications for the business.

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• Standard costing and budgetary systems sometimes include in operating statements
a number of costs over which the manager has no control. This approach can be counter-
productive and demotivating as a manager cannot be held responsible for costs that he
cannot control.
• Unless constant vigilance is maintained it will be possible for managers to incur expenditure
but have it charged to another manager’s cost centre. This practice can result in conflict
within the business which can cause a great deal of harm.
• Managers may feel that they have fully to spend their budgets so as to justify their original
predictions and in so doing avoid having their following year’s budget reduced. This approach
may cause waste within the business.

STANDARD COSTING AND VARIANCE ANALYSIS

A. INTRODUCTION
Planning and Control
One of the principal objects of any management accounting system should be to assist in the
planning and control of operations. The techniques of budgetary control and standard costing
can help management carry out this vital function.

In this study unit and the next we will be looking at the objectives and methods of standard
costing; these will help you understand its purpose, the methods by which standards are set, the
procedures for calculating variances, and the interpretation of variances. In subsequent study
units we will look in detail at budgetary control.

Budgetary Control and Standard Costing Compared

Whereas budgetary control is concerned with the overall plans of the organisation and
assignment of responsibilities for control over revenues and expenditure, standard costing is
concerned with the establishment of detailed performance levels, together with the related costs
and revenues per unit and in total for the planned activities of the organisation.

Both budgetary control and standard costing have certain features in common:

• The setting of targets or standards

• The recording of actual results
• The comparison of actual results with standards (or budgeted)
• The computation of variances and their analysis
These all assist in defining the ‘gatekeeper’ role of the management accountant.

Definitions
The Chartered Institute of Management Accountants, in its terminology, gives the following
definitions:

(a) Standard Costing

A technique which uses standards for costs and revenues for the purpose of control
through variance analysis.

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(b) Standard Cost
A predetermined calculation of how much costs should be under specified working
conditions. It is built up from an assessment of the value of cost elements and correlates
technical specifications and the quantification of materials, labour and other costs to the prices
and/or wage rates expected to apply during the period in which the standard cost is intended to
be used. Its main purposes are to provide bases for control, through variance accounting, for the
valuation of stock and work in progress and, in some cases, for fixing selling prices.

Value and Use of Standards

We can see from these definitions that standards are compiled prior to production taking
place, and that they relate to specific assessments of physical quantities and cost. They
are, in fact, yardsticks against which actual quantities and costs or revenues can be measured.
If circumstances or conditions change, then a revision of standards will be required - so the
standards in use reflect the current specifications. The standards may also be subject to
annual or periodic updating.

B. TYPES OF STANDARD COST AND SYSTEM

Ideal Standard Costs
These are based on ideal conditions - i.e. 100% efficiency is expected from workers,
machinery and management: it is only in an automatic and very efficiently run factory that ideal
standard costs are likely to be achieved.

Attainable Standards
These are based on attainable conditions, and they are more realistic than ideal
standard costs. Provided that all the factors of production are made as efficient as possible
before the standards are set, the standard costs are likely to be of great practical value.
They represent, to workers and management, realistic figures, capable of achievement. The
variances really do mean increased or reduced efficiency.

Basic Standard Costs

These are a special type of standard cost. The idea is to select a ‘base year’, and then
set the standards (ideal or attainable at that time). The standard costs then remain in force for
a number of years without being revised.
Their main advantage is that trends in costs over a number of years can be seen quite easily.
Another advantage is that the actual value of stocks is known - and so there is no problem of
converting standard costs to actual costs for use in final accounts. This assumes, of course, that
it is desirable to use the actual cost of the stocks. There is a tendency to advocate the use of
the standard costs for stock valuation and, if this view is taken, there is no disadvantage in using
ordinary standard costs.

The chief weakness of basic standards is that they do not allow the efficiency achieved to be
measured.

Current Standard Costs

These are standard costs which represent current conditions - i.e. they are kept up-to-
date. Ideal standards and attainable standards are current standard costs, which are changed
when conditions change (normally once a year).

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C. SETTING STANDARDS

• Direct Materials
• Direct Labour
• Variable Overheads
• Fixed overheads
• Sales Variances

Essential Prerequisites
(a) Before manufacturing costs can be predetermined, the following factors must be stated:

• The volume of output.

• The relevant, clearly-defined, conditions of working (grade of materials, etc.).
• The predetermined level of efficiency.

Each element of cost - material, labour and overhead - must be taken in turn, and the standard
cost for each product determined. The object must be to ascertain what the costs should be, not
what they will be.

(b) Before any attempt is made to set the standards, all functions entering into production
should be examined and made efficient. Only then will it be possible to have standard costs
which represent true measures of efficiency.

(c) The following have then to be predetermined:

• Standard Quantities
Due allowance should be made for normal losses or wastage. Abnormal losses should be excluded
from the standards, as these are not true costs.
• Standard Prices or Rates
The aim should be to estimate the trend of prices or rates, and then predetermine these having full
regard to expected increases or reductions.
• Standard Quality or Grade of Materials, Workers or Services
Unless the appropriate grade of material or worker is clearly defined when the standards are set,
there will be great difficulty in measuring accurately any variance which may arise. A lower-grade
material may mean an adverse material usage variance and a favourable material price variance
- the one tending, to some extent, to cancel out the other. This sort of situation is bound to
arise, unless materials are standardised and the appropriate grade for a product strictly defined: all
variances are, in some way, related to each other.

Application of Standard Costing

Standard costing is applied most successfully to continuous or repetitive operations, where
large volumes of a standard product are produced. The application of standard costing
principles to job costing systems is more difficult, as products will vary - each one may be unique.
As the products themselves are not standardised, the emphasis will be on the machines
and operations concerned. Standard feeds and speeds for machines may be developed, as well
as output for handwork operations. These standards will then be applied to the specifications
for individual products.

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Setting Standard Costs for Direct Materials
The product is analysed into its detailed material requirements, and all the materials are
listed on a form called a standard material specification.

(a) Material Quantities

Determination of material quantities may be accomplished by one of the following
methods:

• Referring to past records - e.g. stores records kept when historical costing was adopted.
• Making a model of the product, noting all significant facts when the test runs are carried out.
• Establishing the relationship between the size or weight of the product and the material content,
thereby calculating the standard quantity - in the case of screws, for example, the weight of the
screws will indicate the metal content, and a standard quantity can then be fixed.

Great care must be exercised in calculating a reasonable allowance to cover

unavoidable material wastage - owing to cutting, for example.

(b) Material Prices

Standard prices for materials will be set by the purchasing officer and the accountant.
The actual practice adopted can vary from company to company. Some companies set standards
based on what is expected to be the average price ruling during the budget year. This has the
effect of over-costing products during the first half of the year, and under-costing them during the
second half. These differences are called variances; we will cover their calculation in the next
study unit.

An alternative approach is to set standard prices based on actual prices ruling on the first day
of the new financial year. This can be completed before the year begins, as suppliers generally
notify price increases in advance. As standards are based on actual

prices at the beginning of the year, it is necessary to calculate a budget for material price
variances which is the company’s estimate of the impact inflation will have on material prices.

This approach has the advantage that costs are based on actual prices and not on forward
estimates which may or may not be accurate. The standard cost represents the actual cost on
the first day of the year and can be used with confidence by the marketing team. As the
year progresses the actual material prices will be compared with these standard prices and the
financial impact on the company calculated. By comparing actual prices with the prices ruling
on the first day of the year, it is possible to get an accurate assessment of the rate of inflation
applicable to material purchases. This information will be compared with the forecast rate of
inflation built into the company’s budget, and can be used to assess the need for selling price
adjustments or other corrective actions.

(c) Standard Cost

The standard cost is obtained as follows:

Standard quantity Standard price

This will be done for each type of material, and the totals added together to arrive at the
standard material cost for the product.

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Setting Standard Costs for Direct Labour
An analysis of the operations required to manufacture each product will be essential before
the standards are set. The correct grade of worker for each operation must also be
established.

(a) Standard Time for Each Operation

The standard time for each operation will be set by one of the following methods:

• Referring to past records, and then adjusting to allow for any changes in conditions.
• Use of time-studies based on work study. Each element of an operation is timed, and
then a total standard is determined by adding together all the element times and adding on
allowances for relaxation, interruption, etc.
• Employment of synthetic time-studies. This is really a combination of (a) and (b). Detailed
records are built up by the use of the time-studies, and then, from these records, the appropriate
elemental times are selected to arrive at the total standard time for any operation which has not
been timed.

(b) Standard Wage Rates

As with material prices, the actual practice adopted will vary from company to
company. Some companies base their standards on what they expect to be the average rate
during the budget year. This means that they have to anticipate wage increases and changes in
methods. An alternative approach is to base standard labour costs on the rates and methods
applicable on the first day of the financial year, and then forecast variances based on projected
wage increases and changes in methods. In this way the standard labour cost for each product
represents the actual cost on the first day of the financial year, and provides similar advantages
to those which we outlined in the previous section on material prices.

When an incentive method of payment is in operation, setting the standard rate may be relatively
simple. For example, for a piece-rate system, the standard rate will be the fixed rate per piece.
To avoid having too many rates, average rates may be used.

To summarise, the standard cost for direct labour is:

Standard direct labour-hour Standard direct labour rate

Setting Standard Costs for Overheads - Variable
- Fixed

Overhead costs are often the most difficult costs to predetermine.

(a) Preliminary Classification

One of the first steps will be to divide such costs into the following three classes:

• Fixed overhead costs

• Variable overhead costs
• Semi-variable overhead costs

(i) Fixed Overhead Costs

In this class, the total remains the same irrespective of output, and they are often known as
policy costs. Top management determines the extent of the fixed costs when formulating
policy.

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(ii) Variable Overhead Costs
In this class, the total increases with increased output, and reduces with decreased output,
since variable overhead costs are fixed at so much per unit of output or standard hour. For
example, the rate may be RWF0.35 per unit - so, for each additional unit of output to be
produced, a further RWF0.35 must be included in the budget.

(iii) Semi-variable Overhead Costs

These are partly fixed and partly variable, and they have to be divided into two parts - thus
showing quite clearly the fixed element and the variable element. Once the division has
been made, predetermination of the costs is greatly facilitated. The two methods used for
separating fixed and variable costs are both statistical techniques:

• Use of a regression chart

• Use of the method of least squares

(b) Determination of Standard Amounts

This may be done by using past records or by using a form of time-study, when work
can be divided into work units. For example, it may be possible to estimate the requirements
so far as factory cleaners are concerned by fixing a time per square yard of floor for sweeping,
washing, or other appropriate tasks.

The volume of output must be predetermined, especially so that total variable costs for each type
of expense may be calculated. Particular attention must be paid to the allowances to be made for
normal time losses (labour absenteeism, waiting for material, tools, etc.) and also the abnormal
time losses owing to a falling-off in the volume of sales. It has been suggested that up to 20%,
or even more, may have to be deducted to arrive at a ‘normal capacity to manufacture’, and
a further 20% or thereabouts deducted to arrive at a figure to cover losses of sales (known
as the ‘normal capacity to produce and sell’). In the latter case, the long-term (say, six or seven
years) figures are taken, and then a net yearly average is calculated.

(c) Preparation of Budgets for Factory Overheads

Once the appropriate capacity has been selected and the costs have been classified into
fixed or variable, the factory budgets can be prepared. Usually they are prepared departmentally
- i.e. a separate budget for each cost centre or department. The hourly rate (machine-hour
or direct labour-hour) is then calculated for each cost centre, and applied on the appropriate
standard cost card

For each volume of output, it is possible to have a cost equation, which may take the following
form:
(Variable Units to) Total for each class of expenses = Fixed costs + (cost per unit be made)

The ‘units to be made’ may be expressed in terms of physical units or in standard hours. The
variable cost per unit will have been ascertained from the direct material and labour content,
together with variable overheads. Once the variable cost per unit has been calculated, the
budget may be built up stage by stage, by entering each expense, and then its amount.

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Note in particular the fact that in practice two types of budget are in use:

• Fixed Budget
This shows the output and costs for one volume of output only; it thus represents a rigid plan.
• Flexible Budget
A number of outputs will be shown, together with the cost for each type of expense. The
fixed costs will be the same for all volumes of output, whereas the variable costs will increase
with increases in activity.
Standard Product Costs
Standard product costs are compiled for each product made. This is done by bringing
together the standard product materials specifications, the standard operations,
the performance standards, and the standard rates. A standard product cost card is
shown in Figure 5.1.

Machine Time or Operator Time

So far, the standard rates for labour and overheads have been expressed in terms of operator
time. However, in some circumstances the direct process time is relevant to the machine- hour,
rather than the labour-hour. In these cases, labour and overhead are expressed in terms of a
machine-hour rate.

STANDARD PRODUCT COST

Product Group: elds Part No. - S12

Supershi

UNIT - PER PART

Standard materials Std Qty Std Price Cost Work-in-progress

spec.
lb RWF RWF RWF
EN 2.A.1.25 steel 30.0 0.04 1.200 1.200
Scrap and swarf* (12.0) 0.004 (0.048) (0.048)

Standard mtls cost 18.0 1.1520 1.1520

Standard operations Std time Std m/c Cost
hr rate

Std hrs RWF RWF

Press out on 70 ton
Press 0.01 1.32 0.0132 1.1652
Turn on capstan 0.04 1.26 0.0504 1.2156
Braze 0.02 1.22 0.0244 1.2400
Pack 0.05 1.20 0.0600 1.3000

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Works std cost 1.3000
Admin. overhead -
10% of wks std 0.1300
Costs
Selling overhead -
3% of wks std 0.0390
Cost
Total std cost 1.4690
Std selling price 1.60
Std gross margin
(on wks std
cost) 18.75% 0.30

(on wksstd
cost)
(*Brackets denoteaminus figure.)
Figure 5.1: Standard Product Cost Card

Computerised Systems
The standard-setting process is enhanced if the company has invested in computerised
Material Requirements Planning (MRP) systems which require a detailed breakdown of every
component and sub-component used in the finished product. These systems are used in the
production planning and purchasing functions, and allow companies to ‘explode’ the forecast
production programme into a detailed list of all the material and components required to
manufacture it. This requirement can then be compared with the company’s stock positions so
that order quantities can be calculated. It is therefore relatively easy to add the standard cost
of each component to the computer system, which then enables the computer to calculate the
standard cost of each product. The purchasing system is often linked into MRP systems and as
a result it is also possible to update standard costs to actual costs.

D. TYPES OF VARIANCE
The difference between a standard cost (or budgeted cost) and an actual cost is known as a
variance.

Favourable and Adverse Variance

Variances may be favourable or adverse. If actual cost exceeds standard or budgeted cost,
then the variance is adverse. On the other hand, if actual cost is less than standard or budgeted
cost, then the variance is favourable. Note that overhead volume variance is an exception to
this general statement. An adverse variance is usually shown in brackets.

Classification According to Cost Element

To make the variances as informative as possible, they are analysed according to each
element of cost - i.e. material, labour and overhead. A further analysis is then made, under each
heading (material, etc.), according to price and quantity.
We will be discussing further subdivisions of some of these variances later.

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E. THE STANDARD HOUR
CIMA Definition
Perhaps the most satisfactory way of explaining this expression is to consider the definition
put forward in the CIMA terminology. This defines the standard hour/minute as:

The quantity of work achievable at standard performance, expressed in terms of a standard

unit of work in a standard period of time.

Measure of Output Achieved

From this definition, you can see that a standard hour refers to a measurement of output,
and not to the physical passage of time. If an operative works harder than envisaged by the
standards, he may produce 1.25 standard hours within the physical time of 60 minutes; and,
conversely, if he works more slowly than standard he may only produce 0.75 standard hours in
60 minutes.

In assessing output, the time passage will be 60 minutes and the number of units produced in that
time will be recorded to establish the output of a standard hour. Suppose a factory produces
rulers, and in 60 minutes it is observed that an operative can produce 400 rulers, then 1
standard hour’s output will be assessed at 400 rulers. Further, suppose that, in the course
of an 8-hour day, the output of an operative was 3,600 rulers; on the basis of the agreement the
output would be assessed at 9 standard hours.

Note: 9 standard hours have been produced in 8 clock hours. This distinction between
standard hours and clock hours is vital to the statistics of standard costing.

Example
AB & Co. Ltd produces cars of differing engine capacity, the output being assessed in
standard hours as shown overleaf:

Engine Capacity Standard Hours

Per Unit

1,000 20

1,500 32

2,000 40

2,600 50

The output statement for a week could then be shown in the following way:

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AB & CO. LTD

OUTPUT - WEEK NO. 14

Product Standard No. of Output in

(Engine Hours per Unit Cars Standard

Capacity) Produced Hours
1,000 20 120 2,400

1,500 32 140 4,480

2,000 40 30 1,200
2,600 50 25 1,250
9,330

Obviously, when there are changes in methods of production, output comparisons week by week
will not be valid. The figures produced above are not affected by changes in rates of pay or any
change in the value of money.

The standard overhead cost is expressed as:

Standard hours Standard overhead rate

F. MEASURES OF CAPACITY
CIMA Definitions
The CIMA terminology includes three measures of capacity:

(a) Full Capacity

Production volume expressed in standard hours that could be achieved if sales orders,
supplies and workforce were available for all installed workplaces.

(b) Practical Capacity

Full capacity less an allowance for known unavoidable volume losses.

(c) Budgeted Capacity

Standard hours planned for the period, taking into account budgeted sales, supplies and
workforce availability.

Level of Activity Ratios

Using the above measures as a starting point, various ratios can be developed to show the
level of activity attained, and the efficiency of production. The CIMA terminology refers to three
ratios: idle capacity, production volume and efficiency.

You can see that full capacity refers to an ideal situation, where there are no losses of any
kind. Practical capacity reflects an attainable level of performance, while budgeted capacity takes
into account anticipated conditions in relation to sales, production and labour facilities which will
be available.

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Let’s assume the following data for an accounting period:
(a) Practical capacity expressed in standard hours 10,000

(b) Budgeted capacity in standard hours assuming 80% efficiency 8,000

(c) Standard hours produced 7,000

(d) Actual hours worked 8,500

The following ratios can be produced:

(i) Idle capacity ratio
( a) ( b) 10,000 8,000
20 per cent
a 10,000

(ii) Production volume ratio

(c) 7,000
(b) 8,000 87.5 per cent

(iii) Efficiency ratio

8,500
X 100 = 85%
10,000

G. LIMITATIONS OF STANDARD COSTING

There are criticisms of the appropriateness of standard costing in the modern industrial
environment. The main ones include:

• Standard costing was developed when the business environment was more stable and
operating conditions were less prone to change. Stable conditions cannot be assumed in
today’s dynamic environment.
• Performance to standard used to be considered satisfactory, but constant improvement must
now be aimed for in order to remain competitive.
• The emphasis on labour variances is no longer appropriate with increasingly automated
production methods.

A business’s decision to use standard costing must depend on its effectiveness in helping
managers make correct decisions. Standard costing may be useful even where the final
output is not standardised. It may be possible to identify various standard components and
activities for which standards can be set and used effectively in planning and control. Also,
the use of demanding performance levels in standard costs may help to encourage continuous
improvement.

Remember that if comparison between actual and standard cost is to be meaningful, standards
must be valid and relevant, so it is important for standard cost to be kept as up-to-date as possible.
Frequent updating of standards may be required to ensure that they fairly represent the
latest methods and operations, and the latest prices which must be paid for the resources being
used.

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H. PURPOSE OF VARIANCE ANALYSIS
Guide to Management Action
Having established quantity standards for sales, materials and direct labour with the relevant
standard sales and cost values, actual operational results are compared with the standard
allowances. The differences between the money values for the actual and standard results are
known as variances. These variances are intended as a guide to the management, to identify the
causes of discrepancies between actual and standard performance and to provide a basis for
corrective action and decision-making.

Follow-up Procedures
It is important that follow-up procedures are established to investigate the causes of
significant variances - otherwise the full benefits of standard costing will not be realised.

I. MEANING AND POSSIBLE CAUSES OF VARIANCES

In studying the analysis of variances, you should not only understand the techniques of the
calculations but also the meaning and possible causes of variances.
Scheme of Analysis: Absorption Costing
Variances are calculated for

• Sales
• Direct wages
• Direct materials
• Variable overheads
• Fixed overheads

In each case, the variances are classified according to their nature - whether price, efficiency or
volume - each type of variance having its own title. The analysis of variable and fixed overheads
will depend upon whether absorption or marginal costing methods are used. In the following
calculations, absorption costing principles are adopted. The forms of analysis used when
marginal (variable) costing methods are employed will be given later. The chart in Figure 6.1
shows the main variances produced under absorption costing methods.

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The variances can be summarised as follows:

Sales - Sales margin price variance

Sales margin volume variance

Direct wages - Wage rate variance

Labour efficiency variance

Direct materials - Materials price variance

Materials usage variance

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Variable overheads - Variable overheads expenditure variance
Variable overheads efficiency variance

Fixed overheads - Fixed overheads expenditure variance

Fixed overheads volume variance, divided into:
- Capacity variance
- Efficiency variance

There are also other sub-variances for sales, direct materials and direct wages.

Variance Calculations
In our calculations we shall assume that an organisation has the following estimated (or
budgeted) and actual results:

Budgeted Results

RWF RWF

Sales (10,000 units at RWF20 per unit) 200,000

Costs

Direct materials (10,000 kg at RWF4 per kg) 40,000

Direct wages (20,000 hours at RWF3 per hour) 60,000

Variance overheads (20,000 hours at RWF2 per 40,000

hour)

Fixed overheads 20,000 160,000

Net profit RWF40,000

Actual Results

RWF RWF

Sales (9,500 units) 185,000

Direct materials (9,800 kg) 38,500
Direct wages (19,400 hours) 56,000
Variable overheads 37,500
Fixed overheads 19,500 151,500
Net profit RWF33,500

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The standard selling price and costs per unit can be calculated from the budgeted figures as
follows:

Per Unit

RWF
Selling price 20
Direct materials (1 kg at RWF4) 4
Direct wages (2 hours at RWF3) 6
Variable overheads (2 hours at RWF2) 4
Fixed overheads (2 hours at RWF1) 2
16
Standard net profit per unit 4

(a) Direct Materials

The standard cost for direct materials is made up of two parts:

• Standard quantity
• Standard price

Where the actual quantity differs from the standard quantity, there will be a usage variance.
Where the actual price differs from the standard price, there will be a price variance.

• Direct Materials Price Variance

The formula for calculating the materials price variance is:
(Actual quantity Actual price) (Actual quantity Standard price) This may be abbreviated to:
(AQ AP) (AQ SP) = (AP SP) AQ

Using the figures given, the price variance may be calculated:

AQ AP AQ SP
9,800 RWF4
RWF38,500 RWF39,200

Price variance: RWF38,500 RWF39,200 = RWF700 (we ignore the minus sign, but must
decide whether the variance is favourable or not - see below).

The AQ AP calculation had already been given, RWF38,500, so that no additional

calculations were required. Questions may sometimes be set where it is necessary to multiply
the actual quantity used by the actual price.

Having calculated that there is a variance of RWF700, we must now determine whether it is
favourable or adverse. Had the company paid the standard price for the material, the cost
would have been greater than the actual amount paid. So there is a favourable (F) variance in
this case.

The variance could also have been calculated by using the following formula: AQ (AP SP)
The actual price per kg is: RWF38,500 ÷ 9,800 = RWF3.93

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STUDY MANUAL
The formula then becomes:

9,800 (RWF3.93 RWF4) = RWF686 (difference owing to rounding)

Reasons for the Variance

An essential part of variance analysis is to look at the possible reasons for, or possible causes of,
the variances. The materials price variance can be attributed to the purchasing department.
Where the actual purchase prices are below standard prices, the difference may arise from
special purchase terms, discounts, a general reduction in prices, or the purchase of lower-quality
materials.

Where the purchase prices are above standard, the cause may be a general rise in prices, a
change in materials specifications, or the purchase of smaller quantities from more than one
supplier, with a loss of discounts or less favourable terms.

• Direct Materials Usage Variance

The formula for calculating this variance is:
(Actual quantity Standard price) (Standard quantity Standard price) This may be abbreviated to:
(AQ SP) (SQ SP) = (AQ SQ) SP The calculation from our data is
AQ SP SQ SP
9,800 kg RWF4 = RWF39,2009,500 kg RWF4 = RWF38,000

Usage variance = RWF1,200 (adverse)

The variance is adverse, because there was an excess usage of 300 kg of material which, at the
standard price of RWF4 per kg, caused a variance of RWF1,200.

Note that, in calculating the standard quantity of material, the amount is based on the actual
units sold - not the budgeted quantity, otherwise the variance would not be meaningful. This
procedure of adjusting the budget figures is usually known as flexing the budget.

Reasons for the Variance

The material usage variance is primarily the responsibility of the factory foreman or supervisor.
It may be caused by faulty machinery; loss or pilferage; excess wastage; lower quality of
materials; faulty handling; or changes in inspection or quality standards.

A summary of the direct material cost variances is:

RWF RWF
Actual cost 38,500
Price variance 700
(favourable)

Usage variance (1,200) (500)

(adverse)
Standard cost RWF38,000

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(b) Direct Labour
The direct labour standard cost is made up of direct labour hours multiplied by the
standard direct labour wage rate. Both the actual labour hours and actual wage rates may differ
from the standards, and it is necessary to separate these two differences in order to analyse any
variation between standard costs and actual costs. As shown in Figure 6.1, the two variances
are direct wage rate variance and direct labour efficiency variance.

• Wage Rate Variance

This is equivalent to the materials price variance, as it reflects the difference in the price or rate
paid for direct labour hours.
The formula is:
(Actual hours Actual rate) (Actual hours Standard rate)
or (AH AR) (AH SR) = (AR SR) AH Using our data, the calculation is:
(AH AR) (AH SR)
19,400 hrs RWF3
RWF56,000 RWF58,200
Wage rate variance = RWF2,200 (favourable)

The variance is favourable, since the actual cost is below the standard cost for the actual hours
worked.

Reasons for the Variance

The wage rate variance can be caused by changes in wage rates not provided for in the
standards, or the use of a different class or grade of labour from that specified in the standards.
Unscheduled overtime premiums or shiftwork rates may also account for variations in labour
rates. Where wage rates have changed since the standards were prepared, the variance will not
be within the control of managers. Where a different grade of labour is used from that specified,
the manager or foreman may be held responsible, and the matter would require further
investigation.

• Direct Labour Efficiency Variance

The standard hours for direct labour were produced on the assumption of a given level of output or
performance. These hours multiplied by the standard direct labour hourly rate give the standard
cost per unit.

The formula for the labour efficiency variance is:

(Actual hours Standard rate) (Standard hours Standard rate)

or (AH SR) (SH SR) = (AH SH) SR Using our data, the relevant calculations are: AH SR
SH SR
19,400 hrs RWF3 - 19,000 RWF3

RWF58,200 - RWF57,000
Labour efficiency variance = RWF1,200 (adverse)

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Note that the actual sales of 9,500 units were below the budgeted amount of
10,000 units. In order to make a relevant comparison between actual and standard
hours, the standard must be based on the equivalent standard time for
9,500 units:
9,500 2 hours = 19,000 hours

Reasons for the Variance

The responsibility for the labour efficiency variance will, generally, rest with the supervisor or
factory foreman. It may arise through the use of a different machine or machines from
those specified; machine breakdown; lack of maintenance of plant; the use of defective or sub-
standard materials; the use of different grades of labour from those specified; changes
in operating arrangements or inspection standards; or faulty rate-setting. Delays in production
can also arise from lack of instructions or bad organisation.

The labour cost variances can be summarised as follows:

RWF RWF
Actual cost 56,000
Wage rate variance 2,200
(favourable) Labour
efficiency variance (adverse) (1,200) 1,000
Standard cost RWF57,000

(c) Variable Overheads

These overheads are related to volume of production or sales. Variable production
overheads may be related to machine or direct labour hours, or as a percentage of costs,
depending upon which is most appropriate. From our data, it is clear that the variable overheads
have been calculated in relation to direct labour hours.
The analysis of variable overhead variances follows the pattern already illustrated for direct
materials and direct labour costs. In this case the variances are the expenditure and the efficiency
variance.

• Variable Overhead Expenditure Variance

The formula is:
(Actual variable overhead) (Actual hours Standard rate)
or AVO (AH SR)
The figures from our data are: AVO AH SR
19,400 RWF2
RWF37,500 RWF38,800 = RWF1,300 (favourable)

The actual overhead incurred is below the standard cost of the hours worked.

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Reasons for the Variance
The variance indicates that the total of the individual items making up the variable cost
is below the standard cost of those items for the number of hours worked. It will be necessary
to examine each item in detail in order to show the causes of the difference. The costs
covered under this heading will be the variable elements of indirect wages, indirect materials
and indirect expenses. It will also be necessary to establish which managers or executives are
responsible for the control of these costs.

• Variable Overhead Efficiency Variance

The formula is:
(Actual hours Standard rate) (Standard hours Standard rate)
or (AH SR) (SH SR) = (AH SH) SR Using the figures from our data:

AH SR SH SR
19,400 RWF2 19,000 RWF2
RWF38,800 RWF38,000 = RWF800
(adverse)
As with the calculation for labour costs, the standard hours are based upon actual output.

Reasons for the Variance

The variable overhead efficiency variance follows the same pattern as that for the calculation
for direct labour efficiency and therefore the same causes will apply.

Summary of variable overhead variances:

RWF RWF
Actual variable cost 37,500
Expenditure variance 1,300
(favourable)
Efficiency variance (adverse) (800) 500
Standard cost RWF38,000

(e) Sales Variances

Under absorption costing methods, the sales variances are based on profit margins.
The two main variances are the sales margin price variance and sales margin volume variance.

• Sales Margin Price Variance

This variance is intended to show the difference in profit arising from changes in
the standard selling price. In our data, actual sales were 9,500 units, which resulted in a sales
value of RWF185,000. Had the units been sold at the standard selling price of RWF20, the sales
value would have been 9,500 RWF20 = RWF190,000. The loss of profit arising from the
variation in selling prices is RWF5,000. This variance is adverse, since selling prices were
below the standard price. Expressed as a formula this becomes:
[(Actual quantity Actual selling price) Standard cost]
[(Actual quantity Standard selling price) Standard cost]
= [(AQ ASP) SC] [(AQ SSP) SC]

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RWF185,000 RWF152,000 RWF190,000 RWF152,000
= RWF33,000 = RWF38,000 = RWF5,000 (adverse)
The standard cost of RWF152,000 represents 9,500 units at RWF16.

Reason for the Variance

This variance, together with the sales margin volume variance, is the responsibility of
the sales department. The change in selling prices may have resulted from sales at specially
discounted prices or from allowances for quantity purchases. The company might operate in
an industry in which prices are determined by market leaders, and it may be forced to follow the
market trends. The sales department must also check that price concessions given by its sales
staff are justified, and take care that any major price reductions are authorised by senior staff.

• Sales Margin Volume Variance

This variance shows the profit or loss arising from changes in sales volume.
The formula is:
(Actual quantity Standard margin) (Budgeted quantity Standard margin) (AQ SM)
(BQ SM)

9,500 RWF4 10,000 RWF4

RWF38,000 RWF40,000 = RWF2,000 (adverse)
The result shows that there is a loss of profit of RWF2,000, because 500 fewer units were sold
than were budgeted.

Reasons for the Variance

This variance may be caused by internal factors (through failure to achieve sales targets set in
the budget) or sales targets for representatives may have been set too optimistically and not
be attainable in practice. External factors might include a general depression in the industry
concerned, or the entry of new competitors.

Analysing Variances: Marginal Costing

The variance analysis has so far been based on a system of absorption costing. Under a
variable or marginal costing system, there would be only one variance for fixed overheads - the
expenditure variance - as, in this method of costing, all fixed overheads would be charged
to the accounting period concerned, and no allocations would be made to production units. The
fixed overhead variances for capacity and efficiency would not apply but it would become part of
the sales margin volume variance.

J. RELATIONSHIPS BETWEEN VARIANCES AND INVESTIGATION OF

THEIR CAUSES
Interrelationship of Variances
Variances may be interrelated through some connecting factor. Frequently, a favourable
variance for one cost factor may result in an adverse variance for another. Lower-quality
materials may be purchased, giving a favourable materials price variance. However, this possibly
results in production delays or difficulties - giving an adverse variance for labour efficiency. A
lower, less skilled, grade of labour may be used at a lower rate of pay - producing a favourable
direct wage rate variance. This may result in extended production times - giving an adverse
labour efficiency variance. Similarly, a greater volume of sales may be achieved by selling at
lower prices than standard - giving a favourable sales volume variance but an adverse sales

280 F2.1 Management Accounting CPA EXAMINATION

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price variance. These (and other) linking causes should be considered in analysing standard
costing variances, so that individual variances are not considered in isolation.

Significant Variances
As we have already noted, the full benefits of standard costing will not be realised unless
variances are analysed and investigated, and corrective action taken where shown to be
necessary.

Not every variance will justify the time and expense of investigation, and some consideration
must be given to determining what are to be regarded as significant variances. Minor
variations, either in terms of money value or as percentages of the amounts involved, need
not call for investigation. It will be necessary to decide for each element of cost the control
limits within which variances can be allowed to occur without investigation. Upper and lower
control limits may be set, and only when variances are outside these limits will investigation
be required.

(a) Materials Price, Mix and Yield Variances

In process industries it is common for two or more materials to be mixed together to
produce a new material. There will be a standard specification for the proportion of each
material to be used - a standard mix, or mixture - which will also specify the allowance for normal
wastage from a given input of material. This specification will usually be a standard batch of
mixture, according to the normal quantity of input, to produce a given volume of output. This type
of operation can lead to variances arising from variations in the mix of materials or the amount of
wastage incurred, and the yield obtained from a given input. The material usage variances can
therefore be analysed to show the causes arising from these two factors.

Example
A company mixes three chemicals together to produce a new material for further processing.
The standard specification is:

Input per batch 1,000 kg Quantity Price per kg

material (kg) RWF
A 500 1.00
B 300 3.00
C 200 5.00
The standard output per batch is 900 kg.
During an accounting period in which five batches of the mix were processed, the
following results were recorded:

Input Quantity Price per kg

(kg) RWF
A 2,500 1.20
B 1,600 2.80
C 900 5.20
5,000

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STUDY MANUAL
Output for the period: 4,320 kg
There are three variances - price, mix and yield. The price variance is already familiar to us.
The mix variance represents the gain or loss arising from departures from the standard
percentages or proportions in which materials are mixed.

The yield variance represents the gain or loss arising from greater or smaller wastage than
that specified in the standard.

The steps in the analysis are:

(a) Calculate the actual cost of input.
(b) Calculate the standard cost of the actual input.
(c) Restate the total input quantity in the standard proportions specified.
(d) Calculate the standard input required for the actual output, and multiply by the standard
cost to give the standard cost of the actual output.

282 F2.1 Management Accounting CPA EXAMINATION

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The calculations are as follows:

The variances are:

(a) (b) materials price variance: RWF12,160 RWF11,800
= (RWF360) (adverse)

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(b) (c) materials mix variance: RWF11,800 RWF12,000
= RWF200 (favourable)

(c) (d) materials yield variance: RWF12,000 RWF11,520

= RWF(480) (adverse)

Summary: RWF RWF

Actual cost 12,160
Materials price variance (360)
Materials mix variance 200
Materials yield variance (480)

Net variance (640)

Standard cost of actual output RWF11,520

Interpretation of Variances:

• Materials Price Variance

As we described earlier, this variance shows the gain or loss where purchase prices differ from
standard.
• Materials Mix Variance
This variance shows the gain or loss arising from a change in the input mixture.
Our actual mixture used more of the cheaper materials A and B and less of material C - giving a
favourable mix variance when the same mix is stated in standard proportions. Enquiries would
be needed to find the reason for the change in mix - shortage of the required materials or human
error in preparing the batch mixes.
• Materials Yield Variance
This variance shows the gain or loss arising from excess or lower than standard
wastage allowances. 4,800 kg should have been used to produce the output of
4,320 - bearing in mind that the standard loss is 10 per cent of input. The excess usage might
have been caused by using the cheaper materials in the batch mixtures. The variance of RWF480
represents the standard cost of the excess 200 kg, valued at standard prices.

(b) Sales Variances

In the same way as the materials usage mix can be subdivided, so the sales volume
variance can be further analysed into mix and volume variances, where more than one product
is sold. These additional variances show the gains or losses arising from a change in the
composition of sales. Different products are likely to have different profit margins - therefore,
although gross sales figures may be above budget levels, the profitability of sales may not be
as high as budgeted if more units are sold of a less profitable product.

284 F2.1 Management Accounting CPA EXAMINATION

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Example
Out of Style Ltd has the following budgeted and actual sales for an accounting period:

Budget

Product Units Selling Price Standard Cost Standard Profit

per Unit per Unit per Unit

RWF RWF RWF

A 5,000 10.00 8.00 2.00
B 2,000 30.00 20.00 10.00
C 3,000 15.00 6.00 9.00
10,000

Actual

Product Units Selling Price Standard Cost Actual Profit

per Unit per Unit per Unit
RWF RWF RWF

A 6,000 11.00 8.00 3.00

B 3,000 28.00 20.00 8.00
C 2,000 13.00 6.00 7.00
11,000

CPA EXAMINATION F2.1 Management Accounting 285

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286 F2.1 Management Accounting CPA EXAMINATION
STUDY MANUAL
Variances:
Sales price margin variance

(a) (b) = RWF56,000 RWF60,000 = (RWF4,000) (adverse)

Sales mix margin variance

(b) (c) = RWF60,000 RWF62,700 = (RWF2,700) (adverse)

Sales volume margin variance

(c) (d) = RWF62,700 RWF57,000 = RWF5,700 (favourable)

Summary:

RWF RWF

Actual profit 56,000

Sales price margin variance (4,000)
Sales mix margin variance (2,700)
Sales volume margin variance 5,700
Net adverse variance (1,000)
Budgeted profit RWF55,000

Interpretation of Variances:

• Sales Price Margin Variance

This variance, as we explained earlier, shows the profit or loss arising from changes in selling
prices. This is a responsibility of the sales department.
• Sales Mix Margin Variance
This variance shows the variation in profit arising from a different composition of sales from the
budgeted amounts. It may be caused by falling demand for some products and rising demand for
others. Some products may be more easily sold, and salespeople have concentrated on products
which have a more rapid turnover but possibly less profit. Our adverse variance has been shown
because more products with lower profit margins have been sold than budgeted, and investigations
would be required to find the cause. The advent of new competition can be a factor.
• Sales Volume Margin Variance
This variance indicates the loss or gain in profit through sales quantities being above or below
budget levels. The causes for this variance have been previously outlined.

(c) Costing Method in Use

In answering examination questions on the subject of sales variances, take care to find
whether answers should be based on standard contributions or standard profit margins
- depending upon whether marginal or absorption costing methods are to be used.

CPA EXAMINATION F2.1 Management Accounting 287

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K. PLANNING AND REVISION VARIANCES
Outdated Standards
Standards may become outdated because of changes in market prices, wage rates, selling
prices or other causes. In many organisations the standards will be revised only once a year, so
that any changes which take place during the year will give rise to variances.

Material Price Change

At the time of setting a standard price for a particular material, a price of RWF5 per kg may
appear to be realistic but, owing to factors outside the control of the organisation, the price
may rise to RWF6 per kg. The rise of RWF1 will be uncontrollable so far as the purchasing
department is concerned. But the purchasing department may sometimes be able to secure
materials on slightly more favourable terms than the general rise in prices. Two variances can
then be calculated:

(a) A planning revision variance, reflecting the general rise in prices

(b) A price variance arising from the purchasing department’s efficiency in purchasing above
or below the current market price.

Example
Standard price of material RWF10.00 per kg
Current market price RWF13.00 per kg
Quantity purchased 10,000 kg
Price paid RWF12.80 per kg

The variances may be calculated as follows:

Actual Actual Actual Current Current Standard Standard
Quantity Price Cost Price Cost Price Price

RWF RWF RWF RWF RWF RWF

10,000 12.80 128,000 130,000 130.00 10.00 100,000

Variances:
Price variance

RWF128,000 RWF130,000 = RWF2,000 (favourable)

Planning revision variance

RWF130,000 RWF100,000 = RWF30,000 (adverse)

Interpretation of variances:
(a) The price variance, in this case, shows the purchasing department’s efficiency in
purchasing supplies below the current market price.

(b) The planning revision variance shows the effect of price changes which have arisen since
the standards were prepared, and it is uncontrollable so far as the purchasing department is
concerned.

288 F2.1 Management Accounting CPA EXAMINATION

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Similar variances can be prepared for wage rate variances or other cost or sales factors where
changes in wage rates or other changes have occurred after the standards have been prepared.

Revision Variances
Various changes may occur during the period when standards are in operation, so the
standard cost of production may change.

Temporary changes - if the changes that take place during production are of a temporary
nature, usual variance analysis will indicate the influence on the standard cost of production.
Management action should follow to correct the situation.

Permanent changes - if the changes are in material used, grade of labour used, or in methods
of production and are of a permanent nature, the standards themselves will need to be
revised. Under such circumstances revision variances could be calculated for a short period of
time. On revising the whole structure of standard costs and variance analysis, say at the end of
a year, any permanent changes will be incorporated.

Generally, temporary changes tend to be controllable requiring management action, whilst

permanent changes are often outside the control of the management.

L. WORKED EXAMPLE
Examination questions frequently require the computation of variances, and much
examination time can be wasted if you do not fully understand the methods of calculating,
presenting and reconciling variances. You should work through the following question
carefully, before comparing your answer with the one given.

Question
X Ltd had the following budgeted and actual results for a recent accounting period:

Budgeted:

RWF RWF

Sales (2,000 units) 50,000

Costs
Direct materials (4,000 kg @ RWF3) 12,000
Direct wages (4,000 hours @ RWF4) 16,000
Variable overheads (4,000 hours @ RWF1) 4,000
Fixed overheads 2,000 34,000
Net profit 16,000
Actual:
Sales (1,900 units) 47,000
Costs

Direct materials (3,900 kg) 11,500

CPA EXAMINATION F2.1 Management Accounting 289

STUDY MANUAL
Direct wages (3,700 hours) 15,500
Variable overheads 3,900
Fixed overheads 2,100 33,000
Net profit 14,000

The company uses variable (marginal) costing methods.

REQUIREMENT:
Prepare all variances for the period, and a statement reconciling the budgeted and actual
profits.

Answer
Variance Analysis

Direct materials:

AQ AP AQ SP SQ AP
3,900 RWF3 3,800 RWF3
RWF11,500 RWF11,700
RWF11,400
(a) (b) (c)

Materials price variance: (a) (b) RWF200 (favourable)

Materials usage variance: (b) (c) (RWF300) (adverse)

Direct wages:

AH AR AH SR SH SR
3,700 RWF4 3,800 RWF4
RWF15,500 RWF14,800
RWF15,200
(a) (b) (c)

Direct wages rate variance: (a) (b) (RWF700) (adverse)

Labour efficiency variance: (b) (c) RWF400 (favourable)

290 F2.1 Management Accounting CPA EXAMINATION

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GLOSSARY OF MANAGEMENT ACCOUNTING TERMS A-Z

KEY MANAGEMENT ACCOUNTING TERMS

This glossary contains a number of Management Accounting terms which you might encounter.
It is not intended to be comprehensive; for further explanations of these terms and of terms not
included here, you should refer to the main body of this book.

Abnormal Gains The gain resulting when actual loss is less than the normal or expected
loss.
Abnormal Loss The loss resulting when actual loss is greater than the normal or
expected loss.

Absorption Overhead Overhead charged to products or services by means of

absorption rates. (CIMA Official Terminology)

Absorption Costing The procedure which charges fixed as well as variable overhead
tocost units. (CIMA Official Terminology)
Absorption Rate A rate charged to a cost unit intended to account for the overhead at a
predetermined level of activity. (CIMA Official Terminology)

Account Classification Method A simple cost estimation technique involving the

classification of costs as fixed, variable or semi variable.

Activity Based Costing (ABC) Cost attribution to cost units on the basis of benefit received
from indirect activities e.g. ordering, setting-up, assuring quality. (CIMA Official Terminology)

Administrative Expenses Cost of management, and of secretarial, accounting and

administrative services, which cannot be related to the separate production, marketing or research
and development functions. (CIMA Official Terminology)

Attainable Standard A standard which can be attained if a standard unit of work is carried out
efficiently, a machine properly operated or a material properly used. Allowances are made
for normal losses, waste and machine downtime. (CIMA) Official Terminology)

Avoidable Costs The specific costs of an activity or sector of a business which would beavoided
if that activity or sector did not exist. (CIMA Official Terminology)

Basic Standard A long term standard which remains unchanged over the years and is used
to show trends.

Batch A group of similar articles which maintains its identity throughout one or more stages of
production and is treated as a cost unit. (CIMA Official Terminology)

Batch Costing A form of specific order costing; the attribution of costs to batches. (CIMA
Official Terminology)

Bill of Materials A specification of the materials and parts required to make a product. (CIMA
Official Terminology)

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Breakeven Chart A chart which indicates approximate profit or loss at different levels of sales
volume within a limited range. (CIMA Official Terminology)

Breakeven Point The level of activity at which there is neither profit nor loss. (CIMA Official
Terminology)

Breakeven (cost-volume profit (CVP)) analysis The study of the interrelationships

between costs, volume and profit at various levels of activity.

Budget A plan expressed in money. It is prepared and approved prior to the budget period
and may show income, expenditure, and the capital to be employed. May be drawn up showing
incremental effects on former budgeted or actual figures, or be complied by zero-based budgeting.
(CIMA Official Terminology)

Budget Committee Ideally comprises representatives from every part of the organisation
and oversees the budgeting process by co-ordinating and allocating responsibility for budget
preparation, timetabling, providing information to assist in budget preparation and monitoring
the budgeting and planning process by comparing actual and budgeted results.

Budget Manual A detailed set of documents that provide information and guidelines about
the budgetary process.

Budget Period The period for which a budget is prepared and used, which may then be
sub-divided into control periods. (CIMA Official Terminology)

Budgeted Capacity Standard Hours planned for the period, taking into account budgeted
sales, supplies, workforce availability and efficiency expected.

By-product Output of some value produced incidentally in manufacturing something

else (main product). See joint products. (CIMA Official Terminology)

Cash Buget A statement in which estimated future cash receipts and payments are tabulated
in such a way as to show the forecast cash balance of a business at defined intervals.

Classification The arrangement of items in logical groups having regard to their nature
(subjective classification) or purpose (objective classification). (CIMA Official Terminology)
Code A system of symbols designed to be applied to a classified set of items to give a brief
accurate reference, facilitating entry, collation and analysis. (CIMA Official Terminology)

Committed Cost The future cash outflow that will be incurred regardless of whatever
decision is taken now about alternative opportunities.

Computer-aided design/computer aided manufacturing (CAD CAM) system

Computer based techniques which allow interactive design and testing of a manufacturing
component on a visual display unit and permits the programming and control of production
equipment in the manufacturing task.

Continuous Operation Costing See process costing.

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Contract Costing A form of specific order costing; attribution of costs to individual
contracts. (CIMA Official Terminology)

Contribution/profit volume (P/V) chart Chart showing the impact on profit of changes in
turnover. (CIMA Official Terminology)

Controllable Cost A cost which can be influenced by its budget holder. (CIMA Official
Terminology)

Cost Accounting The establishment of budgets, standard costs and actual costs of
operations, processes, activities or products; and the analysis of variances, profitability or the
social use of funds. (CIMA Official Terminology)

Cost Accumulation The collection of cost data in some organised way through an
accounting system.

Cost behaviour The way in which costs of output are affected by fluctuations in the level
of activity. (CIMA Official Terminology)

Cost Centre A production or service location, function, activity or item of

equipment whose costs may be attributed to cost units. (CIMA Official Terminology)

Cost Department The department responsible for keeping cost accounting records.

Cost Driver An activity which generates cost. (Particularly related to activity based
costing). (CIMA Official Terminology)

Cost Pool A group of costs that are associated with the same activity or cost driver.

Cost Unit A unit of product or service in relation to which costs are ascertained.
(CIMA Official Terminology)

Cost-volume-profit (CVP) analysis See breakeven analysis.

Current Standard A standard based on current working conditions (current wastage,

current inefficiencies).

Database Frequently a much-abused term. In its strict sense a database is a file of data
structured in such a way that it may serve a number of applications without its structure being
dictated by any one of those applications, the concept being that programs are written around the
database rather than files being structured to meet the needs of specific programs. The term is
also rather loosely applied to simple file management software. (CIMA Official Terminology)

Differential/Incremental Cost The difference in total cost between alternatives;

calculated to assist decision-making. (CIMA Official Terminology)

Direct Cost Expenditure which can be economically identified with a specific saleable cost
unit. (CIMA Official Terminology)

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Dual Value See shadow price.

Departmental/functional budget A budget of income and/or expenditure applicable to a

particular function. A function may refer to a department or a process.

Exponential Smoothing A method of short term forecasting which involves the automatic
weighting of past data with weights that decrease exponentially with time so that the most current
values receive the greatest weighting and the older observations receive a decreasing weighting.

Equivalent Units Notional whole units representing uncompleted work. Used to

apportion costs between work in progress and completed output. (CIMA Official Terminology)

Feasible Area/Region The area on a graphical model of a linear programming problem

in which all of the constraints are satisfied.

Feedback A component of a control system which measures differences between planned and
actual results and modifies subsequent actions to achieve the required results. (CIMA Official
Terminology)

Feedforward Control Control based on comparing original targets or actual results with a
forecast of future results.

First-in, First-out (FIFO) Process Costing Method A process costing method that sharply
distinguishes between the work done on opening work in progress and the work done on work
introduced into the process during the period.

Fixed Budget A budget which does not include any provision for the event that actual volumes
of production may differ from those budgeted.

Fixed Cost/Fixed Overhead/Period Cost The cost which is incurred for a period, and
which, within certain output and turnover limits, tends to be unaffected by fluctuations in the levels
of activity (output or turnover). Examples are rent, rates, insurance and executive salaries. (CIMA
Official Terminology)

Fixed Overhead See Fixed Cost

Flexible Budget A budget which be recognising different cost behaviour patterns, is designed
to change as volume of output changes. (CIMA Official Terminology)

Flexible Manufacturing System An integrated production system that uses computer-

controlled robots to produce immense varieties of a product at a low cost; flexibility is promoted
through rapid changeover times.

Forecasting The identification of factors and quantification of their effect on an entity, as a basis
for planning. (CIMA Official Terminology)

Full Capacity Output (expressed in standard hours) that could be achieved if sales order,
supplies and workforce were available for all installed workplaces. (CIMA Official Terminology)

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Full Cost Plus Pricing Method of determining the sales price by calculating the full cost
of the product and adding a percentage mark-up for profit.

Function Costing See Service Costing

Functional Budget See Departmental Budget

Functional Classification of Costs A group of costs that were all incurred for the same basic
purpose.

High-low Method A technique for determining the fixed and variable components of a total
cost that uses actual observations of total cost at the highest and lowest levels of activity and
calculates the change in both activity and cost.

Historical Cost The actual cost of acquiring assets, goods and services. (CIMA Official
Terminology)

Ideal Standard A standard which can be attained under the most favourable conditions, with no
allowance for normal losses, waste and machine downtime. Also known as potential standard.
(CIMA Official Terminology)

Imputed Cost Cost recognised in a particular situation that is not regularly recognised bu usual
accounting procedures.

Incremental Cost See Differential Cost

Industrial Engineering Approach Cost estimation approach which analyses the

relationships between inputs and outputs in physical terms and then transforms the physical
measures into standard or budgeted costs.

Integrated Accounts A set of accounting records which provides financial and cost accounts
using a common input of data for all accounting purposes. (CIMA Official Terminology)

Interlocking Accounts/Non-Integrated Accounts A system in which the cost accounts

using a common input of data for all accounting purposes. (CIMA Official Terminology)

Internal Opportunity Cost The shadow price of a scarce source.

Key Factor See Limiting Factor

Job A customer order or task of relatively short duration. (CIMA OfficialTerminology)

Job Costing A form of specific order costing; the attribution of cost to jobs. (CIMA Official
Terminology)

Joint Products Two or more products separated in processing, each having sufficiently high
saleable value to merit recognition as a main product. (CIMA Official Terminology)

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ust-in-Time (JIT) A technique for the organisation of work flows, to allow rapid, high quality,
flexible production whilst minimising manufacturing waste and stock levels. (CIMA Official
Terminology)

Least Squares Method (of regression analysis) Method of finding the line of best fit.

Limiting Factor/Key Factor Anything which limits the activity of an entity. An entity seeks to
optimise the benefit it obtains from the limiting factor. (CIMA Official Terminology)

Line of Best Fit Represents the best linear relationship between two variables.

Linear Programming The use of a series of linear equations to construct a

mathematical model. The objective is to obtain an optimal solution to a complex operational
problem, given a number of alternative values of stated variables and quantitative constraints as
to their use. (CIMA Official Terminology)

Mark-up Pricing See Marginal Cost Plus Pricing

Marginal Cost Plus Pricing/Mark-up Pricing Method of determining the sales price by
adding a profit margin onto either marginal cost of production or marginal cost of sales.

Marginal Costing The accounting system in which variable costs are charged to cost units and
fixed costs of the period are written off in full against the aggregate contribution. Its special value
is in decision-making. The objective is to obtain an optimal solution to a complex operational
problem, given a number of alternative values of stated variables and quantitive constraints as to
their use. (CIMA Official Terminology)

Master Budget The set of budgeted profit and loss account, budgeted balance sheet
and cash budget.

Minimum Pricing Price charged that just covers both the incremental costs of production and
selling an item and the opportunity costs of the resources consumed in making and selling it.
Mixed Cost See Semi-Variable Cost

Moving Averages A technique involving the calculation of consecutive averages over time
to establish the trend of a time series.

Non-Integrated Accounts See Inter-Locking Accounts

Normal Loss The loss expected during the normal course of operations, for
unavoidable reasons.

Notional Cost The value of a benefit where no actual cost incurred. (CIMA Official
Terminology)

Objective Function The mathematical equation which states the maximisation or

minimisation objective of a linear programming problem.

Operating StatementA regular report for management of actual cost, and revenue,
as appropriate. Usually compares actual with budget and shows variances. (CIMA Official
Terminology)

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Opportunity Cost The value of a benefit sacrificed in favour of an alternative course of
action. (CIMA Official Terminology)

Overhead Absorption Rate A means of attributing overhead to a product or service based, for
example, on direct labour hours, direct hour cost or machine hours. (CIMA Official Terminology)

Overhead/Indirect Cost Expenditure o labour, materials or services which cannot be

economically identified with a specific saleable cost unit. (CIMA Official Terminology)

Period Cost See Fixed Cost

Semi-Fixed Cost See Semi Variable Cost

Semi-Variable Cost/Semi-Fixed Cost/Mixed Cost A cost containing both fixed and variable
components and which is thus partly affected by fluctuations in the level of activity. (CIMA
Official Terminology)

Standard Costing A control technique which compares standard cost and revenues with
actual results to obtain variances which are used to stimulate improved performance. (CIMA
Official Terminology)

Step Cost A cost which is fixed in nature but only within certain levels of activity.

Time Series Analysis The analysis of a series of figures or values recorded over time.

Uncontrollable Cost A cost that cannot be affected by management within a given time
period.

Under or Over-Absorbed overhead The difference between overhead incurred and

overhead absorbed in a given period. In a standard costing system, it is the sum of variable
production overhead total variance and fixed production overhead variance. (CIMA Official
Terminology)

User Cost The incremental cost of using machinery.

Variable Cost Cost which tends to vary with the level of activity. (CIMA Official
Terminology)

Variance Difference between planned, budgeted, or standard cost and actual cost; and
similarly for revenue. Not to be confused with statistical variance which measures the dispersion
of a statistical population.
Variance Analysis The analysis of performance by means of variances. Used to promote
management action at the earliest possible stages.

Weighted Average Process Costing Method A process costing method that adds the cost of
all work done in the current period to the cost of work done in the preceding period on the current
period’s opening work in process and divides the total by the equivalent units of work done to
date.

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Zero Based Budgeting A method of budgeting whereby all activities are re-evaluated each
time a budget is set. Discrete levels of each activity are valued and a combination chosen to
match funds available.

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