JINKA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OFACCOUNTING AND FINANCE

COST AND MANAGEMENT ACCOUNTING MODULE (ACFN-3030)

Prepared By: Mohammed Meko (MSc.)

Bogale Sora (MSc.)

Leta Gemechu(MSc)

2024

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About The course
Course Number AcFn3031
Course Title Cost & management Accounting I
ETCTS Credits 5
Contact Hours 3
(per week)
Course Upon the successful completion of this module, students should be able to:
Objectives &  Use various classifications to analyze costs within the organization.
Competences to  Describe and apply the principles relating to the costing of the different
resource inputs into a business.
be Acquired
 Demonstrate output costing methods appropriate to a variety of different
businesses.
 Illustrate and evaluate absorption, marginal costing, activity-based costing
methods and other management cost accounting methods and techniques.
 Apply and analyze different types of activity-based management tools
through the preparation of estimates.
 Describe, illustrate and comment on the planning and control uses of
standard costing, budgeting and variance analysis
Course Cost accounting course concerns with fundamental cost concepts, behavior, and
Description analysis and the use of cost information to develop superior decision making process
and outputs. This course introduces the production, communication, and the use of
accounting information within the context of business activities.

Course Contents
1. Overview of Cost and Management Accounting
1,1 Objectives of Cost & Management Accounting
1.2 Cost and management accounting in comparison with financial accounting: their purposes, the role of
cost accounting as part of a management information system, and the need for both financial as well as
non-financial information
1.3 Cost classification concepts and terms, such as:
 Direct and indirect costs,
 Fixed and variable costs,
 Period and product costs,
 Controllable and uncontrollable costs,
 Avoidable and unavoidable costs,
 ―Sunk‖ costs,
 Budgeted, standard and actual costs and their comparisons and analyses
1.4 The use of linear, curvilinear and step functions and how their calculations are used to analyze cost
behavior
1.5 The concepts of cost units, cost centers and profit centers

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2 Cost determination: The costing of resource inputs
2.1 Materials
 Accounting for stock (inventory)movements
 Determination of optimum purchase quantities
 Identification of accounting for stock losses
2.2 Labor
 The difference between direct and indirect labor
 Types of labor remuneration methods
2.3 Overheads
 Overhead cost analyses
 The apportionment and absorption of overhead costs, including allocation of service department
costs.
 Accounting for the over- and under absorption of costs
 IAS 2 inventories on Overhead allocations
2.4 Recording of costs and schedule of costs of products.
3. Costing methods: The costing of resource outputs

3.1 Job order, batch and contract costing methods

 Characteristics of each method
 Accounting for direct and indirect costs, including the treatment of waste, scrap, spoilage and re
work costs,
4. The Process and Operation or service costing methods:
4.1 Characteristics of the process costing method,
4.2 Identification and use of appropriate cost units,
4.3Valuation of process transfers and work-in-process using equivalent units of production and based on
FIFO and average costing methods,
4.4 Accounting for normal and abnormal losses and gains, joint and by-products
4.5 Scope of operation or service costing,
4.6 Identification of appropriate cost units,
4.7 Considerations relating to the collection, classification and ascertainment of costs
5. Cost Allocation
5.1 Explain the notions of ‗overhead costs‘, ‗indirect costs‘, ‗direct costs‘, ‗traceable costs‘ and
‗allocated costs‘.
5.2 Explain how accountants choose to create ‗cost centres or ‗cost pools‘ in which to gather
together cost data.
5.3 Explain why and how costs may be allocated from one cost pool or centre to another.
5.4 Support department cost allocation
5.5 Joint and By-products
5.6 Common cost allocation
6. Activity-Based Costing and Management
6.1 Activity-based costing; use of cost drivers and activities
6.2 Activity Based Costing for Customer Profitability
6.3 Activity Based Management

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Assessment/Evalu The evaluation scheme will be as follows:
ation Component Weight Coverage
Test 1 15% Chapter 1 &2
Test 2 15% Chapter 3 & 4
Assignment 1 5% Chapter 1 &2
Assignment 2 5% Chapter 3-6
Quiz 1 5%
Quiz 2 5%
Final Exam 50% All chapters
Work load in
hours
Hours Required
Asses Adv Total ECT
sment Tutor Self- Assig isin Hrs S
Lectures Lab s ials Studies nment g
64 - 22 12 64 - - 162 6
Text Book:
Text and reference  Horngren, Foster, &Datar. Cost Accounting: A Managerial
books Emphasis. 9th Ed. 1997
 Horngren, Sunden& Stratton. Introduction to Management
Accounting. 11th Ed. 1999
Reference Books
 C.T Homgren, Introduction to Management Accounting 4th to 8 th
editions, 1999 USA
 C.T. Homgren, Cost Accounting: A Managerial Emphasis 5th to 8th
ecitionsprentice Hall Inc. 1982 to 1994
 Homgren, foster, &Datar, Cost Accounting A Managerial Emphasis. 10
thEcition
 L.E. Heitger Managerial Accounting 1th and 2 nd editions, McGraw Hill ,
1998, India
 GetuJemaneh, Management Accounting 1996.
 Ray H.Garrison, Managerial Accounting. 6th edition
 Caluinengler, Managerial Accounting 2nd edition
 L. Gayle Rayburn Principles of cost Accounting using a cost Mangement
Approach 4th edition Richard DIR WIN Inc. 1989.
 Robert X. Kaplan Advanced Management Accounting 1st and 2nd
edition prentice Haill, Inc, 1982 and 1989 (Chapters 2, 11,12, and 13 only)

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Chapter One
Overview of Cost and Management Accounting
Learning objectives:
Dear students, after completing this chapter you should be able to:

 Define and differentiate between cost accounting, management accounting and financial
accounting.

 Explain the importance of cost accounting, management accounting and financial accounting.
 Classify and understand various cost types, such as direct/indirect, fixed/variable, and sunk
costs.
 Analyze cost behavior using linear, curvilinear, and step functions to predict cost changes.
 Define cost units, cost centers, and profit centers, and explain their roles in cost tracking and
performance evaluation.

Introduction

In a business environment where each entity is thriving to achieve apex position not only in
domestic but global competitive market, it is essential for the entity to fit into any of the three
Michael E. Porter‘s theory of generic competitive strategies i.e. Cost Leadership, product
differentiation and focus/niche. Cost Leadership implies producing goods or provision of
services at lowest cost while maintaining quality to have better competitive price.
Cost Leadership, also in line with the subject Cost and Management Accounting, can be
achieved if an entity has a robust cost and management accounting system in
place. The word ‗Accounting‘ can be classified into three categories: (A) Financial
Accounting (B) Management Accounting and (C) Cost Accounting.
1.1. Cost accounting, Management accounting and Financial accounting
What is cost accounting? We have different definitions for cost. Some of them are:
Cost accounting is an accounting that provides cost information not only for determination of
cost of something but also for controlling of costs of activities (products, services, projects,
departments, processes, etc) and for decision making.

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Cost accounting measures and reports financial and other information related to the acquisition
or consumption of an organization‘s resources. Cost accounting provides information to both
management accounting and financial accounting.
Objectives of Cost Accounting
 Ascertainment product unit cost
 Controlling cost
 Stimulating cost consciousness
 Determining selling price
 Determining profit and loss for various products and services and inventory valuation &
 Providing basis for formulating operating policies.
Advantage of cost accounting
 Helps in optimum utilization of resources
 Identifies the areas requiring corrective action
 Helps management in formulation of policies and making short term decisions
 Helps to face difficulties in setting prices and improving efficiency.
 Focuses on the profitability of each product or service.
Limitations of cost Accounting
 It is not an exact science and involves inherent element of judgment
 Cost varies with purpose
 It does not give any outright solution to a problem
 Most of its techniques are based on some pre-assumed notions
 It uses arbitrary apportionment of common costs
Techniques of Costing
Historical data: it is ascertainment of cost after they have been incurred based on recorded
data
Standard Costing: is the control technique which compares budgets costs and revenue with
actual results to obtain variances which are used to stimulate improved performance.
Variable costing: is an accounting system in which variable costs are charged to units
produced, service or activities performed and fixed costs of the period are written off in full
against the aggregate contribution margin.

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Direct Costing: it is the practice of charging all direct costs to operations, processes or
products leaving all indirect costs to be written off against profits in the period in which they
arise.
Absorption or full Costing: it is the practice of charging all costs both variable and fixed to
operations, products or processes.
Uniform costing: here standardized principles and methods of cost accounting are employed
by a number of different corporations and firms.

Management accounting
Definition: it is an accounting which provides necessary information to the management for
discharging its functions. The functions of management are planning, organizing, directing and
controlling. Thus management accounting provides information to management so that
planning, organizing, directing and controlling of business operations can be done in an orderly
manner.

Objectives of Managerial Accounting Activity

 Providing managers with information for decision making and planning
 Assisting managers in directing and controlling operational activities
 Motivating managers and other employees toward the organizational goals
 Measuring the performance of sub-units, managers and other employees within the
organization
Advantage of Management Accounting
Management accounting provides invaluable services to management in all of its function.
Planning: Management accounting makes an important contribution in performance of the
planning function. It makes available the relevant data after pruning and analyzing them suitably
for effective planning and decision-making.
Controlling: It involves evaluation of performance keeping in view that the actual performance
coincides with the planned one and remedial measures are taken in the event of variation
between the two.
Coordinating: It involves interlinking of different divisions of the business enterprise in a way
so as to achieve the objectives of the organization as a whole.

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Organizing: A sound system of internal control and internal audit for each of the cost or profit
centers helps in organizing and establishment of a sound business structure.
Motivating: It involves maintenance of a high degree of morale in the organization. The
superiors should be in a position to find out whom to demote or promote and to reward or
penalize.
Communicating: Communicating involves transmission of data, results etc. both to the insiders
as well as outsiders. The management owes a duty to the creditors, prospective investors,
shareholders etc. to communicate to them about the progress, financial position etc of the
enterprise. Management accounting helps the management in performance of their function by
developing a suitable system of reporting.

Limitations of management accounting

Management accounting being a new discipline it suffers from certain limitations, which limit its
effectiveness. These limitations are as follows
Limitation of basic records: Management accounting derives its information from financial
accounting and other records. The strength and weakness of the management accounting depends
upon the strength and weakness of these basic records.
Persistent efforts: The conclusions drawn by the management accountant are not executed
automatically. He has to convince people at all level.
Wide Scope: Management accounting has a very wide scope incorporating many disciplines. It
considers both monetary as well as non monetary factors. This all brings inexactness and
subjectivity in the conclusions obtained through it.
Top-heavy structure: The installation of management accounting system requires heavy costs
on account of an elaborate organization and numerous rules and regulations (high cost, numerous
rules and regulations). It can therefore, be adopted only by big concerns.
Opposition to change: Management accounting demands a break way from traditional
accounting practices. It calls for a rearrangement of the personnel and their activities, which is
generally not liked by the people involved.

Financial accounting

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Definition – it is an art of recording, classifying, measuring and summarizing in a significant
manner in term of money, transactions and events of a financial character and interpreting the
result thereof. Financial accounting is primarily concerned with the preparation of financial
statement, which summarizes the results of operation for selected period of time and show the
financial position of the corporation at a particular date.

The advantages and Objectives of financial accounting: it includes;

 Summarizing the operational result of a business entity for a particular specified period
showing a profit or loss (income statement)
 Presenting the net asset of that enterprise (statement of owners equity)
 Reflecting the financial position of the business entity at a specific date (balance sheet).
 Presenting economic (financial) information based on historical data to external users for
decision makers
Limitations of Financial Accounting
 It shows only overall performance
 It is historical in nature
 It has no performance appraisal
 It has no material control system
 It has no labor cost control mechanism
 It has no proper classification of costs
 It has no sufficient analysis of losses
1.2 Distinction among the accounting disciplines
Cost accounting and financial accounting
 Financial accounting is primarily concerned with the preparation of financial statement
where as Cost accounting is primarily concerned with determination of cost of something.
 A cost accountant unlike financial accountant has an obligation to both external reporting
and internal reporting.
 Cost accounting primarily helps management in planning, controlling and decision making
while financial accounting provides external reporting for outside users.
Cost accounting and management accounting

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 Cost accounting is all about the ascertainment and control of costs on the other hand,
management accounting involves collecting, analyzing, interpreting and presenting all
accounting information, which is useful to the management.
 Management accounting has a wider scope than cost accounting
 Cost accounting primarily deals with cost data while management accounting involves the
considerations of both cost and revenue.
Management accounting and financial accounting
Areas of comparison Management accounting Financial accounting

Report format Flexible Acc. To GAAP or IFRS

Purpose of report Provide information for planning, Report on past performance

control, and decision making
Primary users As a whole business or aggregate External users
employees, mangers, etc
Units of measurement Historical or future dollars Historical dollars

Nature of information Future oriented Historical oriented

Frequency of report Prepared as needed Prepared on regular basis

Legal compulsion Not compulsory (at the discretion of Compulsory (obligatory)

the management)
1.3 Cost classification concepts and terms

Costs and Cost Terminology

Cost: According to Carl .S. Warren the term cost refers to all payments of cash for the purpose
of generating revenues. Costs can be either expensed or capitalized. Expensed costs are treated as
expresses in the period cash is paid. Capitalized costs are treated as assets in the period cash is
paid. The asset is recognized as expenditure in future periods.

According to J. Horngren cost refers as resource scarified or foregone to achieve a specific

objective. It is usually measured as the monetary amount that must be paid to acquire goods and
services.

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Cost object: A cost object is anything for which a separate measurement of costs is desired.
Examples include a product, service, project, customer, brand category, activity, department, etc.
There are two stages for accounting of costs (1) cost accumulation and (2) cost assignment. Cost
accumulation is the collection of cost data in some organized way by means of an accounting
system. Cost assignment means tracing accumulated costs to cost object and allocating
accumulated costs to a cost object.
Cost Classifications for Assigning Costs to Cost Objects
By Degree of Traceability to the Products Cost can be distinguished as direct and indirect.
a) Direct Cost
Direct costs: are costs that can be conveniently or economically traced to a cost object. For
example, the cost of bottles is a direct cost of a Pepsi soft drink, because it can be conveniently
and economically traced to the Pepsi soft drink. The other example, the wages of production line
workers can be conveniently traced to the product because the time worked and the related
hourly wages can be easily found by looking at time cards and payroll records.
b) Indirect Cost
An indirect cost is a cost that cannot be easily and conveniently traced to a specified cost object.
Example, the cost of quality control personnel who taste and content tests on multiple soft drink
products bottled at a Pepsi plant is an indirect cost of a Pepsi soft drink. Unlike cost of bottles, it
is difficult to trace quality control personnel costs to a specific Pepsi soft drink

Behavioral classification of costs

Managers are also interested in the way costs respond or behave to changes in volume or level of
activity. By analyzing those patterns of behavior, managers gain information about how changes

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in selling prices or operating costs affect the net income of the organization. Thus, based on their
behavior cost can classified as variable, fixed and mixed costs.
Variable Cost
Variable cost: are costs that vary in total, in direct proportion to changes in the level of activity
or cost driver i.e. if activity increase by n%, total variable cost also increase by n%, but the per
unit cost remains constant. E.g. direct material cost, direct labor cost, commission paid to sales
personnel, wages paid to employees will increase as level of out put increases. Graphically, total
variable cost can be explained as follows:

Fixed Cost: are costs that remain unchanged in total regardless of variation in the level of
activity or cost driver in a given relevant range. If activity increases or decreases by n% within
the given relevant range, total fixed cost remains the same; but the per unit fixed cost changes.
Example, monthly rental cost of equipment and /or house, depreciation of machines used to
produce furniture‗s is fixed in total per year regardless of the level of production, but in unit,
fixed costs are variable i.e. fixed cost per unit increases as level of production decrease and it
decreases as level of output increases. Graphically, fixed cost can be summarized as follows:

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Exhibit 2–7 Summary of Variable and Fixed Cost Behavior

Mixed costs: are costs that have both variable and fixed characteristics. These costs are often
called mixed costs or semi-variable or semi-fixed costs. Mixed costs have an element that is
constant regardless of change in level of activity and an element that is variable as level of
activity changes. For example, utility costs like telephone, electric and water charges are
composed of monthly fixed charge plus some other variable costs which depends on the level of
usage.

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Product Costs versus Period Costs
Product cost and period costs for financial reporting purposes, costs are often classified as either
product costs or period cost.

In addition to classifying costs as manufacturing or nonmanufacturing costs, there are other ways
to look at costs. For instance, they can also be classified as either product costs or period costs.
To understand the difference between product costs and period costs, we must first discuss the
matching principle from financial accounting.

Generally, costs are recognized as expenses on the income statement in the period that benefits
from the cost. For example, if a company pays for liability insurance in advance for two years,
the entire amount is not considered an expense of the year in which the payment is made.
Instead, one-half of the cost would be recognized as an expense each year. The reason is that
both years—not just the first year—benefit from the insurance payment. The
unexpensed/unexpired portion of the insurance payment is carried on the balance sheet as an
asset called prepaid insurance.

The matching principle is based on the accrual concept that costs incurred to generate particular
revenue should be recognized as expenses in the same period that the revenue is recognized.
This means that if a cost is incurred to acquire or make something that will eventually be sold,
then the cost should be recognized as an expense only when the sale takes place—that is, when
the benefit occurs. Such costs are called product costs.

Product Costs
For financial accounting purposes, product costs include all costs involved in acquiring or
making a product. In the case of manufactured goods, these costs consist of direct materials,
direct labor, and manufacturing overhead. Product costs ―attach‖ to units of product as the goods
are purchased or manufactured and they remain attached as the goods go into inventory awaiting
sale. Product costs are initially assigned to an inventory account on the balance sheet. When the

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goods are sold, the costs are released from inventory as expenses (typically called cost of goods
sold) and matched against sales revenue. Because product costs are initially assigned to
inventories, they are also known as inventoriable costs.

We want to emphasize that product costs are not necessarily treated as expenses in the period in
which they are incurred. Rather, as explained above, they are treated as expenses in the period in
which the related products are sold. This means that a product cost such as direct materials or
direct labor might be incurred during one period but not recorded as an expense until a following
period when the completed product is sold.

Period Costs
Period costs are all the costs that are not product costs. For example, sales commissions and the
rental costs of administrative offices are period costs. Period costs are not included as part of the
cost of either purchased or manufactured goods; instead, period costs are expensed on the
income statement in the period in which they are incurred using the usual rules of accrual
accounting. Keep in mind that the period in which a cost is incurred is not necessarily the period
in which cash changes hands. For example, as discussed earlier, the costs of liability insurance
are spread across the periods that benefit from the insurance—regardless of the period in which
the insurance premium is paid.

As suggested above, all selling and administrative expenses are considered to be period costs.
Advertising, executive salaries, sales commissions, public relations, and other nonmanufacturing
costs discussed earlier are all examples of period costs. They will appear on the income
statement as expenses in the period in which they are incurred.

Prime cost and conversion costs:

In manufacturing companies, the costs can again be classified as Prime Cost and conversion
costs.

Prime costs: are all direct manufacturing costs i.e. direct material costs and direct manufacturing
labor cost.

Conversion Costs: are all manufacturing costs other than direct material costs. Manufacturers
typically use people and machines to convert raw material to output that has substance. Thus,

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conversion costs are the costs incurred to convert direct material into the final product, namely,
costs for direct labor and manufacturing overhead.

Controllable and uncontrollable costs

Controllable costs are those costs, which can be influenced by the action of a specified member
of the undertaking. If a manager can control or heavily influence the level of cost, then that cost
is classified as a controllable cost. Costs that a manager cannot influence significantly are
classified as uncontrollable cost of that manager. Many costs are not completely under the
control of any individual. In classifying costs as controllable or uncontrollable, managerial
accountants generally focus on a manager‗s ability to influence costs.

Economic Characteristics of Costs

In addition to accounting cost classifications, such as product costs and period costs, managerial
accountants also employ economic concepts in classifying costs. Such concepts are often useful
in helping accountants decide what cost information is relevant to the decisions faced by the
organization‗s managers. Some of the most important economic cost concepts are:

 Opportunity costs
 Out-of- pocket costs
 Sunk costs
 Differential costs
 Marginal costs and Average costs
Opportunity cost: is defined as the benefit that is scarified when the choice of one action
precludes taking an alternative course of action. If goat meat and fish are the available choices
for dinner, the opportunity cost of eating goat meat is the foregone pleasure associated with
eating fish.

Sunk Costs: Such costs are past or historical cost. These are costs, which have been created by
a decision that was made in the past that cannot be changed by any decision that will be made in
the future. Investments in plant and machinery, buildings, etc., are important examples of such
costs. Since later decisions can‗t alter sunk costs, they are irrelevant for decision-making.
Differential Cost: The difference in total cost between two alternatives is known as differential

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cost. In case the choice of an alternative results in increase in total cost, such increased costs are
known as incremental costs. While assessing the profitability of a proposed change, the
incremental costs are matched with incremental revenue. Differential cost is a technique used in
the preparation of adhoc information in which only cost and income differences between
alternative courses of action are taken into consideration. Thus, in case of differential costing a
comparison is made between the cost differential and income differential between two or more
situations and decisions regarding adopting a particular cause of action is taken if it is on the
whole profitable.

Marginal costs and Average costs- marginal cost is the extra cost incurred when one additional
unit is produced. The average cost per unit is the total cost of quantity manufactured divided by
the number of units manufactured.

1.4 The use of linear, curvilinear and step functions and how their calculations
a Step-Wise Costs

Linear Cost Function: A linear cost function is a mathematical method used by businesses to
determine the total costs associated with a specific amount of production. This method of cost
estimation can be done whenever the cost for each unit produced remains the same no matter
how many units are produce.

Curvilinear

A curvilinear cost, also called a nonlinear cost, is an expense that increases at an inconsistent rate
as production volume increases. In other words, this is an irregular cost that increases at different
rates as total output increases.

Unlike variable costs that increase at a constant rate as production increases, curvilinear costs
have not set parameters. They tend to increase drastically at lower levels of production, flatten
out at mid-levels, and increase again at higher levels of output. These irregular cost increases
make the curvilinear cost curve look like an ―s‖ when charted on a graph with the x axis
representing volume in units and the y axis representing total costs. Compare this to a variable
cost curve that simply consists of a straight line from zero to infinity.

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Step Cost (or step-function cost) – Step Costs: Such costs are constant for a given level of
output and then increase by a fixed amount at a higher level of output. It is a cost that advances
by steps with increased volume of activity. The increase of number of managers (results increase
in in salary) in a given firm is a typical example of step cost. A step cost remains constant at a
certain fixed amount over a range of output (or sales). Then, at certain points, the step costs
increase to higher amounts. Visually, step costs appear like stair steps.re used to analyze cost
behavior

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1.5 The concepts of cost units, cost centers and profit centers

1.5.1 Cost Unit

A cost unit is characterized as the unit of service, time, movement, product, or mix according to
which cost is assessed. At the time of setting up the cost proclamations, statements, and records,
a specific unit is needed to be chosen. It assists with distinguishing the expense precisely and
allots the different costs. It helps the expense estimation interaction of the organization and
advances correlation.

Example: The cost unit of the steel business would be a ton, and the expense unit of the hotel
business is a room. This is laid by the cost center. There are both basic units and complex units
in cost units. A basic unit addresses a solitary standard estimation like a per piece, per meter, per
kilogram, and so on. A complex unit utilizes a blend of two basic units like each per tonne-
kilometre, kilowatt-hour, and so forth.

1.5.2 Meaning of Cost Center:

A cost center is a division, function, department, or capacity inside an association that doesn‘t
straightforwardly add to benefit or profit yet at the same time costs the association cash to
operate. Cost centers just add to an organization‘s benefit by implication or indirectly, not at all
like a profit center, which adds to profitability straightforwardly through its activities.

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Administrators of cost centers, for example, Accounting and Human Resources departments, are
liable for keeping their expenses in line or underneath the financial plan or the budget plan.

1.5.3 Profit Centre

A profit center is a branch or division of a company that directly adds or is expected to add to
the entire organization's bottom line. It is treated as a separate, standalone business, responsible
for generating its revenues and earnings. Thus profits or losses for a profit center are calculated
separately.

Why are profit centers important? There are several key benefits to create profit centers within
an organization:

 Allowing risks: By having one branch dedicated to generating profits in an organization,

companies may be able to take additional risks. For example, they may allocate some profits to
invest in a new product or service that may take time to generate its own profits.
 Reducing overhead: With a profit center, other departments may focus on reducing their
overheads and costs to balance their limited profits. Rather than revenue-generating activities,
they may try to limit their spending amounts.
 Segmenting costs: With profit centers, other branches and the profit center have their own
financial records. This can help companies to identify other areas that perform well or have high
spending.
 Determining spending: Profit centers can help identify what product areas spend on their
products and what they earn through profits. This can help when forecasting and budgeting and
deciding how you might allocate future funds.

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True/False Questions

1. Cost accounting is primarily concerned with external financial reporting

2. Non-financial information is irrelevant in management accounting
3. Variable costs change with the level of production or output
4. Sunk costs are relevant for future decision-making
5. A cost center is a unit responsible for generating profits

Multiple Choice Questions

1. Which of the following is a primary objective of cost accounting?
A. Preparation of financial statements
B. Cost control and reduction
C. Tax compliance
D. Managing investments
2. Which type of cost is incurred regardless of the level of production?
A. Variable costs C. Direct costs
B. Fixed costs. D. Sunk costs
3. Which of the following best describes indirect costs?
A. Costs directly attributed to a product
B. General expenses not directly tied to production
C. Costs that vary with production
D. Costs that are always controllable
4. Which function describes a cost behavior that increases in steps as production levels change?
A. Linear C. Step
B. Curvilinear D. Variable

5. A cost that can be avoided if an activity is stopped is called:

A. Sunk cost
B. Fixed cost
C. Avoidable cost
D. Uncontrollable cost

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Chapter Two
Cost determination: The costing of resource inputs

Learning Objectives

Dear students, after completing this chapter, you should be able to:

 Account for stock (inventory) movements, determine optimum purchase quantities, and
identify and account for stock losses.
 Differentiate between direct and indirect labor, and describe various labor remuneration
methods.
 Analyze overhead costs, allocate and absorb overheads, and handle service department cost
allocations. Additionally, account for over- and under-absorption of overheads and apply IAS
2 requirements on inventory and overhead allocations.
 Record costs accurately and prepare a schedule of product costs.

2.1. Materials accounting for stock (inventory) movements

2.1.1 Materials Cost
The materials are a major part of the total cost of producing a product and are one of the most
important assets in majority of the business enterprises. All products are made up of one or many
materials. So the accurate determination of material cost is essential. Material is the most
important element of cost. Materials cost refers to the acquisition cost of raw
materials/inputs/components used in the production process. They are the costs of acquiring of
material resources necessary for business. Material costs can be either direct material costs or
indirect material costs.

1. Direct Material Costs

DM costs are the acquisition costs of all materials that eventually become an integral part of
the cost object and that can be traced to the cost object in an economically feasible way.
They must be a significant part of the finished good. For example the metal frame and the
lumber used in manufacturing a chair, steel in the manufacture of automobiles, wires for TV
sets, and the buttons used in manufacturing clothing, costs of paper and ink for a printer.
DMs do not include minor items such as nails or glue. Why? Because the costs of tracing
insignificant items do not seem worth than the possible benefit of precise product costs. So,
such items as supplies or indirect materials are classified as FOH.
2. Indirect Materials- the cost of materials of two types:

a. The cost of materials that are not physically incorporated in the product (such as the cost of
lathe blades in a furniture plant factory, supplies, or operating supplies, cleaning supplies, gloves,
brushes, repair parts, light bulbs etc.). These are materials used in production which do not end
up as part of the finished product.

b. The cost of minor materials, even if they are physically incorporated in the product (such as
glue-in manufacturing arm chair, some paints and lubricants-oils, and greases, small amounts of
wire, thread-in sewing a suit). These are materials used in small amounts in the manufacturing
process that cannot easily be allocated to specific products.

Materials Control

It can be defined as a comprehensive framework for the accounting and control of material cost
designed with the object of maintaining material supplies at a level so as to ensure uninterrupted
production but at the same time minimizing investment of funds.

It is the systematic control over the purchasing, storing, and using of material so as to have the
minimum possible cost of material. In simple words, it is a system which ensures that right
quality of material is available in the right quantity at the right time and right place with the right
amount of investment.

Procedures for purchasing

1. Purchase requisition:
A form known as 'Purchase Requisition' is commonly used as a format requesting the purchase
department to purchase the required material. Normally the purchase requisition is issued by the
Stores Department when the quantity of the concerned material reaches the minimum level.

2. Select suitable suppliers

After the receipt of purchase requisition, the purchase department places an order with a supplier,
offering to buy certain material at stated price and terms. However before issuing the purchase
order, quotations may be invited from various suppliers for arriving at the best deal

3. Purchase order

Purchase order is issued to the selected supplier. Purchase order is a legal document and it results
into a contract between the company and the supplier.

4.Receiving the Materials

The receiving department performs the function of unloading and unpacking materials which are
received by an organization.

5. Approval of invoice

Approval of invoice indicates that goods are purchased according to the purchase order have
been received and payments can be made for the same amounts.
6. Making the payment

After the voice is approved the payment is made to the supplier.

Accounting for stock movements

Material is being moved between different stages, and each stage is being accounted for in the
materials accounts. When material moves from one department to another, the material account
is being debited. And when the material is being moved out from each department after the
process, the material account is being credited.Stages through which material is being moved
normally is as below:

 Supplier-Stores: Here, raw material is being purchased and moved from suppliers'
warehouses to the company's stores.

 Stores-work in progress: Here, raw material is being transferred from stores to the
manufacturing process, i.e., goods are being processed. Thus, work in progress account is
being maintained at this stage.

 Work in progress-Finished goods: At this stage, work in progress goods are fully
manufactured and transferred to the finished goods department for storage.

 Finished goods-customer: Here, finished products are sold to the customer and transferred
to the customer's place.

Therefore, there are certain stages through which raw material is moved. While moving the raw
material, various costs and expenses are being incurred. So, management has to take various
decisions regarding the reduction of costs. As a result, the need for material control arises in the
manufacturing industry.
Selected materials Accounting transactions

Materials purchased from vendor

Materials xx
Cash/Account payable xx
Returns to suppliers:
Cash/Account payable xx
Materials xx
Materials issued to production.
Work in Process xx
Materials xx
Payment to vendor for invoice.
Accounts Payable xx
Cash xx

a Transfer finished work to finished goods.

Finished Goods xx
Work in Process xx

Sale of finished goods.

Cash/Accounts Receivable xx
Sales xx
Cost of Goods Sold xx
Finished Goods Inventory xx

Collection of cash from customer(sales made on credit before

Cash xx
Accounts Receivable xx

2.1.2 Determination of optimum purchase quantities

In a manufacturing process raw materials are in constant use. There is a link

between the purchasing department, the stores warehouse and the production department.
When inventory levels fall to their reorder level in the warehouse a purchase requisition for the
reorder quantity is sent to the purchasing department.

The purchasing process starts with a purchase request prepared for specific quantities
of materials needed in the manufacturing process but not currently available in the materials
storeroom. A qualified manager approves the request and based on the information in the
purchase request, the Purchasing Department prepares purchase order and sends it to a
supplier. When the materials arrive, an employee on the receiving department
examines the materials and enters the information into the company database as a receiving
report.

The system matches the information on the receiving report with the descriptions and
quantities listed on the purchase order. A materials handler moves the newly arrived
materials from the receiving area to the materials storeroom. Accounting department receives
a vendor‘s invoice from the supplier requesting payment for the purchased materials. The cost of
those materials increases the balance of the materials Inventory account and account payable is
recognized. If all documents match, payment is authorized to be made.

Purchase of right quantity depends on such factors as

Average consumption
Inventory levels i.e. maximum, minimum, reorder level, quantity already on order,
Financial considerations, such as availability of funds, interest on capital, quantum of
discount allowed, etc.
Consideration of cost of storage space.
A good purchasing system balances these two situations by skillfully determining Economic
Order Quantity (or E.O.Q.) at a point, where cost of ordering and cost of carrying
the inventory will be minimum

 If the purchase quantity is increased, the cost of ordering decreases, but the cost
of carrying increases.
 If the quantity is reduced, then the cost of ordering increases with the decrease of
the cost of carrying. At economic order quantity, carrying cost equals to ordering
cost
The skill of purchase often depends on the judgment of right time to buy. Urgent material
and spare-parts required for machine-breakdown shall be purchased immediately. But
others, depending on the nature of requirement can be procured economically by using
judgment

Average consumption and reordering level are often considered for timing of purchase.
Purchase of material should be made at right price. It does not mean lowest price, but points to
most economical price. The price agreement as well as the purchase order shall clearly
indicate —

(a) The basic price of the material per unit,

(b) The excise duty, VAT and sales tax applicable,
(c) Transportation, packing and insurance,
(d) Trade and cash discounts applicable, and
(e) Charges for returnable containers

Lastly, the purchase department shall procure materials from the right source. As far as possible
purchases are made from the manufacturer or authorized wholesalers of the various inputs
in order to avoid middlemen, ensuring quality and keeping price at minimum.
2.1.3 Identification of accounting for stock(Material) losses

Loss of materials may arise during handling, storage or during process of manufacture.
Such losses may be classified in two categories, i.e. normal loss and abnormal loss.

Normal loss is that loss which has necessarily incurred and thus is unavoidable. Examples:
Loss by evaporation, Loss due to loading and unloading, Loss due to breaking the bulk, etc.
Abnormal loss is that a loss which arises due to inefficiency in operation, mischief,
carelessness etc . Examples:
- theft , pilferage - use of inaccurate instruments
- breakage - improper storage, etc
- fire, accident ,
- flood
Accounting treatment

As a principle, all normal losses which are necessarily incurred are treated as part of the
cost and abnormal loss should not be included in the cost. In order to absorb normal
material loss in the cost, the rates of usable rates are inflated so that the losses are absorbed.
Alternatively, normal material loss is treated as or transferred to factory overhead cost.
However, abnormal losses are charged to profit and loss account. Material losses may arise in the
form of waste, scrap, spoilage or defectives.

a) Waste

Waste comprises of invisible losses , visible losses that cannot be collected and also unsalable
portion of collected losses . Waste is excluded from output quantity. Examples of waste
are smoke, dust, gasses, slag, etc . In certain cases , waste involves further cost of disposing it e.

Standards are established for waste. Actual wastage is receded and variations from standards are
reported.

- Normal waste: unavoidable and uncountable and treated as part of product cost.
The wastage cost is borne by goods unit.
- Abnormal waste: is valued as if the output is good. This cost is transferred to the costing
profit and loss account g. cost incurred to dispose sewage
b) Scrap – represent unusable loss which can be sold. It is a residue which is measurable and has
a minor value. It may result from processing of materials, obsolete stock or parts. The sale value
is credited to the concerned department that produced it. If the value is negligible,
it is credited to the costing profit and loss account / it is charged to the goods unit.
Examples of scrap:

 Sawdust in wood/timber industry

 Cut pieces in leather industry
c) Spoilage: is those materials or components which are damaged in the manufacturing process
that they cannot be reconditioned or repaired.

- Loss due to spoilage can be debited to the job/ process / product in which it incurred. It may
be charged to factory overheads so that loss is borne by all products
- Abnormal loss which is unexpected but controllable should be transferred to the costing
profit loss account
d) Defectives: are portion of process losses which can be converted to finished goods by
incurring more materials and expenses. The additional expenses are added to the cost
manufacture.
Defective inherent in the manufacturing process are classified as normal and treated in
the following manner

1. loss is charged to the good product

2. The additional cost of rectification is charged to factory overheads and
apportioned to various goods as part of factory overheads cost
3. If a particular department is responsible to for the additional cost of
rectifications it can be charged to that department.

If defective units can be traced to a particular job/ order, the additional cost can be charged to
that job/ order.
If defectives are abnormal and due to uncontrollable factors, the additional cost are
charged to costing profit and loss account
2.2 Labor
Labour cost is a significant element of cost specially in an organization using more manual
operations. It is the cost of human endeavour in the product and requires coordinated efforts
for its control. Low labour cost is possible by giving substantial increase in wages against
corresponding increase in productivity. Labour cost is a vital factor not only affecting the
cost of production but also industrial relations of the organization. No organization can
expect to attract and attain qualified and motivated employees unless it pays them fair
remuneration. The total labour cost can be classified as follows:
a. Direct labour costs;
b. Indirect labour costs.
A) Direct Labour Cost
It refers to all labour expended in altering the construction, composition, conformation or
condition of the product. The wages paid to skilled and unskilled workers for his labour can
be allocated specifically to the particular product or the process as the case may be. In any
manufacturing process or department, the workers employed may be of the following two
categories:
(i) Those who are directly engaged on the production or in the carrying out of an operation or
process;
(ii) Those who are assisting in the process by way of supervision, maintenance,
transportation of materials, etc.
The workers coming under the first category constitute direct labour and the wages paid to them
are called direct wages. In a factory, where production of a number of products is undertaken or
in a jobbing concern, workers are given job cards on which they note the time devoted to each
job or product. It can be easily identified with and charged to a single costing unit as there is a
direct relationship with the product/process. Direct labour cost can be easily calculated and is
quite significant in amount. For example labor engaged in spinning department can be
conveniently allocated to the spinning process.In short Labor may be classified as direct when

 There is a direct relationship of the labor to a particular production unit or

process
 The labor cost is measurable in terms of such production unit or process and
 The labor cost is sufficiently significant in amount and easily identifiable with particular
production unit or process
B) Indirect Labor is that labor which is not directly engaged in the production of goods and
services but which indirectly helps the direct labor engaged in production. Wages or salaries
paid to foremen, supervisors, inspectors, clerks, store-keepers, managers, accountants, salesmen,
directors, etc., are examples of indirect labour cost. The cost of indirect labor cannot be
conveniently allocated to a particular job, order, process or article. Indirect labor costs are
those costs which are necessary for production purposes but are not identifiable with a particular
production unit.

2.2.2 Types of labor remuneration methods

Remuneration has been defined as the reward for labor and services rendered. All business
organizations should have a proper method of remuneration for their employees. There are Two
Types of labor remuneration methods

1. Time Wage System: Under this method of wage payment, the worker is paid at an hourly,
daily, weekly or monthly rate. This payment is made according to the time worked irrespective
of the work done.
Basic pay = hours worked x labor rate per hour
2. Piece Rate System (payment by result): Under this system of wage payment, a fixed rate is
paid for each unit produced, job completed or an operation performed. Thus, payment is made
according to the quantity of work done no consideration is given to the time taken by the workers
to perform the work.
Wage amount = the units produced x the piecework rate per unit
Example: Management are considering introducing an incentive scheme for staff working in
production. Employees work a 40-hour week and are paid 12 Birr per hour. Their output is as
follows:
Staff member A: 325 units
Staff member B: 350 units
Staff member C: 475 units
A. Calculate the basic pay for each employee
Basic pay = hours worked x labor rate per hour
= 40 hours x 12 Birr per hour
= 480 Birr
B. Calculate the wages paid to each employee if Piece Rate System (payment by
result) is introduced
Wage amount = the units produced x the piecework rate per unit
Staff member A: 325 units x A0.75 = 243.75 Birr
Staff member B: 350 units x A0.75 = 262.50 Birr
Staff member C: 475 units x A0.75 = 356.25 Birr

Direct Expense
Expenses may be defined as ―the costs of services provided to an undertaking and the notional
costs of the use of owned assets‖.

Direct expenses are those expenses which are directly chargeable to a job account. Direct
expenses may be defined as those expenses which are easily identifiable and attributable to the
individual units or jobs. All expenses other than the direct material or direct labour which are
incurred for a particular product or process are termed as direct expenses. Expenses which can be
identified with a territory, a customer or product can be considered as direct expenses. Expenses
in relation to a department may be direct but are indirect in relation to the product.

*Direct expenses are defined as ―costs, other than materials or wages, which are incurred for a
specific product or salable service.‖∗

There is no hard and fast rule regarding classification of expenses into direct and indirect. Direct
expenses are specific charges directly attributable while the indirect expenses are apportioned on
suitable basis. Some items by nature are direct but treated as indirect because the amounts
chargeable are either of small or negligible value. It is difficult and costly to analyse them and
hence treated as indirect expenses, e.g. nuts, screws, thread, glue, etc.

Nature of Direct Expenses

Direct expenses is directly attributed to cost unit/cost center. It includes all direct cost except the
direct material and direct labour. Types of Direct Expenses are as under:

(i) Royalties if it is charged as a rate per unit.

(ii) Hire charges of plant if used for a specific job.

(iii) Sub-contract or outside work, if jobs are sent out for special processing.

(iv) Salesman‘s commission if it is based on the value of units sold.

(v) Freight, if the goods are handled by an outside carrier whose charges can be related to
individual units.

(vi) Travelling, hotel and other incidental expenses incurred on a particular contract.

(vii) Cost of making a design, pattern for a specific job.

(viii) Cost of any special process not forming part of the normal manufacture like water proofing
for canvas cloth

Accounting Treatment of Direct Expenses

Direct expenses are chargeable expenses and are debited to Direct Expenses Account in financial
books. Accounts are prepared in columnar form so that the analysis can be made and the
expenses can be related to the specific job/contract.

In cost accounting records, the direct expenses account is credited and the concerned account is
debited. The cost department should verify from the accounts department that the expenses are
properly booked. These expenses should not be mixed up with overheads

Control of Direct Expenses

Items under this head are few. They form a small part of the total cost. Such costs are controlled
by fixing standards. The actual should be compared with the standard. The causes of variations,
if any, should be ascertained and necessary corrective action should be taken.

2.3 Overheads
Overheads are indirect costs. They are either variable or fixed based on their behavior in
response to change in volume of production or level of activity. They are all costs on the income
statement except for direct labor, direct materials, and direct expenses.

CIMA, London defines overhead as ―Expenditure on labour, materials or services which can
not be economically identified with a specific saleable cost unit‖.

COLLECTION OF OVERHEADS
Based on Function
Overheads can be divided into the following categories on functional basis:

(a) Manufacturing or production or factory overheads: Manufacturing overheads includes all

indirect costs (indirect material, indirect labour and indirect expenses) incurred for operation of
manufacturing or production division in a factory. It is also know as, factory overheads, works
overheads, factory cost or works cost etc.

(b) Administration overheads: It is the sum of those costs of general management, secretarial,
accounting and administrative services, which cannot be directly related to the production,
marketing, research or development functions of the enterprise. Administration overheads
include the cost of formulating the policy, directing the organisation and controlling the
operations of an undertaking which is not related directly to production, selling, distribution,
research or development activity or function.

(c) Selling and distribution overheads: Selling overheads is the cost of seeking to create and
stimulate demand and of securing orders. It comprises the cost to products of distributors for
soliciting and recurring orders for the articles or commodities dealt in and of efforts to find and
retain customers. Distribution overhead is the expenditure incurred in the process which begins
with making the packed product available for dispatch and ends with the making the
reconditioned returned empty package, if any, available for re-use. It includes expenditure
incurred in transporting articles to central or local storage. It also comprises expenditure incurred
in moving articles to and from prospective customer as in the case of goods on sale or return
basis. In case of gas, electricity and water industries distribution means pipes, mains and services
which may be regarded as equivalent to packing and transportation.

(d) Research and development overheads: Research overhead is incurred for the new product,
new process of manufacturing any product. The development overhead is incurred for putting
research result on commercial basis.

Based on the nature, overheads can be classified into the following categories:

(i) Fixed overheads: are those which remain fixed in total amount with increases or decreases
in volume of output or productive activity for a particular period of time, e.g. managerial
remuneration, rent of building, insurance of building, plant etc. Fixed overhead costs remain the
same from one period to another except when they are deliberately changed, e.g. increments
granted to staff. The incidence of fixed overhead on unit cost decreases as production increases
and vice versa.

Fixed overheads are stated to be uncontrollable in the sense that they are not influenced by
managerial action. However, it should be noted that an expenditure is fixed within specified limit
relating to time or activity. In a hypothetical organisation no expenditure remains unchanged for
all time. Therefore, it is true to state that ―fixed overhead is fixed within specified limit relating
to time and activity‖.

(ii) Variable overheads: Variable overhead costs are those costs which vary in total in direct
proportion to the volume of output. For instance, if the output increases by 5%, the variable
expenses also increase by 5%. Correspondingly, on a decline of the output it will also decline
proportionately. Examples are indirect material and indirect labour. Variable overhead changes
in total but its incidence on unit cost remains constant.

(iii) Semi-variable overheads: These overhead costs are partly fixed and partly variable. They
are known as semi-variable overheads because they contain both fixed and variable element.
Semi-variable overheads do not fluctuate in direct proportion to volume. They are also called
Step Costs It may remain fixed within a certain activity level, but once that level is exceeded,
they vary without having direct relationship with volume changes. Examples are depreciation,
telephone charges, repair and maintenance of buildings, machines and equipment etc.
Based on element
a) Indirect materials
b) Indirect labour
c) Indirect expense
Based on control
a) Controllable overhead cost
b) Uncontrollable overhead cost
2.3.1 Overhead cost analyses
Overhead costs are allocated to cost objects for three main reasons:
1. To determine full cost of the cost object
2. motivate the manager in the charge of cost object to manage it efficiently
3. To compare alternative course of action for management planning , controlling and
decision making
Purposes of Overhead Cost Analysis

a) The control of overhead expenditures d) Valuation of abnormal losses

b) Charging of overheads to cost units e) Profit measurement
c) Valuation of work in progress f) Decision making
Steps to analysis overhead cost

1. Collection of overhead cost

2. Classification of overhead costs
3. Allocating and apportiment of overhead costs
4. Absorption of overhead costs
2.3.2. The apportionment and absorption of overhead costs

Allocation of Overhead Expenses

Allocation is a direct process of identifying overheads to cost units or cost centers. An expense
which is directly identifiable with a specific cost center is allocated to that center. Thus
the term allocation means allotment of whole item of cost to a particular cost center
or cost object without any division.

Examples for cost allocations

- Electricity charges can be allocated to various departments if separate meters are installed
- Depreciation of machinery can be allocated to various departments as the machines can
be identified
- Salary of stores clerk can be allocated to stores department
- Wages paid to workers of service department can be allocated to the
particular department.
- Indirect materials used by a particular department can also be allocated to the department.
Apportionment of Overhead Expenses
Apportionment refers to the distribution of overheads among departments or cost centres on an
equitable basis. In other words, apportionment involves charging a share of the overheads to a
cost centre or cost unit.

CIMA, London has defined it as ―that part of cost attribution which shares costs among two or
more cost centres or cost units in proportion to the estimated benefit received, using a proxy‖.
Apportionment is done in case of those overhead items which cannot be wholly allocated to a
particular department. For example, the salary paid to the works manager of the factory, factory
rent, general manager‘s salary etc. cannot be charged wholly to a particular department or cost
centre, but will have to be charged to all departments or cost centres on an equitable basis.

Distinction between Allocation & Apportionment

Although the purpose of both allocation and apportionment is identical, i.e to identify or allot
the costs to the cost centres or cost unit, both are not the same.
Allocation deals with the whole items of cost and apportionment deals with proportion of
items of cost.
Allocation is direct process of departmentalization of overheads, where as apportionment
needs a suitable basis for sub-division of the cost.
Whether a particular item of expense can be allocated or apportioned does not depends on the
nature of expense, but depends on the relation with the cost centre or cost to which it is to be
charged
The following are the main bases of overhead apportionment utilized in
manufacturing concerns:
Absorption of Overheads

Absorption of overheads refers to charging of overheads to individual products or jobs. The

overhead expenses pertaining to a cost centre are ultimately to be charged to the products, jobs
etc. which pass through that cost centre. For the purpose of absorption of overhead to individual
jobs, processes or products, overheads absorption rates are applied. The overhead absorption rate
may be computed either based on actual cost or on the basis of estimated cost:
Actual Overhead Rate

This is also known as historical overhead rate. This rate is obtained by dividing the overhead
expenses incurred during the accounting period by the actual quantum (quantity/value) of the
base selected. This rate is determined as follows:

This method suffers from the following limitations:

(i) Actual overhead rate cannot be determined until the end of the period.

(ii) Seasonal or cyclical influences cause wide fluctuations in the actual overhead cost and actual
volume of activity.

(iii) Actual cost is generally used for comparison with the predetermined figures for the purpose
of control. Thus, it is useful only when compared with the established norms or standards

Pre-determined Overhead Rate

Pre-determined overhead rate is determined in advance of the actual production and is computed
by dividing the budgeted overhead expenses for the accounting period by the budgeted base for
the period i.e.

This computation of a pre-determined overhead rate is more practical and has the following
advantages:

(i) Pre-determined overhead rate facilitates product cost determination immediately after
production is completed.

(ii) In those concerns where the budgetary control system is in operation, all the data for the
purpose of calculation of pre-determined overhead rate is available without any extra clerical
cost.

(iii) It is useful when cost plus contracts are undertaken.

(iv) Cost estimating and competitive pricing offer ideal situations for use of pre-determined
overhead rates.
Accounting for the over- and under absorption of costs

What do over-absorbed and under-absorbed mean?

Over-absorption(over recovery) : if the absorbed overheads at predetermined rates are

greater than actual overheads . It may be due to
— Expense being less than estimate; and / or
— Output or hours worked may be exceeding the estimate

Under-absorption (under recovery): if absorbed overheads are less than the actual
overheads. It may be due to as 'under
- Actual expenses exceeding the estimate; and / or
- Output or the hours worked may be less than the estimate
2.3.3 IAS 2 inventories on Overhead allocations
 IAS 2 sets out the accounting treatment for inventories
 Inventories are assets that are held for sale in the ordinary course of business; - in the
process of production for such sale; or - in the form of materials or supplies to be consumed
in the production process or in the rendering of services.
Indirect Expenses

Indirect expenses are expenses other than direct expenses. These refer to those expenses which
cannot be directly, conveniently and wholly allocated to cost centres or cost units. E.g. factory
rent & insurance, power, general repairs etc.

Nature of indirect Expense

Indirect costs are ―those which are incurred for common or joint objectives and therefore cannot
be identified readily and specifically with a particular cost unit/cost centre. A few examples of
such expenses are as follows:

(i) Rent, rates and insurance of factory and office.

(ii) Depreciation, repairs and maintenance of plants, machinery, furniture, building etc.

(iii) Power, fuel, lighting, heating of factory and office.

(iv) Advertising, legal charges, audit fees, bad debts, etc.

Expenses excluded from costs

The following types of items are not included in cost of production or sales:

(a) Matters of pure finance including interest paid and received, dividend received on
investments, rent received, profit or loss on sale of investments or company‘s property, transfer
fees received etc.

(b) Appropriation of profits including income-tax paid, dividends paid, transfer to sinking fund,
general reserve, excessive depreciation, goodwill or other fictitious assets written off, etc.

Accounting Treatment of Indirect Expenses

Indirect expenses may or may not be allocated. For example, office administrative costs are
indirect expenses, but are rarely allocated to anything, unless it is corporate overhead and is
being allocated to subsidiaries. These types of indirect expenses are charged to expense in the
period incurred. Indirect expenses that are factory overhead will be allocated to those units
produced in the factory during the same period that the indirect expenses were incurred, and so
will eventually be charged to expense when the products to which they were allocated are sold.

2.4 Recording of costs and schedule of costs of products

Financial statement of a manufacturing company is more complex as compared to
financial statement of merchandising and service giving companies. Particularly, the
balance sheet and income statement of a manufacturing enterprise are somewhat different
from their merchandising and service counterpart. All costs mentioned above should be
properly accounted for and reported in the financial statement of a manufacturing firm.

Manufacturing organizations perform selling and administrative functions similar to

merchandising firms. However, instead of purchasing goods that are ready for resale, a
manufacturing firm buys raw materials, labor, and other components needed to perform
the manufacturing function of converting the raw materials into finished products. This
difference is shown in the cost-of –goods –sold statements. In addition, the balance sheet at the
end of the period will show ending inventories for raw materials, work in process, and
finished goods. Our objective here is to explain the computation of cost of goods manufactured
and to illustrate the development of external financial statements for a manufacturing
organization.
1. Balance Sheet of a Manufacturing Firm

The balance sheet of a manufacturing firm differs from the balance sheet of a merchandising
firm principally by the type of inventories reported. A manufacturing firm carries three
types of inventory. Namely, Raw material inventory, Work in Process inventory and Finished
Goods inventory.

o Raw Material Inventories: are raw materials in stock and waiting to be used in
manufacturing process.
o Work in Process Inventories: are goods partially processed but not yet completed. They are
also called Work In Progress (WIP).
o Finished Goods Inventories: are goods fully completed but not yet sold
The balance sheet presented below for a hypothetical manufacturing company shows how the
three types of inventories are presented

2. Income Statement of a Manufacturing Firm

Income statement of a manufacturing firm differs from income statement of a merchandising

firm by the cost of goods manufactured section. A merchandising firm sells goods that
are bought from another merchandising firm or from a manufacturing firm, But a manufacturing
company sells goods that are internally produced. Hence, the cost of goods sold section contains
cost of goods manufactured instead of purchase. Cost of goods manufactured must
first be computed before the income statement is prepared
The cost of goods manufactured by itself needs a computation that presents the cost of direct
material used, cost of labor incurred, and factory overhead costs. In general, the following four
steps are required to prepare income statement of a manufacturing firm.

Step 1: The Schedule of Direct Materials Used in Production

The cost of direct material used is equivalent to the beginning inventory of direct material plus
purchase made during that period less the direct material left at the end of the period.

Illustration: Assume that the direct material inventory of Gibe furniture factory amounts to Br.
248, 000 at the beginning of the year i.e., as of July1, 2008. Purchase of direct material
amounting Br. 440,000 was made and freight cost of Br.3, 200 is incurred during the year, and
the amount of direct materials inventory at the end of the year is Br. 234, 900 .

Step 2: The Schedule of Cost Goods Manufactured

Cost of goods manufactured refers to the cost of goods brought to completion

whether they were started before or during the accounting period. To determine the cost of
goods manufactured, three factors are necessary; cost of direct materials used, cost of
direct labor and manufacturing overhead. In addition, work in process at the beginning
and at the end should be incorporated in the calculation.
Assume Gibe furniture factory has beginning work in process of Br. 220,000and ending work in
process of Br. 263,200. The direct labor cost incurred in the year is Br.875,000 and the
different manufacturing overhead costs incurred during the year are given below:

 The cost of goods manufactured for Gibe Furniture factory will be computed as follows using
schedule 2

Step 3: The Schedule of Cost of goods sold

The cost of goods sold represents the cost of goods that are sold during a given period. In
computing cost of goods sold amount, cost of finished goods at the beginning, cost of
goods manufactured in the period and cost of finished goods at the end will be taken in
to account. The following is the schedule used to compute cost of goods sold.

Assume that the finished goods inventory at the beginning of the year was Br. 314,000 and the
ending inventory of finished goods is Br.364,000 for Gibe furniture factory. The cost of goods
sold is then calculated as follows.

Step 4: Income Statement

All of the above schedules are inputs one to the other. The ultimate goal of making all the
schedules is to prepare the income statement. The income statement contains three main
elements. These are sales, cost of goods sold and operational expense. The following is the
schedule used to calculate operating income.

 Assume that the sales amount for the year for Gibe Furniture factory is
Br.3,663,200 and the operating expense for the year is Br.1,498,850, the income
statement for Gibe Furniture factory can be prepared as follows .
Note: There are two forms of income statements

Single step income statement(condensed income statement)

 It does not show how each element is constructed

Multiple Step Income Statement

 It is also possible to include all the schedules at a time to prepare the income statement

 Such statement contains detailed information about each item

Exercise
1. The following data (in thousands of dollars) have been taken from the accounting records of
Larop Corporation for the just completed year.

Sales.......................................................................... $870

Purchases of raw materials .......................................... $190

Direct labor .................................................................. $200

Manufacturing overhead............................................... $230

Administrative expenses............................................... $150

Selling expenses............................................................. $140

Raw materials inventory, beginning ............................... $10

Raw materials inventory, ending .................................... $40

Work in process inventory, beginning ............................ $20

Work in process inventory, ending ................................. $50

Finished goods inventory, beginning .............................. $90

Finished goods inventory, ending.................................... $130

Required:

a) Prepare a Schedule of Cost of Goods Manufactured.

b) Compute the Cost of Goods Sold.
c) What amount of prime costs was added to production during 2012?
2. The East Company manufactures several different products. Unit costs associated with
Product ORD203 are as follows:

Direct materials $50

Direct manufacturing labor 8

Variable manufacturing overhead 10

Fixed manufacturing overhead 23

Sales commissions (2% of sales) 5

Administrative salaries 9

Total $105

a. What are the inventoriable costs per unit associated with Product ORD203?
b. What are the period costs per unit associated with Product ORD203?
Solution
1) First determine Cost of direct material used before compute cost of good manufactured

Raw materials inventory, beginning ........................................................ $10,000

Add: Purchase in the period………………………………………………$190,000

Direct material available for use……………………………………………200,000

Less: Raw materials inventory, ending ....................................................... ($40,000)

Cost of direct material used………………………………………………… 160,000

a) Prepare a schedule of Cost of good manufactured

Work process inventory, beginning……………………………………………………..20,000

Add: Cost of direct material used…………………………...160,000

Direct Labour cost……………………………………………200,000

Manufacturing overhead cost……………………………… …230,000

Cost incurred in the period……………………………………………………………….590,000

Total cost incurred to date……………………………………………………………… 610,000

Less: Work process inventory, ending……………………………………..………..…..(50,000)

Cost of good manufactured……………………………………………………………….560,000

b) : Compute cost of goods sold

Finished goods inventory, beginning ................................................................................. $90 ,000

Add: Cost of good manufactured………………………………………………………….560,000

Cost of good Available for sale…………………………………………………………...650,000

Less: Finished goods inventory, ending...........................................................................(130, 000)

Cost of goods sold…………………………………………………………………………520,000

c) What amount of prime costs was added to production during 2012?

Prime cost = Direct material cost + direct labour cost = 160,000+200,000= 360,000

2. a) Inventoriable costs= Direct material cost + direct labour cost+ Manufacturing overhead

= $50 +8+33=$91

b) Periodic cost- costs other than product costs i.e. The sum of sales commission plus administrative
salaries

=$5+9= 14
Chapter Three
Costing methods: The costing of resource outputs

Learning Objectives

Dear students, after completing this chapter, you should be able to:
 Understand the characteristics of job order, batch, and contract costing methods.
 Account for direct and indirect costs in each costing method.
 Treat waste, scrap, spoilage, and rework costs appropriately in the costing process.

Building-Block (Concepts) of Costing Systems

Before we begin our discussion of costing systems, let's review cost-related terms and introduce
the new terms that we will need for our primary discussion.

Cost object - anything for which a measurement of costs is desired — E.g., a product, such as
chair and table, or a service, such as the cost of repairing a computer.

Direct costs of a cost object - costs related to a particular cost object that can be traced to that
cost object in an economically feasible (cost-effective) way — E.g., the cost of purchasing the
wood and steel used to make a chair or table.

Indirect costs of a cost object - costs related to a particular cost object but that cannot be traced
to that cost object directly in an economically feasible (cost-effective) way — E.g., the costs of
supervisors who oversee multiple products, or the rent paid for a factory building. Indirect costs
are allocated to the cost object using a cost allocation method. Recall that cost assignment is a
general term for assigning costs, whether direct or indirect, to a cost object. Cost tracing is a
specific term for assigning direct costs; cost allocation refers to assigning indirect costs.

Cost pool - is a grouping of individual indirect cost items. Cost pools can range from broad, such
as all manufacturing-plant costs, to narrow, such as the costs of operating a metal- cutting
machine.
Cost-allocation base - How should a furniture company allocate costs of operating a metal-
cutting machine among different products (chair and table)?

One way to allocate such costs (cost pool) is based on the number of machine-hours used to
produce different products. The cost-allocation base (number of machine-hours in this case)
is a systematic way to link an indirect cost or group of indirect costs (operating costs of the
metal-cutting machine) to cost objects (different products the chair & table). E.g. if indirect
costs of operating metal-cutting machine is Br. 500 based on running these machines for 100
hours, the cost allocation rate is Br. 500

100 hours = Br. 5 per machine-hour, where machine-hours is the cost allocation base. If a
product uses 30 machine-hours, it will be allocated Br. 150 (i.e. Br. 5 per machine-hour x 30
machine- hours). The ideal cost-allocation base is the cost driver of the indirect costs, because
there is a cause-and-effect relationship between the cost allocation base and the indirect costs. A
cost-allocation base can be either financial (such as direct labor costs and direct material costs)
or nonfinancial (such as number of direct labor hours or number of machine-hours). When the
cost object is a job, product, or customer, the cost-allocation base is also called a cost-application
base.

Production Cost information: Management depends on relevant and reliable information about
costs in managing their organizations. The role of management accountant is to develop
management information systems that provide managers with the cost information they need.

Product costing system:

Management need extensive information about product related costs. To meet this it is necessary
to develop a highly reliable product costing system that is specifically designed to record and
report the organization‘s operation.
A product costing system is a set of procedures used to account for an organizations product
costs and provide timely and accurate unit cost information for pricing, cost planning and
control, inventory valuation and financial statement preparation. There are three main types of
cost accounting systems for manufacturing operations: Job order, process and operational cost
systems. Each of the three systems is widely used and any one organization may use more than
one type. .
a). Job Order Costing System — In this system, the cost object is a unit or multiple units of a
distinct product or service called a job. Each job generally uses different amounts of resources.
The product or service may be a specialized car made at Toyota Co., costs of bed & Sofa ordered
at Jinka furniture, a construction project managed by Afro Tsion, cost of mobile repair at Jemal
mobile repair & maintenance, an advertising campaign produced by Serawit Fikrie Promotion,
costs of treating a patient at Bole clinic, etc. Each special car made by Toyota is unique and
distinct. An advertising campaign for one client at Serawit Fikrie Promotion is unique and
distinct from advertising campaigns for other clients. Job costing is also used by companies such
as Furniture producers to cost multiple identical units of distinct furniture products. Because the
products and services are distinct, job-costing systems accumulate costs separately for each
product or service (Job).

b) Process-costing system — In this system, the cost object is masses of identical or similar
products. E.g. Dashen Beer Co., MOHA soft drinks and Omo Kuraz Sugar factory produce
identical beer, soft drinks and sugar respectively. In each period, process-costing systems divide
the total costs of producing an identical or similar product by the total number of units produced
to obtain a per-unit cost. This per-unit cost is the average unit cost that applies to each of the
identical or similar units produced in that period.

c) Operational costing system: In reality, few actual production processes perfectly match
either a job order costing system or a process costing system. Thus, the typical product costing
system combines parts of both job order costing and process costing to create a hybrid system
designed specifically for an organizations particular production process. An example of a
company that would use an operational cost system is an automobile manufacturer. An
automobile Maker may use process costing to treat the costs of manufacturing basic car and then
use job order costing to track the costs of customized features such as a convertible or hardtop,
an automatic transmission or stick shift.

3.1 Job order, batch and contract costing methods

3.1.1 Job order costing

What is job order costing?

Job order costing is a costing method which is used to determine the cost of manufacturing each
product. This costing method is usually adopted when the manufacturer produces a variety of
products which are different from one another and needs to calculate the cost for doing an
individual job. Job costing includes the direct labor, direct materials, and manufacturing
overhead for that particular job
Importance of job order costing
To determine the profitability of the job: Job order costing is useful for determining if a job
is profitable. It helps the company make estimates about the value of materials, labor, and
overhead that will be spent while doing that particular job. Efficient job order costing helps
companies to create quotes that are low enough to be competitive but still profitable for the
company.
To make data-driven decisions: Over time, a job order costing system becomes a valuable
database holding the details and costs of doing jobs. The information that is stored can be used as
empirical data to help the company evaluate its own efficiency and reduce costs by changing its
procedures, methods, or staffing.
To monitor machine usage: Job order costing helps companies see how much they‘re using
their fixed assets, such as manufacturing equipment. Since machine costs are distributed amongst
different jobs, the identification of this cost is important to know the cost of the job. This helps
determine the amount of overhead allocated to each asset and distribute it fairly between the
company‘s jobs.
The following are the features of job costing.
 It is a specific order costing
 A job is carried out or a product is produced is produced to meet the specific requirements of
the order.
 Job costing enables a business to ascertain the cost of a job on the basis of which quotation
for the job may be given.
 While computing the cost, direct costs are charged to the job directly as they are traceable to
the job.
 Indirect expenses i.e. overheads are charged to the job on some suitable basis.
 Each job completed may be different from other jobs and hence it is difficult to have
standardization of controls and therefore more detailed supervision and control is necessary.
 At the end of the accounting period, work in progress may or may not exist.
Steps to be involved in Job costing System

Step 1: Identify the Job that has Chosen as a Cost Object:

Step 2: Identify the Direct Costs of the Job.

Step 3: Select the Cost-Allocation Bases to Use for Allocating Indirect Costs to the Job.

Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation Base.

Step 5: Compute the Rate per Unit of Each Cost-Allocation Base.

Step 6: Compute the Indirect Costs Allocated to the Job.

Step 7: Compute the Total Cost of the Job (Direct + Indirect Costs) Assigned to that Job.

Actual Costing Vs Normal costing

Actual costing is a costing system that:

I) Traces direct costs to a cost object and;
2) Allocates indirect costs based on actual indirect-cost rates. Actual indirect-cost rate is
calculated by dividing actual total indirect costs by the actual total quantity of the cost- allocation
base.
As its name suggests, actual costing systems calculate the actual costs of a jobs. However, an
actual costing system is not practical because actual costs cannot be computed in a timely
manner.
Normal costing is a costing system that
l) Traces direct costs to a cost object by and;
2) Allocates indirect costs based on the budgeted indirect-cost rates.
The budgeted indirect-cost rate for each cost pool is computed as follows:

Job cost sheet: - is a form prepared for each separate job that records the direct materials, direct
labor, and manufacturing overheads. This is a key source document (original record) of cost of a
product in job order costing system.

Illustration on iob order costing system

Assume that Neri Furniture is a furniture firm that uses job costing system to cost its two jobs
or products Job — 01 (Chair) and Job — 02 (Table). The company has started operation on Jan
1, 2021 so it had no beginning raw material, work in process and finished goods inventories at
Jan l, 2021. Consider during its operation on January the company has two direct cost categories;
direct materials and direct labor, and one indirect cost pool; that is manufacturing overhead. The
company applies overhead cost to its jobs on the basis of Labor — hours worked. For the
current year, the company estimated that it would use a total of 750 direct labor hours and
incur Br. 15,000 in manufacturing overhead costs.
The following transactions were completed during the year:
a. Raw materials (such as Wood and Metal) were purchased on account for Br. 40,000.
b. Raw materials used in production Br. 36,000 (32,000 direct materials & 4,000 indirect
materials). Out of Br. 32,000 direct materials, Br. 22,000 is used for Job — 01 and Br. 10,000 for
Job — 02.
c. The following costs were paid for employee services; direct labor, Br. 20,000(i.e. Br. 8,000 is
used for Job — 01 while Br. 12,000 is used for Job — 02; indirect labor, 7,000; sales
commission, Br. 3,000; and administrative salaries, Br. 4,000.
d. Paid utility costs in the factory, Br. I ,500
e. Paid Advertising costs Br. 2,200.
f. Depreciation expenses were recorded for the year, Br. 1,000 (80% to factory equipment, and
20 % selling and administrative activities).
g. Insurance expired during the year, Br. 800 (70% relates to factory operations, and 30% for
selling and administrative activities).
h. Manufacturing overhead was applied to production. Due to many reasons, the company
actually used 800 direct labor hours during the year which is greater than expected (320 hours for
Job — 01 and 480 hours for job — 02).
I. Goods costing Br. 55,000 to manufacture according to their job cost sheet were completed and
hence transferred from WIP inventory to finished goods inventory during the year (of which Br.
30,000 is from Job — 01 and the remaining Br. 25,000 from Job — 02).
J. Goods were sold on account to customers during the year for a total of Br. 70,000. The goods
cost Br. 42,000 to manufacture (of which Br. 22,000 is from Job — 01 and Br. 20,000 from Job
— 02.)

Required: - Prepare journal entries to record the preceding transactions.

a. Raw material -----------------------------40,000

Account payable ------------------------------------- 40,000
Problem of Overhead Application and the concept of Under/Over Applied Overhead

Since the predetermined overhead rate is established based on entirely estimated data, generally,
there will be a difference the amount of overhead cost which is applied to work in process and
the actual overhead costs, Budgeted or estimated indirect manufacturing costs rate have the
advantage of being timeliness than actual indirect manufacturing cost rate. Indirect costs can be
assigned to individual jobs on ongoing basis rather than waiting until the end of the accounting
period when actual costs will known. But, the disadvantage of budgeted predetermined rate is
that they likely will inaccurate. Hence, we should consider adjustments when the indirect costs
allocated differ from actual indirect cost incurred. The difference between the overhead cost
applied to work in process and actual overhead costs incurred are termed as either under applied
or over applied overhead cost. Under allocated indirect costs occur when the allocated amount
of indirect costs in an accounting period is less than the actual (incurred) amount. Over allocated
indirect costs occur when the allocated amount of indirect costs in an accounting pericni is
greater than the actual (incurred) amount.
Under or over allocated indirect Costs = Actual indirect costs incurred - Indirect costs allocated
There are two indirect-cost accounts in the general ledger that have to do With manufacturing
overhead:
• Manufacturing Overhead account (actually incurred): - the record of the actual costs in all
the individual overhead categories (such as indirect materials, indirect manufacturing labor,
supervision, utilities. and factory depreciation).
• Manufacturing Overhead Allocated (Estimated): - the record of the manufacturing overhead
allocated to individual jobs on the bmsis of the budgeted rate multiplied by actual quantity of
cost allocation base.
Generally, the difference is resulted from the computation of the predetermined rate; i.e.
• Budgeted allocation base vary from actual allocation base. Hence,
• Budgeted indirect cost rate varies from actual indirect cost rate.
There are two common approaches to dispose /clear any balance in the manufacturing overhead
account at the end of an accounting period (Proration and Write-off methods).

I. Proration Approach
Proration spreads under/over allocated overhead among ending work in process, finished goods
and cost of goods sold balances proportionately.
II. Write-off to cost of goods sold approach
In this case, the entire amount of under/over allocated overhead cost is included in the current
year's cost of goods sold amount.
3.1.2 Batch Costing
What is Batch Costing?
Batch costing is that form of specific order costing under which each batch is treated as a cost
unit and costs are accumulated and ascertained separately for each batch. Batch costing is one of
the assignments of job costing which entails manufacture of a large number of items at the same
time.
Characteristics of batch costing method
Products are manufactured in batches.
All batches produced has similar or identical item one to the other.
Each batch is assigned only one identification number for identification purposes.
Cost per unit is determined by dividing the total cost of a batch with the total identical units
in each batch produced.
Products lose their identity during processing for they are all assumed to be the same in
every way.

3.1.3 Contract costing

Contract costing is form of specific order costing which applies where work is undertaken to
customer's special requirements and each order is of long duration (compared with those to
which job costing applies).contract costing is used by contractors, builders and engineers, who
undertake definite contracts such as building construction, ship building, bridge construction and
so on. A contract is usually undertaken for a fixed period and price (called contract price), which
is payable either on the completion of the contract or by installments according to the progress of
work done.

3.2 Accounting for direct and indirect costs, including the treatment of waste,
scrap, spoilage and re work costs
Terminology - While the terms used in this chapter may seem familiar, be sure you understand
them in the context of management accounting.

Spoilage, Rework, and Scrap

Defects are natural to any production process, and thus cannot be totally avoided. In fact it is
possible to reduce the rate of defect and that is the important point of managing defects.
Reducing defects means reducing cost of products which in turn means adding value on the
products manufactured. Defective units are those units that cannot be sold at normal prices
without incurring additional costs in the form of rework. Defective units are either spoiled units
that cannot be reworked and that cannot be sold at all or that can be sold at less than normal price
or defective units that are sold at normal prices after they get reworked.
Spoilage refers to defective units that are unacceptable and as a result cannot be sold for normal
prices. Spoiled units may or may not have any selling price. Spoiled units have selling prices
when the level of defect is insignificant and if it can be used for some purpose with that defect
remain intact. If the level of defect is significant, the defective unit may not serve any purpose,
and therefore, the spoiled units may not have any selling price.
spoilage can be classified as normal and abnormal based on the level of defect
a) Normal spoilage: Normal Spoilage – is spoilage inherent in a particular production process
that arises under an efficient operating condition. Management determines the normal
spoilage rate. There is a tradeoff between the speed of production and the normal spoilage
rate. Management makes a conscious decision about how many units to produce per hour with
the understanding that, at the rate decided on, a certain level of spoilage is almost unavoidable.
Because of this Costs of normal spoilage are typically included as a component of the costs of
good units manufactured because good units cannot be made without also making some units
that are spoiled. The cost of normal spoilage is added to the cost of good units produced because
good units cannot be produced without simultaneous production of spoiled units. In calculating
normal spoilage, the base is the number of good units produced. The total production is not
considered as it includes abnormal spoilage as well. Also normal spoilage represents the level of
defect that is linked with the production of good units.
Normal spoilage rates are computed by dividing units of normal spoilage by total good units
completed
b) Abnormal spoilage is a spoilage that is not inherent in a particular production process and
would not arise under an efficient operating conditions. If a firm has 100% good units as its goal,
then any spoilage would be considered abnormal. Abnormal spoilage is usually regarded as
avoidable and controllable. Line operators and other plant personnel generally can decrease or
eliminate abnormal spoilage by identifying the reasons for machine breakdowns, operator errors,
etc., and by taking steps to prevent their recurrence.
Abnormal spoilage refers to unacceptable units that are above and beyond the defect level that is
considered as normal. In other words, it is a level of defect that is not expected under an efficient
operation system. Abnormal spoilage represents defects that can be avoided and controlled with
increased level of efficiency. The cost of abnormal spoilage is separately reported as loss from
abnormal spoilage.
Rework, on the other hand, refers to unacceptable units that can be reworked and then sold for
normal prices. After the units get repaired, they become good units and sold for normal price.
Scrap refers to materials that are left over from production processes. As defects are integral part
of any production process, some level of defect is tolerable. The important point is to determine
that level of defect that is accepted as normal. There is no hard and fast rule as to the level of
defect that is considered as normal. It depends on several factors like the philosophy of the
management, and the nature of the manufacturing process. Some managers may consider
defective units up to 10% of good units as normal. Another manager may say any defect level
beyond 5% of good units is abnormal.

Waste – is often used to refer to the portion of material inputs the either disappears in the
production process or the part of raw materials left over after production that has no further use
or resale value. A cost of disposal may be incurred for waste materials.
Scrap is residual material that results from manufacturing a product. Examples are short lengths
from woodworking operations, edges from plastic molding operations, and frayed cloth and end
cuts from suit-making operations. Scrap can sometimes be sold for relatively small amounts. In
that sense, scrap is similar to byproducts. The difference is that scrap arises as a residual from the
manufacturing process, and is not a product targeted for manufacture or sale by the firm. Some
amounts of spoilage, rework, or scrap are inherent in many production processes. For example,
semiconductor manufacturing is so complex and delicate that some spoiled units are commonly
produced; usually, the spoiled units cannot be reworked. In the manufacture of high-precision
machine tools, spoiled units can be reworked to meet standards, but only at a considerable cost.
And in the mining industry, companies process ore that contains varying amounts of valuable
metals and rock. Some amount of rock, which is scrap, is inevitable.
Accounting for Spoilage

Accounting for spoilage aims to determine the magnitude of spoilage costs and
to distinguish between costs of normal and abnormal spoilage

To manage, control and reduce spoilage costs, they should be highlighted, not simply folded
into production costs

The concepts of normal and abnormal spoilage also apply to job-costing systems. When
assigning costs, job-costing systems generally distinguish normal spoilage attributable to a
specific job from normal spoilage common to all jobs.

Example 3: In the Hull Machine Shop, 5 aircraft parts out of a job lot of 50 aircraft parts are
spoiled. Costs assigned prior to the inspection point are $2,000 per part. When the spoilage is
detected, the spoiled goods are inventoried at$600 per part, the net disposal value.
Normal Spoilage Attributable to a Specific Job: When normal spoilage occurs because of the
specifications of a particular job, that job bears the cost of the spoilage minus the disposal value
of the spoilage. The journal entry to recognize the disposal value (items in parentheses indicate
subsidiary ledger postings) is as follows:

Materials Control (spoiled goods at current net disposal value):

5 units * $600 per unit………………………………………….. 3,000

Work-in-Process Control (specific job): 5 units * $600 per unit………………… 3,000

Note, the Work-in-Process Control (specific job) has already been debited (charged)$10,000 for
the spoiled parts (5 spoiled parts $2,000 per part). The net cost of normal spoilage $7,000

($10,000- $3,000), which is an additional cost of the 45 (50- 5) good units produced. Therefore,
the total cost of the 45 good units is $97,000: $90,000 (45 units * $2,000 per unit) incurred to
produce the good units plus the $7,000 net cost of normal spoilage. Cost per good unit is
$2,155.56 ($97,000/ 45 good units).

Normal Spoilage Common to all Jobs: In some cases, spoilage may be considered a normal
characteristic of the production process. The spoilage inherent in production will, of course,
occurs when a specific job is being worked on. But the spoilage is not attributable to, and hence
is not charged directly to, the specific job. Instead, the spoilage is allocated indirectly to the job
as manufacturing overhead because the spoilage is common to all jobs. The spoilage is costs as
manufacturing overhead because it is common to all jobs

Materials Control (spoiled goods at current disposal value):

5 units * $600 per unit………………………………………………………. 3, 000

Manufacturing Overhead Control (normal spoilage): ($10,000 - $3,000)……. 7,000
Work-in-Process Control (specific job): 5 units * $2,000 per unit…………………… 10,000
Abnormal Spoilage: If the spoilage is abnormal, the net loss is charged to the Loss from
Abnormal Spoilage account. Unlike normal spoilage costs, abnormal spoilage costs are not
included as a part of the cost of good units produced.

Materials Control (spoiled goods at current disposal value):

5 units * $600 per unit……………………………………….. 3,000

Loss from Abnormal Spoilage ($10,000 - $3,000)…………… 7,000

Work-in-Process Control (specific job): 5 units * $2,000 per unit …………….10, 000

Rework

Rework is units of production that are inspected, determined to be unacceptable, repaired, and
sold as acceptable finished goods.
Three types of rework:
I. Normal rework attributable to a specific job – the rework costs are charged to that job
II. Normal rework common to all jobs – the costs are charged to manufacturing overhead and
spread, through overhead allocation, over all jobs
III: Abnormal rework – is charged to the Loss from Abnormal Rework account that appears on
the income statement

Consider the Hull Machine Shop data. Assume the five spoiled parts are reworked. The journal
entry for the $10,000 of total costs (the details of these costs are assumed) assigned to the five
spoiled units before considering rework costs is as follows:
Work-in-Process Control (specific job)……….. 10,000
Materials Control…………………………………………….. 4,000
Wages Payable Control………………………………………. 4,000
Manufacturing Overhead Allocated…………………………. 2,000
. Assume the rework costs equal $3,800 (comprising $800 direct materials, $2,000
direct manufacturing labor, and $1,000 manufacturing overhead).

III. Abnormal rework – is charged to the Loss from Abnormal Rework account that appears
on the income statement
Consider the Hull Machine Shop data. Assume the five spoiled parts are reworked. The journal
entry for the $10,000 of total costs (the details of these costs are assumed) assigned to the five
spoiled units before considering rework costs is as follows:
Work-in-Process Control (specific job)……….. 10,000
Materials Control…………………………………………….. 4,000
Wages Payable Control………………………………………. 4,000
Manufacturing Overhead Allocated…………………………. 2,000
.
Assume the rework costs equal $3,800 (comprising $800 direct materials, $2,000
direct manufacturing labor, and $1,000 manufacturing overhead).
Normal Rework Attributable to a Specific Job
If the rework is normal, but occurs because of the requirements of a specific job, the rework
costs are charged for that job. The journal entry is as follows:
Work-in-Process Control (specific job)…………. 3,800
Materials Control………………………...................... 800
Wages Payable Control………………………………. 2,000
Manufacturing Overhead Allocated…………………... 1,000
Normal Rework Common to All Jobs
When rework is normal and not attributable to a specific job, the costs of rework are charged
with manufacturing overhead and are spread, through overhead allocation, overall jobs.
Manufacturing Overhead Control (rework costs)……… 3,800
Materials Control………………………………………. 800
Wages Payable Control……………………………….. .2, 000
Manufacturing Overhead Allocated………………….. 1,000
Abnormal Rework
If the rework is abnormal, it is recorded by charging abnormal rework to a loss account.
Loss from Abnormal Rework………… 3,800
Materials Control………………………….. 800
Wages Payable Control……………………. 2,000
Manufacturing Overhead Allocated……….. 1,000

4.5 Accounting for Scrap

Scrap is residual material that results from manufacturing a product; it has low total sales value
compared with the total sales value of the product. No distinction is made between normal and
abnormal scrap because no cost is assigned to scrap. The only distinction made is between scrap
attributable to a specific job and scrap common to all jobs.
1. Planning & Control, including physical tracking
2. Inventory costing, including when and how it affects operating income
NOTE: Many firms maintain a distinct account for scrap costs. To illustrate, we extend our Hull
example. Assume the manufacture of aircraft parts generates scrap and that the scrap from a job
has a net sales value of $900.Scrap Attributable to a Specific Job – job costing systems sometime
trace the scrap revenues to the jobs that yielded the scrap. This method is used only when the
tracing can be done in an economically feasible way. No cost assigned to scrap.
Scrap returned to storeroom: No journal entry
Sale of scrap: Cash or Accounts Receivable………… 900

Work-in-Process Control…………………. 900

Posting made to specific job cost record
Scrap common to all jobs: - Scrap is not linked with any particular job or product. Instead, all
products bear the production costs without any credit for scrap revenues except in an indirect
manner: Expected scrap revenues are considered when setting the budgeted
manufacturing overhead rate. Thus, the budgeted overhead rate is lower than it would be if the
overhead budget had not been reduced by expected scrap revenues.

Scrap returned to storeroom: No journal entry.

Sale of scrap: Cash or Accounts Receivable…….. 900
Manufacturing Overhead Control……… 900
Recognizing Scrap at the Time of Its Production
Recognizing Scrap at the Time of its Production – sometimes the value of the scrap is material,
and the time between storing and selling it can be long. The firm assigns an inventory cost to
scrap at a conservative estimate of its net realizable value so that production costs and
related scrap revenues are recognized in the same accounting period
Scrap Attributable to a Specific Job
Scrap returned to storeroom: Materials Control……….. 900

Work-in-Process Control………. 900

Scrap Common to All Jobs
Scrap returned to storeroom: Materials Control……… 900
Manufacturing Overhead Control ……….900
When the scrap is sold, the journal entry is as follows:

Sale of scrap: Cash or Accounts Receivable ……………900

Materials Control…………………… 900

Scrap is sometimes reused as direct material rather than sold as scrap. In this case, Materials
Control is debited at its estimated net realizable value and then credited when the scrap is reused.
For example, the entries when the scrap is common to all jobs are as follows:
Scrap returned to storeroom: Materials Control……………. 900
Manufacturing Overhead Control ………….900
Reuse of scrap: Work-in-Process Control………………… 900
Materials Control……………………….. 900
 Accounting for scrap under process costing is similar to accounting under job costing when
scrap is common to all jobs. That‘s because the scrap in process costing is common to the
manufacture of masses of identical or similar units

Review Questions

I. Multiple Choice Questions

1. Which costing method is most suitable for customized, small-scale production?

A. Batch Costing C. Contract Costing
B. Job Order Costing D. Process Costing
2. In batch costing, the cost per unit is determined by:
A. Dividing the total batch cost by the number of units in the batch
B. Adding up all the direct and indirect costs for the entire production line
C. Allocating costs based on the percentage of completion
D. Subtracting abnormal spoilage costs from total costs
3. Contract costing is typically used in which of the following industries?
A. Textile production C. Large-scale construction projects
B. Custom furniture making D. Pharmaceutical manufacturing
4. How is abnormal spoilage treated in costing?
A. Added to production overhead
B. Charged to a loss account in the profit and loss statement
C. Deducted from the normal spoilage
D. Credited as miscellaneous income
5. What is the primary feature of job order costing?
A. Costs are accumulated for each unit of output
B. Costs are allocated to a specific customer order or job
C. Costs are averaged over identical products
D. Costs are recognized based on percentage completion
6. Scrap materials are usually treated as:
A. An expense in the profit and loss account
B. Reducing production costs through scrap value recovery
C. Part of normal spoilage costs
D. Part of abnormal spoilage costs
7. Which of the following costs cannot be directly traced to a job, batch, or contract?
A. Direct materials C. Overheads
B. Direct labor D. Subcontractor costs
8. Rework costs that arise due to normal defects are typically treated as:
A. Added to direct costs for the job
B. Allocated as overhead costs
C. Charged to abnormal loss accounts
D. Deducted from total direct costs
Chapter Four
The Process and Operation or service costing methods
Learning Objectives

Dear students, after completing this chapter, you should be able to:

 Understand the characteristics of the process costing method.

 Identify and use appropriate cost units for process costing.
 Valuate process transfers and work-in-process using equivalent units of production,
applying both FIFO and average costing methods.

 Understand the scope of operation or service costing and identify the relevant cost units.
4.1 Introduction
Process cost accounting is used to assign costs to products or services. It is used in industries that
produce essentially homogenous/like units which are often mass produced on continuous or
repetitive basis. Examples are: chemical processing, oil refining, pharmaceuticals, plastics, brick
and tile manufacturing, semiconductor chips, beverages, and breakfast cereals.

Since every unit is essentially the same, each unit receives the same manufacturing input as
every other unit. A process costing system accumulates manufacturing costs for a period of time
and computes an average manufacturing cost for the units produced during the period of time

Similarities between job order and process costing include:

The same basic purpose: to assign material, labor, and overhead cost to products
The same overhead assignment method: predetermined rates time actual activity and disposal
of under/over applied OH.
The same basic manufacturing accounts: Manufacturing overhead, Raw materials,
Work in process, Finished Goods.
The flow of costs through the manufacturing accounts is basically the same in both systems.
Process costing is concerned, however, with the assignment of these costs to the appropriate
departmental WIP inventory accounts.

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A department production report (cost of production report) is a cost sheet used for process
costing for each department that summarizes the total cost charged to a department and the
allocation between the ending work-in-process inventory and the units completed and
transferred to the next department or finished goods inventory. The production report is an
internal report which provides cost information for financial statements and also
helps managers control their departments

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Because most companies make more than one type of product, costs must be accumulated by
product (specific production runs) within each department. Costs can be accumulated by using
different WIP Inventory accounts for each product and for each department through which that
product passes. Alternatively, costs can be accumulated using departmental Work in Process
Inventory control accounts that are supported by detailed subsidiary ledgers containing specific
product information. Costs are reassigned at the end of the period (usually each month) from the
departments (production runs) to the units worked on during the period.

 So product costing is an averaging process (whether job or process costing). But

the main difference between job and process costing is the extent of averaging used to
compute unit costs of products or services.
 A process cost system requires much less effort and expense in accumulating costs than a job
order cost because of the work involved in analyzing each cost and recording it on a job cost
sheet.
 The central product costing problem in process costing is how each department should
compute:
 The cost of goods transferred out, and
 The cost of goods remaining in the department
Journal Entries Using Process Costing (Perpetual system assumed)

Similar to those for job order costing, entries accumulate DM, DL, and FOH in process
costing.However, instead of tracing costs to specific jobs or batches, we
accumulate costs fordepartments or processes resulting in more than one WIP inventory
account. Let‘s look at theaccounting journal entries for a process cost system before we see a
serious of examples

Material journal entries:

Raw material ------------------- xx
Accounts payable --------- xx
To record purchase of raw materials
WIP-Dpt.A --------------------- xx
WIP-Dpt.B --------------------- xx
Raw materials ----------- xx
To record the use of direct materials
• Direct material costs arte traced. The source document is the material requisition form.
Labor journal entries:
WIP-Dpt.A --------------------------- xx
WIP-Dpt.B --------------------------- xx
Salaries &Wages payable ---- xx
To record the use of direct labor costs

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• In process costing, labor costs are traced to departments-not to individual jobs. Direct labor
can be determined from employee time sheets and wage rates for the period. If an employee
works in Dpt. A, his gross salary is charged to Dpt. A

Factory overhead journal entries:

In contrast, overhead is indirectly assigned to output. If total overhead costs are relatively
constant from period to period and production volume is relatively steady over time, actual
overhead costs provide a fairly uniform production cost and may be used for product
costing. If such conditions do not exist, using actual overhead for product costing would result in
fluctuating unit costs and, therefore, POR are more appropriate.

• When FOH occurs solely within a department, it is recorded as FOH cost of

that department. If we have FOH cost common to many departments, some method would be
used to allocate the common cost, such as square footage owned, number of employees etc. FOH
subsidiary ledger or a separate departmental OH analysis sheet summarize

actual costs by departments.

• The entry to record actual FOH in the company is:

Manufacturing OH Control ---------------- xx

Prepaid insurance ------------------ xx

Accounts payable ----------------- xx

Accumulated depr. ----------------- xx

And so forth ----------------- xx

• If we use actual costing, actual OH rate rather than an estimated OH rate to cost the product, we
make the following journal entry to distribute actual OH

WIP-Dpt.A ------------------------------------- xx

WIP-Dpt.B ------------------------------------- xx

Manufacturing OH Control ----------- xx

This journal entry becomes the source for the OH charged to the departments in the cost

of production report.

• If normal costing is used FOH costs are charged to WIP inventory of each department at a
POR and we will make the following journal entry to apply FOH to each department:

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WIP-Dpt.A ----------------------------------- xx

WIP-Dpt.B ---------------------------------- xx

Manufacturing OH Applied ---------- xx

Note that even if we use POR to cost products, we also allocated actual FOH costs to
departments. This allows a comparison of actual and applied OH and determine OH variance.
In process costing POR are usually used. Each department has its own separate rate

Transfer of costs between Departments:

• Once processing has been completed in a department, the units are transferred to the next

department for further processing.

WIP-Dpt.B ------------------------ xx

WIP-Dpt.A ----------------- xx

To record the transfer of goods from Dpt.A to Dpt.B.

Other related journal entries:

Finished Goods -------------------- xx

WIP-Dpt.B -------------------- xx

To record the completion of goods and their transfer from Dpt. B to Finished- Goods inventory.

Accounts receivable ------------------- xx

Sales ------------------------------- xx

To record sale on account

COGS ----------------------------- xx

Finished Goods ---------------------------- xx

To record cost of goods sold

Process Costing- Three Cases

Three types of situations are discussed in this section to illustrate process costing techniques

excluding spoilage and lost units. In the next chapter we will discuss process and job costing

when spoilage is included.

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i. Zero beginning and zero ending WIP inventory

ii. Zero beginning and some ending WIP inventory

iii. Both some beginning and ending WIP inventory

Case 1: Zero Beginning and Zero Ending WIP Inventory

This condition exists if all items started are completed on the date of reporting.

Example 1

Product- DG-19

Two departments─ Assembly and Testing

Two cost categories─ DMs and Conversion cost

All DMs are added at the beginning to the process in Assembly

Conversion costs are added evenly during assembly

The company uses actual costing

Data for the Assembly Department for January Year 4:

Physical units:
WIP-beginning (Jan. 1) ------------------------------ 0 units
Started during January ------------------------------- 400 units
Completed and transferred out during Jan. -------- 400 units
WIP-ending (Jan.31) --------------------------------- 0 units
Total Costs:
DM ---------------------------------------------------- $32,000
Conversion costs -------------------------------------- $24,000
$56,000
Required: How much is cost per unit?
Solution: DMs = $32,000/400 units = $80
CC = $24,000/400 units = $60
Assembly Dpt. Cost per unit $140

This approach applies when a company produces homogenous product or service but has no
incomplete units (i.e, all units are 100% complete) when each accounting period ends. This
situation is common in service rendering firms who have no inventories. But in most production
processes, Work in Process (WIP) Inventory exists, which consists of partially completed units.
Process costing assigns costs to both fully and partially completed units by mathematically
converting partially completed units to equivalent whole units.

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Process costing systems separate cost into cost categories according to when costs are
introducedinto the process. Often only two cost classifications, DMs and CC, are necessary to
assign coststo products. Why only two? This is because all DMs are added to the process at one
time and allconversion costs are generally added to the process evenly through time.
If, however, twodifferent DMS were added to the process at different points in time, two DMs
categories wouldbe needed to assign these costs to products. Similarly if manufacturing labor
were added to theprocess at a different time than when the other conversion costs were added, an
additional costcategory direct-manufacturing labor costs would be needed to separately assign
these cost toproducts. The increased use of multiple cost pools and/or activity-based costing
concepts makes. it less likely that the degrees of completion for the direct labor and overhead
components of processing will be equal.

Case II: Zero Beginning and Some Ending WIP Inventory

Because the production process is continuous, most companies have partially completed units

(i.e., WIP Inventory) at the end and/or beginning of the period. Ending WIP inventory consists of

units started during the period, but incomplete at the end of the period. This requires application

of the concept of equivalent units.

Physical inspection of the units in ending inventory is needed to determine the proportion of

ending WIP Inventory that was completed during the current period

Data for the Assembly Department for February Year 4:

Physical units:
WIP-beginning (Feb. 1) -------------------------------- 0 units
Started during February ------------------------------- 400 units
Completed and transferred out during Feb. ------- 175 units
WIP-ending (Feb.29) --------------------------------- 225 units
Assume WIP (225 units) are 60% completed in terms of CC.
Total Costs:
DM ----------------------------------------------------- $32,000
Conversion costs --------------------------------------- $18,600
$50,600

Required: 1) Compute the cost of goods completed and transferred out (to Testing Dpt.)

2) Compute cost of WIP as of February 29,Year 4

Solution

Five Key Steps in Process Costing

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Step 1. Summarize the Physical Flow of Goods

The first step in preparing a production report is to prepare a quantity schedule, which shows

the physical flow of units through the department. Where did they come from? Where did they

go? This schedule allows managers to see at glance how many units moved through the

department during the period.

Step 2. Express Performance in Terms of Equivalent Units (EU)

EUs are the number of complete whole units one could obtain from the materials and efforts
contained in partially completed units. For example, two one-half filled cups are equivalent
toone full cup, performing, say, 50% of the processing on 500 units is equivalent to performing
all of the processing on 250 units.

EUs are the common denominator for completed units and partially completed units, and are
computed by multiplying the units accounted for by their percentage of completion for each
category of costs. If we have multiple cost categories, we will have multiple EUs
computations.

Total DM CC
Completed units 175 175 175
WIP ending 225 225 135(0.6×225)
Total EUs (work done in 400 310
current period only)
Any material added at the start of production is 100 percent complete at any point in the
process after the start of production. Additional materials may be added at any point or even
continuously during processing. Additional material added at 40 % of the process is
0% complete before 40% stage of the process; after the 40% point, these materials are 100%
complete. With regard to a material added at the end of a process, the product is 0 % complete
throughout production until production is completed.

EU calculations are used at the end of a month, to prepare monthly production reports. They

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are also used at the end of the year to determine ending inventory values.

Step 3. Summarize Total Costs to Account For

Costs come into the department from units in beginning inventory, from material, labor, and
overhead costs that are added during the period, and from any units that might have been
transferred in from a prior department. For now, we are assuming that beginning WIP is zero and
no costs have been transferred in from a prior department.

DM + CC $32,000 + $18,600 = $50,600

Step 4. Compute Equivalent Unit Costs

Costs per EU of production are computed for each category of costs by dividing the costs to be

accounted for by the total EUs of production

DM CC

$32,000/400 = $80 $18,600/310 = $60

Overall unit cost $80 + $60 = $140

Step 5. Cost Assignment

Once the cost per EU has been calculated (step 4), a department‘s costs are accounted for by

assigning them to:

- Goods transferred out to the next department (or to finished goods), and

- Goods still in process (WIP)

The EUs associated with the units transferred out and are still in process are multiplied by the

cost per EU to determine the amount of cost transferred out and in ending WIP inventory

To: Completed and transferred out units (175 units × $140) ------- $24,500

To: WIP-ending (225 units):

DM (225×$80) ---------------- $18,000

CC (135 ×$60) ---------------- 8,100 26,100

Total cost accounted for ------------------------------------- $50,600

Case III: Process Costing with Beginning and Ending WIP Inventory

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Beginning WIP Inventory consists of goods stared last period but not completed by the end of

last period. Ending WIP Inventory consists of units started during this period, but incomplete at

the end of this period.

When there is a beginning inventory of WIP, a cost flow assumption is required. The
two assumptions commonly used are weighted average (WA) and First-in, First-out (FIFO).

Example 3:
Data for the Assembly Department for March Year 4:
Physical units:
WIP-beginning (March 1) -------------------------------- 225 units
DM(100% complete)
CC (60% complete)
Started during March ----------------------------------- 275 units
Completed and transferred out during March ------- 400 units
WIP-ending (March 31) ------------------------------- 100 units
DM(100% complete)
CC (50% complete)
Total Costs:
WIP-beginning (March 1):
DM(225×$80) ---------------- $18,000
CC(135×$60) ---------------- $8,100 $26,100
DMs ------------------------------------------------------ 19,800
CC --------------------------------------------------------- 16,380
Total cost to account for ---------------------------- $62,280
Required: 1) Compute the cost of goods completed and transferred out (to Testing Dpt.)
2) Compute cost of WIP as of March 31, Year 4
Weighted-average

Step 1 Summarize the physical flow of goods− in identifying the units accounted for, the WA
method does not keep the beginning inventory units separate from the units that were started and
completed during the current period.

2. Equivalent Units of Production− in computing EUs of production, the WA method does not
keep the percentage of completion performed in the prior period separate from the percentage of
completion performed in the current period.

3. Costs to Account For− in identifying the costs to account for, the WA method does not keep
the costs of the units in beginning inventory at the start of the current period separate
from the costs added to production during the current period. It combines cost of WIP-beginning
and current period costs.

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4. Cost per Equivalent Unit− to compute unit costs in a department, the department‘s
output in terms of EUs must be determined. In the WA method, the EUs for a period are the sum
of the units transferred out of the department during the period and the EUs in ending WIP
inventory at the end of the period. In computing costs per EU of production, the WA method
divides the total costs to be accounted for by the total EUs of production.

i.e., a single unit cost for all EUs is computed:

Unit cost = TC (Cumulative)

TQ (Cumulative work done)

5. Cost Assignment− in allocating the total costs to be accounted for to the units accounted for,
the WA method does not keep the cost of the units in beginning inventory at the start of the
current period separate from the costs added to production during the current period.

Total cost accounted for should agree (or at least be close) to total cost to account.

Any small difference would be due to rounding

Solution

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FIFO

Step 1. Summarize the physical flow of goods− in identifying the units accounted for, the
FIFO method keeps the beginning inventory units separate from the units that were started and
completed during the current period.

2. Equivalent Units of Production− in computing EUs of production, the FIFO method nkeeps
the percentage of completion performed in the prior period separate from the
percentage of completion performed in the current period.

•The units completed and transferred out come from two sources that must be kept track of
separately:

a) Units completed from WIP beginning. For purposes of EU, we indicate the number of EUs
for DM, DL, and FOH that are required to complete these units (e.g., if
beginning WIP was 60% complete, then it would take 40% worth or EUs to
complete)
b) Units started and completed this period. This group will always be 100% complete

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The units in ending EIP will only have been partially worked on this period. Therefore, calculate
the EUs for each of DM, DL, and FOH using the % completed this period times the total number
of units in ending WIP.
3. Costs to Account For− in identifying the costs to account for, the FIFO method keeps the
costs of the units in beginning inventory at the start of the current period separate from the costs
added to production during the current period. It combines cost of WIP-beginning and current
period costs.
4.Cost per Equivalent Unit− to compute unit costs in a department, the FIFO method
divides the current costs to be accounted for by the current EUs of production. i.e., it computes
an average cost that is separate for the current period from the beginning inventory.

•So we will have two unit costs for units completed:

i) Units completed from WIP beginning(obtained from prior period production report),
and

ii) Units started and completed during the current period

= TC (Current cost)

TQ (Current period performance)

•This method focuses on current period costs and work done

•Note that while the costs in WIP beginning will appear in the total column of costs toaccount
for, they will not appear in the DM, DL, and FOH columns. This is because the cost per EU
calculation under the FIFO method only includes costs from the current period

5.Cost Assignment− in allocating the total costs to be accounted for to the units accounted for,
the FIFO method keeps the cost of the units in beginning inventory at the start of the current
period separate from the costs added to production during the current period. FIFO assumes
WIP-beginning is completed first before any new product is completed.

•For costs relating to goods completed and transferred out, there are three costs to deal with:

i) Costs in beginning WIP (from a previous period)

ii) Costs added this period to complete units in beginning WIP;

− Use the EUs for each of DM, DL, and FOH and multiply by the current cost for EU for DM,
DL, and FOH.

iii) Costs from units added and completed this period, take the number of such units and multiply
by the full cost per EU.

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•For costs added this period relating to units in ending WIP, take the EUs for each of DM,DL,
and FOH, and multiply these quantities by the cost per EU for DM,DL, and FOH

Total cost accounted for should agree (or at least be close ) to total cost to account. Any small
difference would be due to rounding

*Note that the numerator ONLY includes current period costs.

Service Costing/ Operating Costing

Meaning of Service Costing

Service costing, also known as Operating Costing is a method of cost ascertainment used in those
undertakings which provide services. Example, transport companies, electricity companies,
hospitals, cinema houses, schools, colleges etc. use service costing to find out cost per unit.

According to CIMA, London, ―Operating costing is that form of operation costing which applies
where standardized services are rendered either by an undertaking or by a service centre within

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Characteristics of Service Costing

1. Services provided are standardized i.e. similar type of services are provided to all customers.
2. Services are produced on a uninterrupted/regular basis.

3. Capital is invested more in fixed assets (e.g. buying buses for a transport company) in
comparison to investment in working capital (e.g. day-to-day expenses in running buses).

4. Some part of operating costs of these undertakings is fixed cost and the other part is the
variable cost. an organization.‖

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Chapter Five
Cost Allocation

Learning Objectives

Dear students, after completing this chapter, you should be able to:

 Explain the concepts of overhead costs, indirect costs, direct costs, traceable costs, and
allocated costs, and understand their significance in cost accounting.
 Describe how accountants create cost centers or cost pools to gather cost data and track
expenses more effectively.
 Explain the reasons for cost allocation between cost pools or centers, and understand the
methods used for this process.
 Understand the principles and methods of support department cost allocation and how
costs from support services are distributed to production departments.
 Explain the concepts of joint products and by-products, and how their costs are allocated
in production.
 Understand how common costs are allocated across various departments or products, and
the appropriate bases for this allocation

5.1 Meaning of cost allocation and other related terms

Cost Allocation: the process of assigning or applying collected indirect costs to cost objects
using an allocation base is known as cost allocation. The following terms are to be known and
they have strong tie with the allocation of costs to products or services. These are:
-Cost object
-Cost pool and
- Cost driver
Cost object: - is the destination of all assigned or allocated costs. For example, a cost may be
assigned to a particular product, service or department. For purposes of product costing, cost
allocation is the assignment of manufacturing overhead costs to the product (cost object) during
the accounting period.

Cost pool: is a collection of overhead costs related to a cost object (a product related activity).

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Cost driver: is an activity that causes the cost pool to increase in amount as the cost driver
increases in volume,
Cost allocation requires.
i. the pooling of manufacturing overhead costs that are affected by a common activity and
ii. the selection of a cost driver whose activity level causes a change in the cost pool

5.2 Purposes of cost allocation

 To provide information for economic decisions:
For making economic decisions like add a new product to existing product, make or buy a
product, and pricing of a product true cost is required. The true cost can be arrived only if the
manufacturing overhead cost is properly and correctly assigned to a product.
 To motivate managers and other employees:
To encourage the design of products that is simpler to manufacture or less costly to service and
to encourage sales representatives to increase high margin product or services.

 To justify cost or compute reimbursement:

To fix the fair price for a product especially government defense contracts, the true costs are to
be arrived. Besides, to get reimbursement for a consulting firm the correct and true costs are to
be arrived.
 To measure income and assets for reporting to external parties:
The true cost of product enables the management to report inventories correctly in financial
reporting to stockholders, bondholders etc. And also to cost inventories for reporting to tax
authorities.

 Allocating Costs from One Department to Another.

 Single-Rate and Dual-Rate Methods

The single-rate allocation method pools all costs in one cost pool and allocates these costs to
cost objects using the same rate per unit of the single allocation base. There is no distinction
between costs in a cost pool in terms of cost behavior, such as fixed costs versus variable costs.

The dual-rate cost allocation method classifies costs in each cost pool into two sub cost pools,
a variable cost pool and a fixed cost pool. Each of these pools uses a different rate per unit of the
single allocation base.

Example:
Sand Hill Co. has a Central Computer Department; the department has two users,
Microcomputer Division and Peripheral Equipment Division. The following data apply to the
coming budget year.

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Fixed costs of operating the computer facility in the
6000-18000hr relevant range Br3, 000,000/year
Total capacity available 18,000hrs
Budgeted long-run usage
Microcomputer Division 8,000hrs
Peripheral Equipment Division 4,000hrs
Total 12,000hrs
Budgeted variable cost per hour $200/hour used
Assume during the year the Microcomputer uses 9,000 hrs and Peripheral Equipment uses 3,000
actual hours.

1. Single Rate Allocation Method

Total cost pool =3,000,000+200*12,000 5,400,000
Budgeted usage 12,000hrs

Budgeted totals rate per hour= 5,400,000 = Br.450/hr

12,000hrs
Allocation rate for Microcomputer Division Br. 450/hr

Allocation rate for Peripheral Division Br. 450/hr

Microcomputer=9000*450= Br. 4,050,000.

Peripheral Equipment= 3000*450= Br.1, 350,000.

2. Dual-rate Allocation Method

Allocation of Fixed Costs to:
Microcomputer Division = 8000/12000hrs * 3,000,000 = Br. 2,000,000/year.
Peripheral Equipment Division = 4000/12000hrs * 3,000,000 = Br. 1,000,000/year.
Allocation of variable costs to:
Microcomputer: (200*9000) = Br. 1,800,000.
Peripheral Equipment: (200*3000) = Br. 600,000.

I. Allocating costs of multiple Support Departments

Operating and Support Departments
Operating Department (Production Department) adds value to a product or service that is
observable by a customer.
Support Departments (Service Department) provide the service that assists other internal
departments.

Support Department creates a special cost allocation problem when they provide reciprocal
support to each other as well as support to operating departments.

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Methods:
1. Direct Allocation Method
2. Step-Down Allocation Method
3. Reciprocal Allocation Method

Example: ABC Engineering has two Support Departments and Two operating Departments.
Costs are accumulated in each department for planning and control purposes.
Support Departments Operating Departments
Plant Maintenance Machining
Information Systems Assembly

The two support departments provide reciprocal support to each other as well as to the two
operating departments. Costs are accumulated in each department for planning and control
purpose.
Support Departments Operating Departments
Plant Main. Info. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Support work finished
By plant maintenance
Budgeted labor hrs - 1,600 2,400 4,000 8,000
Percentage - 20% 30% 50% 100%
By Infor. System.
Budgeted com. Hrs 200 - 1600 200 2000
Percentage 10% - 80% 10% 100%

Required: Allocate costs using the three methods.

1. Direct Allocation Method
This method is the most widely used method of allocating support department costs. This
method allocates each support department costs directly to the operating departments.

Plant Maintenance Machining

Information Systems Assembly

Support Departments Operating Departments

Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept

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Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Allocation by Plant Mai. (600,000) 225,000 375,000
(2400/6400, 4000/6400)
Allocation by Inf. Syste. 0 (116,000) 103,111 12,889
(1600/1800, 200/1800)
Total Budgeted MOH of 0 $728,111 $578,889 $1,316,000
Operating department

Advantage of this method:

 Simplicity
 No need to predict the usage of support department service by other support
departments.
Disadvantage
 Failure to recognize reciprocal services provided among support departments.

2. Step-Down Allocation Method (Sequential Allocation Method)
 Allows the partial recognition of the service rendered by support departments to other
support departments.
 This method requires the support departments to b ranked (sequenced) in order that the step-
down allocation is to proceed. Different sequences will result in different allocation of
support department costs to operating departments.
 Popular step-down begins with the support department that renders the highest percentage of
its total services to other support departments and so on, ending with the support department
that renders the lowest percentage of its total services to other support departments.

Plant Maintenance Machining

Information Systems Assembly

Support Departments Operating Departments
Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Allocation by Plant Mai. (600,000) 120,000 180,000 300,000
(1600/8000, 2400/8000, 4000/8000)
Allocation by Inf. Syste. 0 (236,000) 209,778 26,222
(1600/1800, 200/1800)
Total Budgeted MOH of 0 $789,778 $526,222 $1,316,000
Operating departments

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Note: The step-down method does not recognize the total services that support department
provide to each other.

3. Reciprocal Allocation Method

 Allocates cost by explicitly including the mutual services provided among all support
departments.
 Conceptually the direct method and the step-down allocation method are less accurate than
the reciprocal method when the support departments provide service to another reciprocally.
 The reciprocal method enables us to incorporate interdepartmental relationships fully not the
support department cost allocations.
 Implementing the reciprocal allocation method requires three steps:

1. Express Support Department Costs and support department reciprocal relationships in

the form of Linear Equation.
Let PM be the completed reciprocated costs1 of Plant Maimtance and IS be the
complete reciprocated costs to Information Systems.

PM = $600,000 + 0.1 IS
IS = $116,000 + 0.2 PM

2. Solve the cost of linear equation to obtain the complete reciprocated costs of each
support departments.
PM = 600,000 + 0.1 (116,000 + 0.2PM)
PM = 600,000 + 11,600 + 0.02PM
0.98PM = 611,600
PM = $624,082

IS = 116,000 + 0.2(624,082)
IS = $ 240,816
3. Allocate the complete reciprocated costs of each department to all other departments
(both support department and operating departments).

Plant Maintenance Machining

Information Systems Assembly

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Support Departments Operating Departments
Plant Main. Infor. Systems. Machining Assembly Total
Budgeted MOH cost
Before any inter-dept
Cost allocations $600,000 $116,000 $400,000 $200,000 1,316,000
Allocation by Plant Mai. (624,082) 124,816 187,225 312,041
(1600/8000, 2400/8000, 4000/8000)
Allocation by Inf. Syste 24,082 (240,816) 192,652 24,082
(200/2000 1600/2000, 200/2000)
Total Budgeted MOH of 0 0 $779,877 $536,123 $1,316,000
Operating departments

II. Allocating Common Costs

A common cost is a cost of operating a facility, activity, or like cost object that is shared by two
or more users.
Three methods of allocating this common cost are:
1. Stand-Alone Cost-Allocation Method
This method uses information pertaining to each user of a cost object as a separate entity to
determine the cost-allocation weights.
Example : Imagine that department A pays $900 for rent and a department B pays $1,500. The
total sum for the departments is $2,400. Then the company got a discount from a property owner
and now pays only pays $2,000. To allocate this sum between two departments, count the
percent each of them paid initially.
A stand-alone amount for the department A is $900/$2,400 =37.5%.
A stand-alone amount for the department B is $1,500/$2,400 =62.5%.
To count the sum after allocation, multiply the percentage of the new sum.
Department A's payment after reallocation is 37.5%*$2,000 = $750.
Department A's payment after reallocation is 62.5%*$2,000 = $1230.
Advantage: Fairness occurs because each employer bears a proportionate share of total costs in
relation to their individual stand-alone costs.
2. Incremental Cost Allocation Method
You can use this method if one of the costs is inevitable and the other is additional. For instance,
the company's goal was to rent a workspace for department B.

The adjoining room was vacant, and the firm decided to rent it and place department A there. In
this case, you need to subtract the additional cost from the total amount:

$2,000 - $1,500 = $500. So, now department B pays $1,500 and department A — $500.

If the workspace for a department A was the initial goal, the table turns: $2,000 - $900 = $1,100.

In this situation, department A pays $900 and department B—$1,100

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3. Shapley value cost allocation Method

According to this method, you need to count two or more costs and calculate the average.

 The payment for a department A would be ($500+$900)/2 = $700.

 The department B would pay ($1500+$1100)/2 = $1,300

5.3 Joint products and by products

Joint Process/ Joint products

A Joint process, simultaneously converts a common input into several outcomes. For example,
processing timber results jointly into lumber of various grades plus woodchips and sawdust that
can be converted into paper pulp. Pulp can be sold or processed further in to paperboard. Another
example, processing crude oil can result jointly in gasoline of various grades, kerosene, jet fuel,
asphalt and /or petrochemicals. The products that jointly result from processing a common input
are called joint products.
The cost of the input and the joined production process is called a joint product cost. The point in
the production process where the individual products becomes separately identifies is called the
split-oft point. An example is the point at which coal becomes coke, natural gas and other
products.
Separable costs or further processing costs are all costs incurred after the split off point that are
assignable to one or other more individual products.
A joint product has relatively high sales Value compared to other products yielded by a joint
production process. When a joint production process yields only one product with a relatively
high sales value, that product is known as a main product. A byproduct has a relatively low sales
value compared with the sales value of a joint or main product. Some outputs of the joint
production process have zero sales value. For example, the offshore processing of hydrocarbons
to obtain oil and gas also yields water that is recycled is led back into the ocean. Similarly, the
processing of mineral ore to obtain gold and silver also yield dirt that is recycled back into the
ground.
Basic terms that are commonly used in joint cost allocation system

Joint Process: is a single production process that converts a common input into several outputs.

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For example, processing timber results jointly in lumber of various grades plus wood chips and
sawdust that can be converted into paper pulp. Another example is processing crude oil can
result jointly in gasoline of various grades, Kerosene, jet fuel, asphalt, and/or petrochemicals.

Joint costs: are the costs of a single production process that yields products simultaneously.

Joint products: are the products that jointly result from processing a common input and that
have relatively the same sales value. We can think of the examples given under the joint process.
Or X, Y, and Z are joint products.
The split off point:-is the juncture or the point in a joint production process where one or more
products become separately identifiable.
Separable costs:-are all costs incurred beyond the split off point that are assignable to one or
more individual products.
Final product- a final product is one that is ready for sale without further processing.
Intermediate products- are products that usually require further processing before they are
salable to the ultimate consumer, either by the producer or by another processor.
The output of joint production process can be classified into two general categories-those with a
positive sales value and those with a zero sale value. A product is any output that has a positive
net sales value (or an output that enables an organization to avoid incurring costs). A joint
product has relatively high sales value compared to other products yielded by a joint production
process. No journal entries are made in the accounting system to record the processing of such
products with zero sales value.
In practice companies distinguish between main products and by-products before allocating joint
costs because, by convention, joint costs are allocated only to main products. To take a very
simple example, consider a slaughterhouse (Abattoir Enterprise) and assume slaughtering of an
ox. The products are meat, skin and wastage. Meat and skin have the sales value and wastages
have zero sales value.

Main product-when a joint production process yields only one product with a relatively high
sales value, that product is termed a main product. Thus, main product is a joint output that
generates a significant portion of the net realizable value from the process.

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Byproducts- are products that have relatively low sales value compared with the sales value of
joint or main products. These are outputs from a joint production process that are minor in
quantity and/or net realizable value when compared to the main products. Some outputs of the
joint production process have zero sales value. Example, the processing of mineral ore to obtain
gold and silver also yields dirt that is recycled back into the ground. No journal entries are
usually made in the accounting system to record the processing of such outputs with zero sales
value.
Objectives of allocating joint costs
The organizations allocate joint costs for many reasons, including measuring performance,
estimating casualty losses, determining and responding to regulatory rates, and specifying and
resolving contractual interests and obligations.
Manufacturing companies are required to use joint cost allocations for financial and tax reporting
to value inventories and cost of goods sold. It is realized that the results of allocating joint costs
in different ways can be very important to management decision-making.
(a) Measuring performance:
Joint cost allocations can serve as measures of some departmental or division costs when
executive performance is evaluated. Many companies compensate executives and other
employees, at least partly on the basis of departmental or divisional earnings for the year, which
could be based on allocated joint costs.
Using any cost allocation as a performance measures raises the issue of fairness and could affect
the use of resources or provide the incentive to manipulate the performance measure.
(b) Estimating casualty losses:
Joint cost allocations can be useful in valuing inventory for insurance purposes. If a causality
loss occurs, the insurance company and the insured party must agree on the value of the lost
goods. For example suppose that a portion of the specialty lumber was destroyed at timber
traders place and the cost of the lumber destroyed should include a portion of the joint costs.
(c) Determining and Responding to Regulated Rates
When companies are subject to rate (Price) regulation, the allocation of joint costs can be a
significant factor in the way regulators determine rates. Thus, the manner of allocating and using
joint costs can be important cost drivers in utilities that depend on joint cost allocations for
pricing or reimbursement.

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(d) Specifying and Resolving contractual interests and obligations: -
Many contracts involve parties with potentially conflicting interests. Often prices for goods and
services exchanged among contracting parties are based on costs, including allocated joint costs.
Any cost allocation method contains an element of arbitrariness or inexactness attempts to more
accurately assign costs to products. Thus, specifying how to allocate costs in advance is
advisable. Cost management analyses, by estimating the effects of joint cost allocations and
clearly spelling out how to allocate joint costs, contribute to informed negotiations and a
smoothly functioning contractual arrangement.
Joint cost-Allocation Methods
There are two basic approaches are used to allocate joint costs.
Approach –I Market based data such as revenues:
Three sub methods:
(a) Sales value at split off method
(b) Estimated net realizable value (NRV) method and
(c) Constant gross- margin percentage NRV method

Approach II: - Physical measure based data, such as weights or volume.

Approach I Market based data method:
(a) Sales value at split off method allocates joint, costs based on the relative sales values of the
joint products at their split off point. This method does not consider additional processing
costs after the split off point. This method uses the sales value of the entire production of the
accounting period. The reason is that the joint costs were incurred on all units produced, not
just those sold in the entrant period. This method exemplifies the benefits-received criterion
of cost allocation (allocated in proportion to their potential revenues).
Example1. ABC Company manufactures three types of fertilizers in a joined production
process. The production and sales data for April 2010 is given below:
ABC Company
Schedule of production and sales data for the month of April 2010
Items X Y Z Total

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Produced & sold 50,000 Bags 25,000 Bags 10,000 Bags 85,000 Bags
Sales price 10 per Bag 15 per Bag 20 per Bag
Cost after split off 100,000 150,000 70,000 320,000
Joint cost 340,000

Compute joint cost to items X, Y, & Z on the basis of sales value at the split off point method:
Solution: a) Sales value at the split off point method

Item Quantity produced Unit Price Sale vale Joint cost

X 50,000 Bags $ 10 500,000 158,140
Y 25,000 Bags $ 15 375,000 118,605
Z 10,000 Bags $ 20 200,000 63,255
85,000 Bags 1,075,000 340,000
(b) Estimated net Realizable value (NRV) method:
The estimated net realizable value (NRV) method allocates joint costs to joint products on the
basis of the relative estimated NRV (estimated sales value in the ordinary course of business
minus the expected separable costs) of the total production of these products during the
accounting period. This method is typically used in preference to the sales value at split off point
method only when market-selling prices for one or more products at the split off point are not
available.
Example-2: Refer Example 1. Allocate joint costs to joint products on the basis of Net realizable
value (Assuming selling price after further processing is $ 15, 20 and 25 respectively for items
X, Y&Z and joint cost are 590,000)

Solution:
Items Sales S.P Per Sales Further Net realizable Joint cost
qty bag value processing cost value
X 50,000 15 750,000 100,000 650,000 325,000
Y 25,000 20 500,000 150,000 350,000 175,000
Z 10,000 25 250,000 70,000 180,000 90,000
1,500,000 1,180,000 590,000

(c) Constant gross margin percentage NRV method

Under this method the joint costs are allocated to products in a way that the gross margin
parentages as a percent of revenues are the same for each joint product .The following three steps
are to be followed.
(i) Compute the total gross margin percentage.

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(ii) Use the total gross margin percentage calculated in step 1 to calculate the gross
margin for each product (total gross margin percentage & sales value).
(iii) Deduct the additional processing costs from the total costs to calculate joint costs
allowed to each product.
Example 3: ABC Dairy Company purchases raw milk from individual farms and process it
until the split off point, where two products (cream and liquid skim) emerge. These two products
are sold to all independent company, which markets and distributes them to supermarkets and
other retail outlets.
Summary data for July 2003 are as follows:
Raw milk processed, 220,000 gallons. Twenty thousand gallons of raw milk are lost in the
production process due to evaporation, spillage and the like yielding 200,000 gallons of good
product.
Production during the month is as follows
Cream- 50,000 gallons
Liquid- 150,000 gallons
Cost of purchasing and processing it unlit the split off point, $ 1,600,000
The above production is further processed as follows:
Cream-Butter cream: 50,000 gallons of cream are further processed to yield 40,000gallons of
butter cream at additional processing cost of 1,120,000. Butter cream sold for $ 50 per gallon is
used in the manufacture of butter based products.
Liquid skim Condensed milk: 150,000 gallons of liquid skim are further processed to yield
100,000 gallons of condensed milk at additional processing costs of $ 2,080,000, condensed milk
is sold for $ 44 per gallon.
Required:
Allocate joint cost to joint product under constant Gross-Margin percentage NRV method.
Solution:
Step1: Computation of the overall gross margin percentage.
Expected sales value
40,000 gallons x $ 50 6,400,000
100,000 gallons x 44
Less: joint cost & additional cost

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(1,600,000 + 1,120,000 + 2,080,000) 4,800,000
Gross Margin 1,600,000
1,600,00
Gross margin percentage = x100  25%
6,400,000
Step 2: Computation of cost of goods sold:
Butter Cream Condensed Milk Total
Expected sales value $ 2,000,000 4,400,000 6,400,000
40,000 x 50
100,000 x 44
Less Gross margin 500,000 1,100,000 1,600,000
@ 25%
Cost of goods sold 1,500,000 3,300,000 4,800,000

Step 3- Computation of joint cost:

Cost of goods sold 1,500,000 3,300,0000 4,800,000
Less: Additional costs 1,120,000 2,080,000 3,200,000
Joint cost allocated 380,000 1,220,000 1,600,000

Approach II Physical measure based data such as weights or volume

The physical measures (or quantities) method is a joint cost allocation based on the relative
volume weight, energy content, or other physical measure of each joint product or other physical
measure of each joint product at the split off point. Companies might prefer the physical
measures method when the prices of their output products are highly volatile or unpredictable.
This method is sometimes used when significant processing occurs between the split off point
and the first sales opportunity, or when the market does not set product prices. The latter
situation could arise when regulators set prices in regulated pricing situations or in cost based
contract situation.
Many oil and gas producing companies allocate joint costs on the basis of the products energy
equivalents. They use this method because the products are typically measured in different
physical units (e.g., natural gas by thousands of cubic feet, oil by barrels) although oil and
natural gas often are produced simultaneously from the same well.

Example 4: Refer example 3 and compute joint allocation on the basis of physical measure
method.

Solution: Computation of joint allocation under physical measure method:

Cream Liquid Cream Total
(i) Physical measure of
production (gallons) 50,000 150,000 2,000,000
(ii) Weighing 0.25 0.75
(iii) Joint cost allocated 400,000 1,200,000 1,600,000

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(0.25 x 1,600,000) and
(0.75 x 1,600,000)
(iv) Joint production 400,000 1,200,000
50,000 150,000
Cost per gallon $ 8 per gallon $ 8 per gallon

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Chapter Six

Activity-Based Costing and Management

Learning Objectives

Dear students, after completing this chapter, you should be able to:

 Understand the concept of Activity-Based Costing (ABC), including the use of cost
drivers and activities to allocate costs more accurately.
 Apply Activity-Based Costing to assess customer profitability, and evaluate how different
customers impact an organization‘s cost structure.
 Understand the principles of Activity-Based Management (ABM), and how it can be used
to improve efficiency, control costs, and enhance decision-making within an organization.

6.1 Introduction

The activity-based costing (ABC) system is a method of accounting you can use to find the total
cost of activities necessary to make a product. The ABC system assigns costs to each activity
that goes into production, such as workers testing a product, setting up of machines, orders
passed for purchase of raw materials etc. Activity based costing is a methodology that identifies
activities in an organization and assigns the cost of each activity with resources to all products
and services according to the actual consumption. It can also be said as a process of attributing
indirect costs to cost units on the basis of benefits received from indirect activities (ordering,
setting up, assuring quality). ABC is an effective management approach for distributing and
controlling the overhead costs.

Definition of Activity Based Costing

CIMA defines‘ Activity Based Costing‘ as ―An approach to the costing and monitoring of

activities which involves tracing resource consumption and consisting final outputs. Resources

are assigned to activities and activities to cost objects based on consumption estimates. The latter

utilise cost drivers to attach activity costs to outputs.

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Factors Promoting the Development of ABC

1. Growing overhead costs because of increasingly automated production.

2. Increasing market competition which necessitated more accurate product costs.

3. Increasingly product diversity to secure economies of scope & increased market share.

4. Decreasing costs of information processing because of continual improvements and increasing

application of information technology.

Suitability of Activity Based Costing

ABC is particularly needed by organizations for product costing in the following situations.

1. High amount of overhead: When production overheads are high and significant cost, ABC

will be very much useful instead of traditional costing system.

2. Wide range of products: ABC is most suitable, when, there is a diversity in the product range

or there are multiple products.

3. Presence of non-volume related activities: (Eg. Material handling and inspection set up) The

traditional costing system cannot be applied, ABC is a superior and better option. ABC sill

identify non-value-adding activities in the production process that might be a suitable focus for

attention or elimination.

4. Stiff competition: During stiff competition faced by the organization, there is a urgent

requirement to compute cost accurately and to fix the selling price according to the market

situation, the ABC is very useful

TERMINOLOGY
Activity – Here, refers to an event that incurs cost.
Cost Object – it is an item for which cost measurement is required; Eg. a product or a customer.
Cost Pool - It is an aggregate of all the costs associated with performing a particular business
activity.
Meaning and Example:

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A company producing T-shirt has cost of materials such as buttons, threads, labor cost for

stitching the T-shirt and other costs are accumulated into meaningful groups. These groups are

called cost pool.

Cost driver:

 A cost driver is any factor that has the effect of changing the level of total costs

 It is an activity that is the root cause of why a cost occurs.

 It must be applicable and relevant to the event that is incurring a cost.

 A cost driver assists with allocation expenses in a systematic manner that results in more

accurate calculations of the true costs of producing specific products.

ABC attempts to relate overhead costs to the activities that cause or drive them. There are Two

categories of Cost Driver, which is mentioned below.

A Resource Cost Driver – it is a measure of the quantity of resources consumed by an activity.

It is used to assign the cost of a resource to an activity or cost pool.

An Activity Cost Driver – it is a measure of the frequency and intensity of demand, placed on

activities by cost objects. It is used to assign activity costs to cost object.

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STEPS IN ABC
1. Identify which activities are necessary to create a product
2. Separate each activity into its own cost pool
3. Assign activity cost drivers to each cost pool
4. Divide the total overhead in each cost pool by the total cost drivers to get your cost driver rate
5. Compute how many hours, parts, units, etc. that the activity used and multiply it by the cost driver
rate to find total cost
6. Calculate Cost per Unit by dividing the Total Cost by Total Units produced.

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USES OF ABC
I. Identification of necessary activities: The ABC system shows how overhead is used, which
helps to determine whether certain activities are necessary for production.
II. Focus on Value adding activities: The Activity Based Costing helps the management on
focusing the forces on value adding activities and eliminate non-value adding activities.
III. Ensuring profit margin: The specific allocation of costs also helps to set prices that produce
a healthy small business profit margin.
IV. Product pricing: With an ABC system, the business can assign costs to each activity in the
production process, allowing it to more accurately set a price that accounts for how much it costs
to create a product.
V. Measures to improve productivity: The accurate cost information helps the management to
adopt productivity improvement approaches like Total Quality Management (TQM), Business
Process Re-engineering (BPR) etc.
VI. Help in deciding Make or Buy: The management can take make or buy decisions by
considering the cost of manufacture of a product or sub contract the same with an outside agency
through Activity Based Costing analysis.
ADVANTAGES OF ACTIVITY BASED COSTING
1. More accurate costing of products/services.
2. Overhead allocation is done on logical basis.

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3. It enables better pricing policies by supplying accurate cost information.
4. Utilizes unit cost rather than just total cost.
5. Help to identify non-value added activities which facilitates cost reduction.
6. It is very much helpful to organization with multiple product.
7. It highlights problem areas which require attention of the management
Limitations of Activity Based Costing
The main limitations using Activity Based Costing are;
i. It is more expensive particularly in comparison with Traditional costing system
ii. It is not helpful to small organization
iii. It may not be applied to organization with very limited products
iv. Selection of most suitable cost driver may not be useful
Different Stages in ABC
1. Identification of major activities: Eg. machine related activities, labour related activities,
material ordering, material receiving, material handling, machine set up, production scheduling
etc.
2. Creation of cost pool or cost centre: cost pool is like a cost centre or activity centre around
which costs are accumulated. For example the total of machine set up might constitute are cost
pool for all set up related costs.
3. Allocation and apportionment of overhead costs to cost pool
4. Determination of cost driver: Cost driver is a factor which causes a change in the t of an
activity. Examples of cost driver are number of machine set up, number of purchase order,
number of customer order placed etc. Activity cost driver rate= total cost of activity/ activity cost
driver
5. Calculation of activity cost driver absorption rate: If the total costs of purchasing materials
were 1,00,000 and there were 1000 purchase orders the cost driver during the period. The rate
per purchase order is 1,00,000/1000= Etb.100 If the particular product needs 2 purchase order
the charge to the product will be 100 *2= 200 If 10 units of the product are produces CPU will be
200/10 units = Rs20.

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Review questions
1. Which of the following best describes Activity-Based Costing (ABC)?
a) A method of budgeting based on historical costs.
b) A method of allocating costs based on the volume of production.
c) A method of allocating costs based on activities and resource usage.
d) A method of allocating costs evenly across all products.

2. What is an example of a cost driver?

a) Raw material costs.
b) Number of machine setups.
c) Revenue generated by a product.
d) Employee satisfaction surveys.

Which of the following is NOT a benefit of ABC?

a) Improved cost allocation accuracy.
b) Simplifies the costing process.
c) Identifies non-value-adding activities.
d) Supports strategic decision-making.

4. Activity-Based Costing helps in customer profitability analysis by:

a) Allocating costs equally across all customers.
b) Assigning costs to customers based on their resource usage.
c) Reducing the price charged to unprofitable customers.
d) Eliminating customers with high revenue but low profit.

5. A cost driver in customer profitability analysis could be:

a) Total sales revenue.
b) Number of invoices processed.
c) Total units sold.
d) Customer satisfaction scores.

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6. Activity-Based Management (ABM) is used to:
a) Eliminate high-value activities.
b) Focus solely on reducing operational costs.
c) Use ABC data to improve processes and strategic outcomes.
d) Replace traditional costing methods entirely.

7. Which of the following is an example of Operational ABM?

a) Outsourcing non-core activities.
b) Identifying and eliminating non-value-adding tasks.
c) Aligning activities with business goals.
d) Launching a new product line.

8. What is a key benefit of ABM?

a) Simplifies financial reporting.
b) Eliminates the need for traditional costing systems.
c) Enhances decision-making by identifying valuable activities.
d) Ensures costs are distributed evenly across all products.

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COST AND MANAGEMENT ACCOUNTING II
(ACFN3032)

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Course Objectives & Competences to be acquired
After successfully completing this course, the students should be able to:
 Explain the importance of cost- volume- profit analysis;
 Describe the benefit of budgeting and its application;
 Prepare a master budget;
 Prepare a flexible budget;
 Compute and interpret variances;
 Apply relevant costing to different decisions;
 Explain the methods of pricing;
 Explain the costs and benefits of decentralization.
Course Description
The course builds on the knowledge acquired from the course entitled cost and Management
Accounting and introduces some new concepts and uses of accounting tools and techniques in
the analysis, planning and control of business operations and management decision making
processes. Topics covered include: intensive review of the management decision making
processes and nature of management information, examination of concepts and rationale
underlying managerial accounting managerial methods, the budgeting process and standard
costing, the investment decision and quantitative methods of evaluation.

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Chapter One
Cost-Volume-Profit Analysis, Absorption, and Variable Costing

Dear learners, after completing this chapter, you should be able to:
 Understand the cost volume profit (CVP) assumptions
 Distinguish between contribution margin and gross margin
 Explain Essential features of CVP analysis
 Determine break even point and out put to achieve target operating income
 Explain the use of CVP analysis in decision making and how sensitivity analysis can help
managers cope with certainty

Introduction
In this unit you will be introduced with one of the most powerful management accounting toll
that helps managers in quick decision about the income generated at different activity level. The
tool is termed as Cost-Volume-Profit (CVP) Analysis, as the relationship among cost, profit and
the volume of output or the level of activity is considered in the model.
Understanding the relationship between a firm‘s costs, profits and its volume levels is very
important for strategic planning. When you are undertaking a new project, you will probably ask
yourself, ―How many units do I have to produce and sell in order to breakeven?‖ The feasibility
of obtaining the level of production and sales indicated by that answer is very important in
deciding whether or not to move forward on the project in question. Similarly, before
undertaking a new project, you have to assure yourself that you can generate sufficient profits in
order to meet the profit targets set by your firm. Thus, you might ask yourself, ―How many units
do I have to sell in order to produce a target income?‖ Breaking Even? You could also ask, ―If I
increase my sales volume by certain percent, what will be the impact on my profits?‖
The topics in this unit are, therefore designed to acquaint you with the ability of applying Cost-
Volume-Profit (CVP) Analysis in answering different questions while you are taking part in
planning decision in different types of organizations.
Although the term ―profit‖ is attached in the CVP model; it does not mean that, the application of
CVP analysis is limited to business organizations only. It can be used by government and
nongovernmental organizations (NGOs) as well in planning their activity levels in light of the
recourse availability and constraints.

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1.1 Absorption versus variable Costing
a) Absorption costing
Absorption costing treats the costs of all manufacturing components (direct material, direct
labor, variable overhead and fixed overhead) as inventoriable or product costs in accordance
with generally accepted accounting principles (GAAP). Absorption costing is also known as
full costing. Under absorption costing, costs incurred in the nonmanufacturing areas of the
organization are considered period costs and are expensed in a manner that properly matches
them with revenues.
Absorption costing presents expenses on an income statement according to their functional
classifications. A functional classification is a group of costs that were all incurred for the
same principal purpose. Functional classifications include categories such as cost of goods
sold, selling expense, and administrative expense.

b) Variable costing
Variable costing is a cost accumulation method that includes only variable production costs
(direct material, direct labor, and variable overhead) as product or inventoriable costs. Under
this method, fixed manufacturing overhead is treated as a period cost. Like absorption
costing, variable costing treats costs incurred in the organization‘s selling and administrative
areas as period costs. Variable costing income statements typically present expenses
according to cost behavior (variable and fixed), although they may also present expenses by
functional classifications within the behavioral categories.
Generally, two basic differences can be seen between absorption and variable costing
1) Under absorption costing, FOH is considered a product cost; under variable costing, it is
considered a period cost.
2) Presentation of costs on the income statement. Absorption costing classifies expenses by
function, whereas variable costing categorizes expenses first by behavior and then may
further classify them by function

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1.2 Cost-volume profit (CVP) analysis
Cost-volume profit (CVP) analysis examines the behavior of total revenues, total cost and
operating income as changes occur in the output level, selling price, variable costs per unit or
fixed costs.
Managers often classify costs as fixed or variable when making decisions that affect the
volume of output. The managers want to know how such decision will affect costs and
revenues. They realize that many factors in addition to the volume of output will affect cost.
Yet, a useful starting point in their decision process is to specify the relationship between the
volume of out puts and costs and revenues.

This analysis is applicable in all economic sectors, including manufacturing, wholesaling,

retailing, and service industries and not-for- profit (NFP) organizations. CVP can be used by
managers to plan and control more effectively because it allows them to concentrate on the
relationships among revenues, costs, volume changes, taxes, and profits.

The term ―profit‖ is attached in the CVP model; it does not mean that, the application of
CVP analysis is limited to business organizations only. It can be used by government and
nongovernmental organizations (NGOs) as well in planning their activity levels in light of
the recourse availability and constraints.

Cost-volume-profit (CVP) analysis is a powerful tool that helps managers to understand the
relationships among cost, volume, and profit. CVP analysis focuses on how profits are
affected by the following five factors:

1) Selling prices. 4) Total fixed costs.

2) Sales volume. 5) Mix of products sold.

3) Unit variable costs.

Because CVP analysis helps managers understand how profits are affected by these key
factors, it is a vital tool in many business decisions. These decisions include what products

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and services to offer, what prices to charge, what marketing strategy to use, and what cost
structure to implement.

CVP – Underlying Assumptions

1) Changes in the level of revenues and costs arise only because of changes in the number of
product (or service) units produced and sold.

2) Total costs can be divided into a fixed component and a component that is variable with
respect to the level of output.

3) When graphed, the behavior of total revenues and total costs is linear (straight-line) in
relation to output units within the relevant range (and time period).

4) The unit selling price, unit variable costs, and fixed costs are known and constant.

5) The analysis either covers a single product or assumes that the sales mix when multiple
products are sold will remain constant as the level of total units sold changes.

6) All revenues and costs can be added and compared without taking into account the time
value of money

CVP analysis has wide-range applicability. It can be used to determine a company‘s break-
even point (BEP), which is that level of activity, in units or dollars/Birr, at which total
revenues equal total costs. At breakeven, the company‘s revenues simply cover its costs; thus,
the company incurs neither a profit nor a loss on operating activities.

At the breakeven point total revenue is equal to total cost (both variable and fixed cost)

For instance Sebastopol Cinema sold 4,800 tickets during a show one month run. The
following contribution margined approach income statement show that the operating
income for the month will be zero:

Sales Revenue (4800 X Br25) --------------------------- Br 120, 000

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Less Variable Cost (4800 X Br 15) -------------------------- 72,000

Total Contribution Margin----------------------------------Br 48,000

Less Fixed Costs-------------------------------------------------- 48,000

Operating Income---------------------------------------------------Br 0

The income statement above highlights (1) the distinction between variable and fixed cost
and (2) the total contribution margin, which is the amount that contributes towards covering
Sebastopol Cinema‘s fixed cost and income generation. To state it differently, each ticket
sold add Birr 10 to the firm‘s bottom line profit. The Birr 10 unit contribution margin is
derived by deducting the unit variable cost Birr 15 from Birr 25 the unit selling price of a
ticket.

How could you compute Sebastopol Cinema‘s breakeven point if you didn‘t already know it
is Birr 4,800 tickets per month? Well on the following discussion you will get the basics of
CVP analysis to determine BEP and other application.

In discussing CVP application we will assume that the following variables have the meanings
given below:

 SP = Selling Price Per Unit  FC = Total Fixed Costs

 Q = Units Produced and Sold  TOI =Target operating Income
 VCU = Variable Cost Per Unit  TNI=Target Net Income
 CMU=contribution margin per Unit  t = Tax rate
 CM%= contribution margin percentage
(CMU÷SP)

CVP analysis can be done using three alternative approaches, namely: equation approach,
contribution margin approach and graphical approach.

a) Equation Method

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In using equation approach to CVP analysis, you need to convert your income statement in
the following equation form.

Revenue –Variable Costs- Fixed Costs = Operating Income

Your Sales Revenue is equal to the number of units sold times the price you get for each unit
sold:

Sales Revenue = SPxQ

Assume that you have a linear cost function, and your total costs equal the sum of your
Variable Costs and Fixed Costs:

Total Costs = Variable costs + Fixed costs

The profit equation can, therefore rewritten as:

(SPXQ) - (VCUXQ) - FC= OI

This equation provides the most general and easiest approach to remember approach to any
CVP situation. The determination of breakeven level using this method can easily performed
by making the operating income on the right hand side of the equation zero. Here the basic
assumption is that, when you are at breakeven, your Sales Revenue minus your Total Costs is
zero.

 At breakeven point,
(SPXQ) - (VCUXQ) - FC = 0

From the information given above for the Sebastopol Cinema, you can determine the
breakeven point (BEP) using the equation approach as follows,

(Br25 X Q) – (Br15 X Q) – Br48, 000 = 0

Br10Q = Br 48,000

Q= 4,800

If Sebastopol sells fewer than 4800 tickets, it will have a loss, if it sells 4800 tickets, it will
breakeven; and if the sales are more than 4800 units, it will make a profit.

The breakeven point stated in units can be stated in terms of Birr by multiplying the
breakeven quantity and unit selling price.

The breakeven point in Birr= BEQ x SP

= 4,800 x Br25

= Br120, 000

b) Contribution Margin Approach

The contribution margin technique is merely a short version of the equation technique. The
formulas used in the determination of the breakeven point in unit as well as in value are
derived by the rearrangement of the terms in the equation method above, which is

(SP x Q) – (VCU x Q) – FC= OI

Re-written equation takes the following format:

(SP-VCU) x Q = FC + OI

That is, Q= FC + OI/ (SP-VCU)

The difference between unit selling price and unit variable cost is termed as unit
contribution margin. You can replace the (P-V) by the term "Contribution Margin per Unit
(CMU),

Q= FC + OI/CMU
As you know from the discussion above at breakeven point the target operating income is
Birr 0, so replacing OI by 0, you will get,

Q= FC/ (SP-VCU)

i. Breakeven point in units using contribution Margin Approach

Breakeven point in units using this formula is determined by dividing the total fixed cost by
the contribution margin per unit due to the fact that this approach centers on the idea that
each unit sold provides a certain amount of fixed costs. When enough units have been sold to
generate a total contribution margin equals to the total expense and only after that point the
units sold contributes for profit of the organization.

The breakeven number of tickets that Sebastopol Cinema must sold to reach at breakeven
using this method can be determined as,

Q = FC/CMU = Br48, 000/Br10 = 4,800 units

ii. Determining breakeven point in terms of sales value (Dollar/Birr)

To find the breakeven sales value, you can use contribution margin percentage in place of
contribution margin per unit in the formula you used in the determination of breakeven
units. Contribution margin percentage is simply the ratio of contribution margin to selling
price.

CM% = CMU/USP

It can also determine by dividing the total contribution margin to total sales when the unit
selling price and variable cost is not known. We will see how this formula is used in such a
situation later. Before that let see how the formula works using the above example.

CM % on our example of Sebastopol Cinema = UCM/USP= Br 10/ Br 25= 0.4

This can be interpreted as, units sold cover variables costs and contribute 40 percent to cover
fixed cost and increase in profit.

The break even sales amount (Birr) for Sebastopol Cinema

= FC/CM = 48,000/0.40 = Br 120,000

The breakeven sales determined using equation method was a mere multiplication of the
breakeven point in unit and the unit selling price (4800 units x Br 25) which is exactly the
same with what you determined using a more complicated contribution margin approach.

c) Graphical Approach
You have seen how solutions to break-even problems are determined using an algebraic
formula. However, sometimes managers need information in more visual format, such as
graphs. In this approach you can construct a CVP graph by plotting total cost and total
revenue graph at different activity level. The breakeven point is found at the intersection
point of total revenue and total cost lines.

The chart or graph is constructed as follows:

1. Plot fixed costs, as a straight line parallel to the horizontal axis

2. Plot sales revenue and variable costs from the origin
3. Total costs represent fixed plus variable costs.
4. The breakeven point represents the intersection point of total revenue and total
cost lines
Now you can draw a CVP graph to Sebastopol Cinema following the steps given above and
locate the breakeven point.
Birr Total Revenue Line
Operating Profit
Total Cost Line

Operating Loss

120,000
Total Variable Cost
48,000
Breakeven Point

Fixed Cost Line

Fixed Cost
4,800 Units

The
breakeven points for Sebastopol cinema can determined from the graph by identifying the
level of output and sales value where the total revenue and total cost line cross to each other.
In the case of Sebastopol cinema this happened when 4800 tickets are sold for birr 120,000 in
which both the unit and the Birr value are similar with what have been determined in the
equation and contribution margin approaches. The graphical approach is usually preferred
by managers as it can provide a detail insight of the cost volume and profit relationship
pictorially.

1.3 Target Operating Income Analysis

Using CVP analysis managers can determine the total sales in unit and Birr/Dollar needed to
reach the target profit level. The computation of sales volume in unit and/ or in amount to
attain the targeted profit is similar with that of the break even analysis, except that the
targeted profit is more than offsetting the cost. For instance, the management of Sebastopol
Cinema desires to get Br 9000 profit for the coming month, instead of operating at breakeven
point, how many tickets must be sold? Managers want to answer this question to provide the
necessary resource support to attain the desired profit at already determined volume of
activity. The analysis can be performed using equation method or contribution margin
approach on the basis of personal preference.

See both the methods using the information given for Sebastopol Cinema to determine the
target sales in unit and Birr to that enable the firm to earn the targeted profit of birr 9,000
can be determined using the equation method and contribution margin method as follows:

Equation Method to Determine Contribution Margin Approach

(Target sales unit) (Target sales unit)

(SP x Q) - (VCU x Q) -FC= TOI Q = FC +TOI/ CMU

(25 x Q) – (15 x Q) - 48,000= 9000 Q = (48,000 + 9,000)/10

10Q= 57,000 Q= 5,700

Q= 5,700

Equation Method to Determine Contribution Margin Approach

(Target sales in birr) (Target sales in birr)

TR= SP x Q Target Sales in Birr = (FC + TOI)/CM%

=25 x 5700 = (48,000 + 9000)/ 40%

= Br 142,500 = Br 142, 500

Both the methods provided similar result that the cinema must sell 5,700 tickets at a total of
Birr 142, 500 to meet its target profit goal of birr 9000.

1.3.1 The Impact of Income Tax on CVP Analysis

Profit seeking enterprises must pay tax on their profit, meaning that target income figures
are set at high enough to cover the firms tax obligation to the government. The relationship
between an organization ‗s before tax income and after tax income is expressed in the
following formula:

After Tax income = Before Tax Income – Income Taxes

NIAT = NIBT- (NIBT x t)

= NIBT x (1-t)

Dividing both sides by (1-t) you can get:

NIAT/ (1-t) = NIBT

Which gives you the desired before tax income that will generate the desired after tax
income, given the company‘s tax rate.

For instance, if the target profit given for Sebastopol Cinema above is expressed on after tax
basis and the firm is subject to a 40 percent income tax rate, what will be the required sales of
ticket in units and Birr? If you want to know how many units that you need to produce and
sell in order to generate a target Net Income (or after-tax profit), just convert the after-tax
number into a before-tax number.

NIBT = NIAT/ (1-t) =Br 9000/ (1-0.4) = Br 15,000

You can then substitute the before-tax profit figure in the formulas used in target operating
income analysis. The analysis of sales of tickets and amount of Sebastopol cinema to earn the
desired profit after tax can be determined using the equation and contribution margin
approach as shown on the following table:

Equation Method to Determine Contribution Margin Approach

(Target sales unit) (Target sales unit)

(SP x Q) - (VCU x Q) -FC= TOIBT Q = FC +TOIBT/ CMU

(25 x Q) – (15 x Q) - 48,000= 15,000 Q = (48,000 + 15,000)/10

10Q= 63,000 Q= 6,300

Q= 6,300

Equation Method to Determine Contribution Margin Approach

(Target sales in birr) (Target sales in birr)

TR= SP x Q Target Sales in Birr = (FC + TOIBT)/CM%

=25 x 6300 = (48,000 + 15,000)/ 40%

= Br 157,500 = Birr 157, 500

CVP Analysis in service and non-profit organizations

CVP analysis can be applied in service and NFP organizations in measuring their out put.
Examples of out-put measures in venous service and not profit industries follow:

Example

Haramaya University has annual budget of $10,000,000 for MSC scholarship, $ 30,000 per
student per year. Fixed cost of the programmed is $1,000,000.

Required: -

1. How many students can get the scholarship?

2. Suppose total budget for the next year is reduced by 30% calculate the number of MSC
scholarship that AU can offer next year.
Solution:

1. 10,000,000- 30,000 Q –1,000,000 = 0

9,000,000
Q  300students
30,000

2. 10,000,000 (0.7) – 30,000 Q – 1,000,000 = 0

6,000,000
Q  200students
30,000

The percentage reduction in service is more than the 30% reduction in the budget. Why?

1.4 The Margin of Safety

The margin of safety is the excess of budgeted (or actual) sales over the breakeven volume of
sales. It states the amount by which sales can drop before losses begin to be incurred. In
other words, it is the amount of sales revenue that could be lost before the company‘s profit
would be reduced to zero. The formula for its calculations follows:
Margin of safety = Total sales - Break even Sales

The margin of safety can also be expressed in percentage form. This percentage is obtained
by dividing the margin of safety in birr terms by total sales:

Margin of safety (in % age) = Margin of safety in birrs

Total sales

Example (1): Consider the cost structure for ABC Company and XYZ in Exhibit 1-3

ABC Co. and XYZ Co.

Comparative Cost Structures
ABC Co. XYZ Co.
Amount Percent Amount Percent
Sales Br. 500,000 100 Br. 500,000 100
Variable 100,000 20 300,000 60
costs
Contribution 400,000 80 200,000 40
Margin
Fixed costs 300,000 100,000
Net income Br. 100,000 Br. 100,000
The break even sales for each company may be computed as follows:
BEP (in birrs) = Fixed Costs
CM ratio
BEP (ABC Co.) = Br.300, 000 = Br.375, 000
0.8
BEP (XYZ Co.) = Br.100, 000 = Br.250, 000
0.4

The margin of safety for each company may be computed as:

Total sales - Break even Sales = Margin of safety

ABC Co.‘s: Br.500, 000- Br.375, 000 = Br.125, 000

XYZ Co.‘s: Br.500, 000- 250,000 = Br. 250,000

Note that the companies‘ sales revenues are the same (Br. 500,000) and their net incomes are
the same (Br. 100,000) their individual margins of safety are different.

This is because they have different cost structures, and consequently different breakeven.

A higher breakeven sales amount for ABC Co. produces a lower margin of safety.

For ABC Co., the Br.125, 000 margin of safety means that sales would have to diminish by
more than this amount before the company suffers a loss. In effect the margin of safety is a
buffer before losses are incurred.
The same analysis applies to XYZ Co., except its buffer is Br. 250,000. At this point, neither
company is experiencing losses;

Thus it is difficult to say which company is better off. Because they are in different
businesses the amounts computed as buffers may mean the companies‘ operating results are
fine. A comparison within each company on a year-by-year basis may shed light on the
possibility of impending difficulties.
The margin of safety may also be expressed as a percentage. The calculation is done by
dividing the margin of safety (in birrs) by the total sales (in birrs). This, the calculation of the
margins of safety percentage is:

Margin of safety percentage = Margin of safety in birrs

Total sales in birrs
ABC Co.‘s: Br. 125,000 = 25 %
Br.500, 000

XYZ Co.‘s: Br. 250,000 = 50 %

Br.500, 000

1.4 The concepts of cost units, cost centers and profit centers
What is cost unit?

Cost unit is the amount of money that a company invests in manufacturing a single unit of a
saleable product. It also known as the cost per unit, the cost of goods sold or the cost of sales.
The cost of unit calculation appears in the company's financial statement. Cost per unit
calculations are often used by businesses that are dependent on product sales, but service-
based companies may also use them.
Why is cost per unit important?

o Cost per unit calculation is important because it can inform the company about the
efficiency of its business operations. Then, if necessary, it can take appropriate steps to
make operational improvements.

o Cost per unit also helps the company decide what to charge for each product so they can
be sure they are making a profit. To be profitable, the company must ensure that its
production cost is lower than the price at which it sells it to the customer.

How to calculate cost per unit

You can calculate cost per unit by taking the following steps:

 Determine your fixed costs

 Identify your variable costs

 Know how many units you are producing

 Use the cost per unit formula

Example

Classy Kurtas is a company that makes and sells women's kurtas to customers. They pay
₹10,000 a month to rent its workshop, and their monthly electricity bill is ₹800. This means
they have a monthly fixed cost of ₹10,000 + ₹800 = ₹10,800. The company may buy 2,500
meters of 200gsm cotton cloth at ₹25 per meter from a cotton cloth manufacturer every
month, which costs them ₹62,500. They may also hire a seamstress for ₹20,000 per month to
stitch 50 kurtas as per a given design. So the company's variable cost for a month is ₹62,500 +
₹20,000 = ₹82,500.To get their monthly cost per unit, the company can add their monthly
fixed cost of ₹10,800 with their monthly variable cost of ₹82,500. That amounts to ₹10,800 +
₹82,500 = ₹93,300. Now they can divide this amount by the number of kurtas the seamstress
makes per month. So, it is ₹93,300 / 50 = ₹1,866. This is their cost per unit. The company can
use this number as a reference to set the selling price of each kurta. The selling price has to
be more than ₹1,866 if Classy Kurtas wants to make a profit.

Cost centre vs Profit Centre

A cost center is a department or a unit that supervises, allocates, segregates, and eliminates all
sorts of costs related to a company. The cost center is authorized to decrease and manage the
cost. These costs are generally monitored by analyzing and deducting the actual cost incurred
with the standard cost.

A profit center is a division or department of a company that operates for the calculation of
profit. In an organization, different profit centers are managed by managers who identify
profits on the basis of costs and revenues. The profit center is accountable for all the actions
associated with the sale of goods and production. Principal object of a profit center is to
generate and maximize the profit by minimizing the cost incurred and increasing sales. This
objective helps to uplift the profit-making capability of a company. Generally the difference
between cost center and profit center summarized as follows

Cost center Profit center

Definition A cost center is a A profit center is a company‘s

company‘s department department that is responsible for
that supervises all the the profits of the company.
costs of the company.
Responsibilities Reducing costs and Helping in earning profits and
effective cost control maximizing revenue
within the organization
Complexity A cost center has lesser A profit center is more complex
involved complexity as the only as it has to focus on costs, profits,
focus is on costs. and revenue.
Approach followed Short-term approach Both short and long-term
approaches are followed
Scope of operations Comparatively narrow Comparatively wide
Summary
Using CVP analysis requires simplifying assumptions, including the assumption that costs are
either fixed or variable with respect to the number of output units (units produced and sold) and
that total revenue and total cost relationships are liner. CVP analysis assists managers in
understanding the behavior of total costs total revenues, and operating income as changes occur
in the output level, selling price, variable costs, or fixed costs. The three methods outlined for
computing the breakeven point (the quantity of output where total revenues equal costs) and the
quantity of output to achieve target operating income are the equation method, the contribution
margin method, and the graph method.

Each method is merely a restatement of the other. Managers often select the method they find
easiest to use in their specific situation. Income taxes can be incorporated into CVP analysis by
using target net income rather than target operating income. The breakeven point is unaffected
by the presence of income taxes because no income taxes are paid if there is no operating come.

When making decisions, managers use CVP analysis to compare contribution margins and fixed
costs in different alternatives. Sensitivity analysis, a ―what-if‖ technique, systematically
examiners how a result will change if the original predicated data are not achieved or if an
underlying assumption changes. CVP analysis highlights the downside risk and upside return of
alternatives that differ in the structure of their fixed costs variable costs.

When CVP analysis is applied to a multiple-product company it is assumed that there is a

constant sales mix of products as the total quantity of units sold changes.

Contribution margin is revenues minus all variable costs (throughout the value chain), while
gross margin is revenues minus cost of goods sold. The basic concepts of CVP analysis can be
adapted to multiple cost driver situations but the simple formulae of the single cost driver case
can no longer be used.
Review Questions

PART I- True or False Instruction, dear learners, please write true if the statement is correct
and write false if the statement is wrong

1. In financial accounting, the term expense relates to expenditure and when this expense
expires it will be reported on an income statement as cost.
2. The difference between total revenues and total variable costs is called gross margin.
3. Service-sector companies can compute a contribution margin figure but not a gross
margin figure
4. Variable non-manufacturing costs are deducted from revenues when computing gross
margin but are not deducted when computing contribution margin.
5. Income taxes can be incorporated into CVP analysis by using target net income rather
than target operating income
6. The breakeven point is unaffected by the presence of income taxes because no income
taxes are paid if there is no operating come.
7. Always, qualitative factors dictate management‘s make-or buy decision
8. When CVP analysis is applied to a multiple-product company it is assumed that there is a
constant sales mix of products as the total quantity of units sold changes.
9. Like contribution margin, gross margin can be expressed as a total, as an amount per unit,
or as a percentage.
10. Fixed manufacturing costs are deducted from revenues when computing contribution
margin but are not deducted when computing gross margin.
PART II- Fill in the Blank Spaces Instruction, Dear Learners, please fill in the blank spaces
with appropriate words or phrases

11. ._________ examines the behavior of total revenues, total costs and operating income as
changes occur in the output level, selling price, variable costs per unit or fixed costs.
12. In decision making process, any cost that differs among alternatives and will influence
the outcome is a ___________
13. The difference between operating revenue and operating costs including cost of goods
sold is the _____________
14. _________ is the difference between the unit selling price and the variable cost per unit.
15. ___________ (also called contribution margin ratio) is the contribution margin per unit
divided by the selling price
16. The _________ is that quantity of output where total revenues equal total costs-that is,
where the operating income is zero
17. ______ is a ―What- if‖ technique that managers use to examine how a result will change
if the original predicted data are not achieved or if an underlying assumption changes.
18. __________ is the amount of budgeted revenues over and above breakeven revenues
PART III- Problems Instruction,

Dear Learners, please work out the following questions by showing the necessary steps
Problem 1-1 Max Company produces a single product that it sells wholesale for $100 per
unit. Variable costs per unit amount to $80 and total fixed costs are $100,000. Assume the
applicable tax rate is 40%. Required:

a. Find the break-even point in sales dollars.

b. Find the sales dollars needed to generate $20,000 in net income before taxes.
c. Find the sales dollars needed to generate $24,000 in net income after taxes.
d. Find the sales dollars needed to generate a 9% return on sales dollars after taxes.
e. Find the sales dollars needed to generate an 18% return on sales after taxes.
CHAPTER TWO

2. DECISION MAKING AND RELEVANT INFORMATION

2.1 Introduction
During the last decade, increasing competition has forced many companies to refocus their
resources and to defend their core businesses against aggressors. In developing strategies to fight
this war, managers have generally reached a consensus on two strategic criteria. First, to win a
battle, the focus of organizations must be on delivering products and services in the manner most
consistent with the desires of customers.

Second, no company can do all things well. The strategies managers devise in this intensive
struggle evolve from internal evaluations in which the managers identify the functions they must
do well to survive. These functions are regarded as core competencies and maintaining
leadership in these areas is regarded as vital. All other functions, although important to the
organization, are regarded as noncore functions. By intensely focusing on core functions,
managers try to maintain a competitive advantage.

However, an undesirable consequence of focusing on only the core competencies is that the
quality and capabilities of the noncore functions can deteriorate. This deterioration, in turn, can
reduce a firm‘s ability to attract customers to its products and services. Outsourcing the noncore
functions to firms that have core competencies in those functions frequently solves the dilemma
of maintaining a focus on core competencies while also maintaining excellence in noncore
functions.

Decision making is a fundamental part of management. The managerial accountant‘s role in

the decision-making process is to provide relevant information to the managers who make
the decisions. Thus, the managerial accountant needs a good understanding of the decisions
faced by those managers. A key function of a Financial Manager is to both facilitate and part
take in the decision making process.
Decision-making is the process of choosing the best course of action from the alternative
available. That is, when you are faced with making a decision (or choice), you need to
perform a number of tasks before making the final decision (choice).

2.2 Decision Making Process

The formal method used by managers for making a choice involves the following decision
making process.

1. Recognize and define the problem

2. Identify alternatives as possible solution to the problem

3. Identify the cost and benefit associated with each feasible alternative

4. Total the relevant costs and benefits for each alternative

5. Assess qualitative factors

6. Select the alternative with the greatest overall benefits

7. Implement the alternative selected

8. Follow-up

The concept of Relevance

Relevance is one of the key characteristics of good management accounting information.

This means that management accounting information produced for each manager must relate
to the decisions which he/she will have to make. Before the management of an enterprise
can make an informed decision on any matter, they need to incorporate all of the relevant
costs which apply to the specific decision at hand in their decision making process. To
include any non-relevant information or to exclude any relevant information will result in
management basing their decision on misleading information and ultimately to poor
decisions being taken.
Relevant Costs and Relevant Revenue

Relevant costs are expected future costs and relevant revenues are expected future revenues
that differ among the alternative courses of action being considered. Revenues and costs that
are not relevant are said to be irrelevant. Be sure you understand that to be relevant costs
and revenues must

 Occur in the future—every decision deals with selecting a course of action based on
its expected future results. The Consequences of decisions are borne in the future,
not the past. To be relevant to a decision, cost or revenue information must involve a
future event.

 Differ among the alternative courses of action—costs and revenues that do not differ
will not matter and, hence, will have no bearing on the decision being made.
Relevant information must involve costs or revenue that differs among the
alternatives. Costs or revenues that are the same across all the available alternatives
have no bearing on the decision.

Importance of Identifying Relevant Costs and Benefits

Why it is important for the managerial accountant to isolate the relevant costs and benefit in
a decision analysis? The reasons are two. First, generating information is a costly process.
The relevant data must be sought, and this requires time and effort. By focusing on only the
relevant information, the managerial accountant can simplify and shorten the data-gathering
process.

Second, People can effectively use only a limited amount of information. Beyond this, they
experience information overload, and their decision-making effectiveness declines. By
routinely providing only information about relevant costs and benefits, the managerial
accountant can reduce the likelihood of information overload.
Now let us see how we are going to use the relevant information to make decision through
example and we will start with the special order and we will proceed using the above order
of decision making area.

Generally, the term that are used to describe the relevant costs are:

1. Avoidable costs.-those costs that would not be incurred I f the activity to which thy
related did not exist. All incremental costs are also referred as avoidable costs. What
are incremental costs? This are costs which are specifically incurred by following a
course of action and which are avoidable if such action is not taken. That is, there are
costs that are directly affected by the decision or occur as direct consequences of the
making a decision (they are costs that will be incurred if the decision is
implemented but not incurred if the decision is rejected or not implemented). Such
costs are known as incremental costs and considered as relevant cost for decision.
They are also termed as avoidable costs. Because, such costs can be avoided or would
not be incurred, if the activity to which it relates did not exist.

2. Opportunity costs. - Opportunity costs are the benefit which could have been earned,
but which has been given up, by the choosing one option instead of another option.
In other words, it is the value of an option, which cannot be selected because of
choosing a different option. You may find the idea of opportunity costs difficult to
grasp at first. This is because they are costs, which are not included in the accounting
books and records of an enterprise. They are, however, relevant in certain decision-
making situation and you must bear in mind the fact that that exists when assessing
any such situations.

Non-Relevant cost

Non-relevant costs are costs which are either not a future cash flows or which are costs
which will be incurred any wary, regardless of the decision taken. Fore example, expenses
for full time salaries, heat and light, and the apportionment of other administrating costs are
usually unaffected by the decision and are considered as irrelevant for the decision.

The common types of non-relevant costs are explained as follow:

1. Non-Incremental costs: - These are costs which will not be affected by the decision at
hand. Non-incremental costs are non-relevant costs because they are not related to the
decision at hand (that is non-incremental costs will remain the same no matter what
decision is taken). An example of non-incremental costs would be fixed costs, which by
their very nature shouldn‘t be affected by decisions (at least in the short term). If,
however, a decision gives rise to a specific increase in fixed costs then the increase in
fixed costs would e an incremental (or additional) and, hence, considered as relevant cost.

2. Sunk Costs: - A sunk cost is a cost that has already been incurred and cannot be altered by
any future decision. If sunk costs are not affected by a decision then they must not be
considered for decision-making purposes. Generally Sunk costs are considered a s non-
relevant for a particular decision.

For example, assume that an organization, which incurs market research, costs in studding
the market for introducing a new product. After studying the market, the final decision on
whether or not to launch the product, would regard these market research costs as ‗sunk‘
(that is irrecoverable past cost) and thus, not incorporate them in making the launch
decision.

3. Committed cost: - These are future cash flows that will be incurred anyway, whether
decision is taken now about alternative opportunities. Such costs are usually the result of
the contract already entered by the organization. Generally, committed costs are similar
to sunk costs in that they exist because of previous decisions. Committed costs are
different from sunk costs because they are costs that have been committed by
management. However, the costs committed contractually are effectively a sunk cost.
4. Notional Costs: - Notional costs are hypothetical accounting costs to reflect the use of a
benefit for which no actual cash expense is incurred. Notional costs are also called
Imputed cost. The primary objective of charging notional costs is to enable management
to make clearer internal decisions by making sure that internal decision making become
more realistic. Notional charges are typically used to charge responsibility centers. Were
as, notional interest is often charged for the use of internally generated funds. Examples
of using notional costs, to enhance internal management making decision, are intra
division charges to enable management to see the performance of certain departments.

5. Spare Capacity Costs: - Because of the recent advancements in manufacturing technology,

most enterprises have greatly increased their efficiency and as a result are often operating
at a capacity, which is below full capacity. Operating with spare capacity can have a
significant impact on the relevant costs on any short-term production decision the
management of such an enterprise might have to make. If spare capacity exists in an
enterprise, some costs which are generally considered incremental may in fact be non-
incremental and thus, no-relevant, in the short term. For example, if an enterprise is
operating at less than full capacity then its work force would be a non-relevant cost for a
decision on whether to accept or reject a once-off special order. The labor cost is non-
relevant because the wages will have to be paid whether the order is accepter or not. If
the special order involved and element of overtime then the cost of such overtime would
be of course be a relevant cost (as it is an incremental cost) for the decision.

I. SPECIAL ORDER

Managers must often evaluate when a special order should be accepted, and if the order is
accepted, the price that should be charged. A special order is a one-time order that is not
considered part of the company‘s normal ongoing business.

Example 5.1
A company produces a single product and has budgeted for the production of 100,000 units
during the next quarter. The costs estimates for the quarter are as follows:
Direct labor…………………$ 600,000
Direct materials……………… 200,000
Variable overheads………….200,000
Fixed overheads…………… …400,000
$ 1,400,000
The company has agreed to sell 80,000 units during the coming period at the generally
accepted market price of $18 per unit. It appears unlikely that orders will be received for the
remaining 20,000 units at a selling price of $18 per unit, but a customer is prepared to
purchase them at a selling price of $12 per units. Should the company accept the offer?
Additional Information. A study of the cost estimates indicates that during the next quarter
the fixed overheads and direct labor cost will remain the same irrespective of whether or not
the special order is accepted.

Solution
Order not accepted Order accepted
(80,000 units @18) (80,000@18 and 20,000 @ 12)
Sales (80,000 x $18) = 1,440,000 + (20,000 x $12)=$1,680,000
$1,440,0000
Less: Variable Cost:
Direct material 160,000 200,000
Variable overheads 160,000 200,000 400,000
(320,000)
Contribution Margin 1,280,000
1,120,000
Less: Fixed Overhead (400,000) 400,000
Direct Labor (600,000) 600,000 1,000,000
(1,000,000)
Operating income 120,000 280,000
Decision: Based on this analysis the company should accept the special order since the special order will
add the operating income of the company by 160,000, this may because there are unused capacity of the
company with regards to Fixed overhead and Direct Labor cost.
Summary The decision to accept or reject a specially priced order is common in both service industry and
manufacturing firms. Manufacturers often are faced with decision about selling products in a special
order at less than full price. The correct analysis of such decisions focuses on the relevant costs and
benefits. Fixed costs, which often are allocated to individual units of product or service, are usually
irrelevant. Fixed costs typically will not change in total, whether the order is accepted or rejected.
When excess capacity exists, the only relevant costs usually will be the variable costs
associated with the special order. When there is no excess capacity, the opportunity cost of
using the firm‘s facilities for the special order are also relevant to the decision.

II. Deletion or addition of product, service or department

Decision relating to whether product line, service or department of a company should be

dropped and new ones added are among the most difficult that a manager has to make.
Ultimately, however, any final decision to drop a business segment or to add a new one is
going to hinge primarily on the impact the decision will have on net operating income. To
assess this impact, costs must be carefully analyzed. There are two main classifications of
expenses in this decision making analysis. Unavoidable expenses, expenses that will continue
to be incurred even if a subunit or activity is eliminated. Avoidable expenses, expenses that
will no longer be incurred if a particular action is taken. All variable costs are avoidable.

In making such kind of decision, the main consideration is the contribution margin that can
be given up if the product line or factory is drooped and the fixed costs that can be avoided
or that would be saved if the product line or factor is dropped.
Generally, if the contribution margin given up by dropping the product line, department, or
factory is less than the fixed costs that can be avoidable, then it is better to drop the segment
or the product or the department. Similarly; if contribution margin given up by dropping
the product line, department, or factory is greater than the fixed cost that can be avoidable
the product or the segment should be kept to continue in function.

Example 5.2.
The following table provides sales and cost information for the preceding month for the Xyz Drug
company and its three major product lines—drugs, cosmetics, and house-wares.
Product Line
House-
Total Drugs Cosmetics Wares
Sales 250,000 125,000 75,000 50,000
Variable expenses 105,000 50,000 25,000 30,000
Contribution margin 145,000 75,000 50,000 20,000
Fixed expenses:
Salaries 50,000 29,500 12,500 8,000
Advertising 15,000 1,000 7,500 6,500
Utilities 2,000 500 500 1,000
Depreciation—fixtures 5,000 1,000 2,000 2,000
Rent 20,000 10,000 6,000 4,000
Insurance 3,000 2,000 500 500
General administrative 30,000 15,000 9,000 6,000
Total fixed expenses 125,000 59,000 38,000 28,000
Net operating income (loss) 20,000 16,000 12,000 (8,000)
Suppose the Xyz Drug company has analyzed the fixed costs being charged to the three product
lines and has determined the following:
1. The salaries expense represents salaries paid to employee working directly on the product.
2. The advertising expense represents advertisements that are specific to each product line and
are avoidable if the line is dropped.
3. The utility expense represents utilities costs for the entire company.
4. The depreciation expense represents depreciation of fixtures used to display the various
product lines.
5. The rent expense represents rent on the entire building housing the company; it is allocated
to the product lines on the basis of sales dollars.
6. The insurance expense is for insurance carried on inventories with in each of the three
product lines.
7. The general administrative expense represents the costs of accounting, purchasing, and
general management, which are allocated to the product lines on the basis of sales dollars.
Required: Should the company keep the house-wares product line or drop it?
Solution

Keep Drop Difference: Net

House- House-ware operating
wares income Increase
(or Decrease)
Sales 50,000 $0 $(50,000)
Variable expenses 30,000 0 30,000
Contribution margin 20,000 0 (20,000)
Fixed expenses:
Salaries 8,000 0 8,000
Advertising 6,500 0 6,500
Utilities 1,000 1,000 0
Depreciation—fixtures 2,000 2,000 0
4,000 4,000 0
Rent
Insurance 500 0 500
General administrative 6,000 6,000 0
Total fixed expenses 28,000 13,000 15,000
Net operating income $(8,000) $(13,000) $(5,000)
(loss)
Conclusion: As the above analysis show that if the house-wares product line is dropped, then
overall company net operating income will decrease by $5,000 each period so the company should
not drop the product line rather it should keep the product line.
Why keep a product line that is showing a loss? If you look at the first table of this example it shows
that the product line has a loss of (8,000) based on this simple analysis you may mistakenly conclude
it should be dropped but after the analysis we have conducted in the second table we have noticed
that it should not be drooped otherwise the company would loss $5,000 operating income. The
explanation for this apparent inconsistency lies in part with the common fixed costs that are being
allocated to the product lines. In this instance, allocating the common fixed costs among all product
lines makes the house-wares product line appear to be unprofitable. However, as we have shown
above, dropping the product line would not avoid all the allocated fixed costs; as a result if the
product line is dropped the net operating income of the company would decrease by $5,000.

III. Make or Buy Decision (In-sourcing or out-sourcing Decision)

Make or buy decision involves a decision by an organization about whether it should make a
product or carry out an activity with its own internal resource, or whether it should pay
another organization to make the product or carry out the activity. An example for such
types of decision usually includes whether a company should manufacture its own
component, or else buy the components from the outside supplier.

Out-sourcing is the process of purchasing goods or services from vender‘s rather than
producing the same good or providing the same services within the organization, which is
referred as in- sourcing. Even though, cost is the major factor in deciding make or buy
decision, usually qualitative factors will dictate managers make or buy decision. The major
qualitative factor in such situation includes;

 Lack of know-how and technology to produce the component.

 The need to maintain the long-term relationship with its existing suppliers,

 The need to retain the quality control of the product and delivery to production area

 The need to avoid too much dependency on the suppliers

 Reduction of cost……etc

For example if the company decides to make the component, it will give the management
more direct control over the work or production of the component. Similarly, if the
company decides to buy from the suppliers, they might get the benefit that the external
organization has a special skill and experts in the production of the component. Thus, make
or buy decision should certainly not be based exclusively on cost consideration.

If an organization has the freedom of choice about whether to make internally or buy
externally and has no scare resource that put a restriction on what it can do itself, the
relevant costs for the decisions will be the differential costs between the make and buy
options. That is, we to identify and compare the relevant cost of making the part with the
relevant cost of buying from outside. If the relevant costs of making a part is greater than the
relevant cost of buying the part from outside, then the company is advised to buy from
outside. In addition, if the relevant cost of making a part is less than the relevant cost of
buying the part from outside, then the company is advised to make the component
internally.
Example 5.3.
Suppose that Xyz mountain cycles company is producing the heavy duty gear shifters used in
its most popular line of mountain bikes. The company‘s Accounting department reports the
following costs of producing 8,000 units of the shifter internally each year:
Per 8,000
Unit Units
Direct materials $6 $48,000
Direct labor 4 32,000
Variable overhead 1 8,000
Supervisor‘s 3 24,000
Depreciation of special equipment 2 16,000
Allocated general overhead 5 40,000
Total Cost $21 $ 168,000
An outside supplier has offered to sell 8,000 shifters a year to Xyz mountain cycle company at
a price of only $19 each. Should the company stop producing the shifters internally and buy
them from the outside supplier?
Solution
Total Relevant
Costs—8,000 units
Make Buy
Direct materials $48,000
Direct labor 32,000
Variable overhead 8,000
Supervisor ‗s Salary 24,000
Depreciation of special equipment (not
relevant)
Allocated general overhead (not relevant)
Outside purchase price $152,000

Total Cost $112,000 $152,000

Conclusion: Since it costs $40,000 less to make the shifters internally than to buy them from
the outside supplier, Xyz mountain cycles company should reject the outside supplier‘s offer.
However the company may wish to consider one additional factor before coming to a final
decision—the opportunity cost of the space now being used to product the shifters. Now let‘s
consider the following two possible situations.
1. If the space now being used to produce the shifters would otherwise be idle, then Xyz
Mountain Company should continue to produce its own shifters and the supplier‘s
offer should be rejected, as stated above. Idle space that has no alternative use has an
opportunity cost of zero.

2. But what if the space now being used to produce shifters could be used for some other
purpose? In that case, the space would have an opportunity cost equal to the segment
margin that could be derived from the best alternative use of the space.
To illustrate assume that the space now being used to produce shifters could be used to
produce a new cross-country bike that would generate a segment margin of $60,000 per year.
Under this conditions, Xyz mountain cycle company should ace[t the supplier‘s offer and use
the available space to produce the new product line:
Make Buy
Total annual $112,000 $152,000
cost…………………………………………………………………………
…………
Opportunity cost—segment margin forgone on a potential new
product line 60,000
Total $172,000 $152,000
Cost………………………………………………………………………
……………………….
Decision: Xyz company should accept the supplier offer because there is $20,000 difference in
favor of purchasing from the outside supplier. The company should not produce the shifter
internally.

IV. Product mix under capacity constraint

Management routinely faces the problem of deciding how constrained resources are going to
be use. A department store, for example, has a limited amount of floor space and therefore
cannot stock every product that may be available. A manufacturer has a limited number of
machine-hours and a limited number of direct labor hours. When a limited resource of some
type restricts the company‘s ability to satisfy demand, the company has a constraint. Since
the company cannot fully satisfy demand, mangers must decide which products or services
should be cut back. In other words, managers must decide which products or services make
the best use the constrained resource. Fixed costs are usually unaffected by such choices, so
the course of action that will maximize the company‘s total contribution margin should
ordinarily be selected.

Example 5.5
LTM private company makes two products, B and S. Unit variable costs are as follows;
B S
Direct $1 $3
material……………………….
Direct labor ($3 per 6 3
hour)…………
Variable 1 1
overhead………………….
Total unit variable $8 $7
cost…………….
The sales price per unit is $14 per B and $11 per S, during July the available direct labor
limited to 8,000 hours. Sales demand in July is expected to be 3,000 units for B and 5,000
units for S
Required: Determine the operating income-maximizing production levels
Solution
Step 1: Confirm to what extent the limiting factor is short to meet the demand.
B S Total
Labor hour per unit 2 hour 1 hour
Sales demand 3,000 unit 5,000 unit
Labor hours needed 6,000 hour 5,000 hour 11,000
hour
Labor hour available 8,000
hour
Shortfall 3,000
hour
From the above table, we came to know that labor is the limiting factor on the production of
the company
Step 2: Identify the contribution earned by each product per unit of scares resource, that is ,
per labor hour worked.
S
B
Sales $14 $11
price………………………………………………………………
….
Variable $8 $7
cost………………………………………………………………
…
Unit contribution $6 $4
margin………………………………………………
Labor hour per 2 hour 1 hour
unit………………………………………………………
Contribution per labor hour (+unit of Constraint factor) (6÷3)=$ (4÷1)=$
3 4
N.B. Although B‘s has a higher unit contribution that S‘s, two S can be made in the
time it takes to make one B. Because labor is in short supply, it is more profitable
to make S than B
Step 3: Work out the budgeted production and sales. Sufficient S will be made to meet the
full sales demand, and the remaining labor hours available will then be used to make B.

Product Units Hours needed Unit contribution Total

S 5,000 5,000 $4 $20,000

B 1,500 3,000 $6 $9,000

Total 8,000 $29,000

Less Fixed Cost ($20,000)

Operating $9,000
income

So the company should produce 5,000 units of S and 1,500 units of product B, in order to
maximize the operating income given that there is a constraint of labor hours.
Note that, it is not more profitable to begin by making as many units as possible of the
product with the bigger unit contribution. We could make 3,000 unit of B in 6,000 hours
and 2,000 units of S in 2,000 hours. However, the operating income would be only $6,000.
Therefore, unit contribution is not the correct way to decide priorities, because it takes two
hours to earn $6 from B and one hour to earn $4 from S, product S will result in a profitable
use of scares resource that is labor hour.

V. Sells or process further

This is the Short-term, non-routine decision about whether to sell a product at a particular
stage of production or to process it further in the hope of obtaining additional revenue.
When two or more products are produced simultaneously from the same input by a joint
process, these products are called JOINT PRODUCTS. The term JOINT COSTS is used to
describe all the manufacturing costs incurred prior to the point where the joint products are
identified as individual products, referred to as the SPLIT-OFF POINT. At the split-off point
some of the joint products are in final form and salable to the consumer, whereas others
require additional processing. In many cases, the company might have the option to sell the
products at the split-off point or process them further for increased revenue. In connection
with this type of decision, joint costs are considered irrelevant, since the joint costs have
already been incurred at the time of the decision, and therefore are SUNK COSTS. The
decision will rely exclusively on additional revenue compared to the additional costs
incurred due to further processing. A separable processing cost is incurred on a joint product
after the split-off point of a joint production process.
Example 5.5.
International chocolate company import cocoa beans and processes them into cocoa powered and cocoa
butter. Only a portion of the cocoa powder is used by international chocolate company in the production
of chocolate candy. The remainder of the cocoa powder is sold to an ice cream producer. Mr. John, the
president of the company is considering the possibility of processing the remaining cocoa powder into an
instant cocoa mix. The company purchases the cocoa bean costing $500 per 1-ton in batch and incurred
joint production process costing of $600 per ton. The joint production will result cocoa butter with sale
value of $750 for 1,500 pound and cocoa powder with sales value of $500 for 500 pound immediately after
a split of point. The company should incur a separable process costing of $800 to process further the cocoa
powder after the split off point and this separable process will result a product call Instant cocoa mix with
the sales value of $2,000 for 500 pounds. The information can be presented in graphic form as follows.

Cocoa butter
Instant
sales value:
Cocoa Cocoa mix
$750 for 1,500
Beans sales value;
pounds
Costing $2,000 for

$500 500

per 1- pounds
Joint
ton production
Cocoa
batch process Separable
Powder
costing process
Sales Value:
Total Joint $600 per Cost: costing $1,100
$500 for
Required: Should ton the $800 company sell the cocoa
500 pounds
powder immediately or process it further?
Solution

Sales value of instant cocoa mix…………………………………………………………….

$2,000
Sales value of cocoa powder…………………………………………………………………
500

Incremental revenue from further processing……………………………………….. 1,500

Less: Separable processing cost……………………………………………………………. 800

Net benefit from further processing………………………………………………………. $ 700

The Co. should decide to process the cocoa powder into instant cocoa mix.
Summary
The following points are linked to the chapter‗s learning objectives
1. The five-step decision process is (a) obtain information, (b) make predictions, (c) choose
alternative courses of action, (d) implement decisions, and (c) evaluate performance.
2. To be relevant to a particular decision, a revenue or cost must meet two criteria: (a) It
must be an expected future revenue or cost, and (b) it must differ among alternative
courses of action.
3. The consequences of alternative actions can be quantitative and qualitative. Quantitative
factors are outcomes that are measured in numerical terms. Some quantitative factors can
be easily expressed in financial terms, others cannot. Qualitative factors, such as
employee morale, cannot be measured in numerical terms. Due consideration must be
given to both quantitative and qualitative factors in making decisions.
4. Two potential problems that should be avoided in relevant-cost analysis are (a) making
incorrect general assumptions such as all variable costs are relevant and all fixed costs are
irrelevant, and (b) losing sight of grand totals and focusing instead on unit costs.
5. In choosing among multiple products when resource capacity is constrained, managers
should emphasize the product that yields the highest contribution margin per unit of the
constraining or limiting resource (factor).
6. Managers should ignore allocated overhead costs when making decisions about dropping
and adding customers and segments. They should focus instead on how total costs differ
across alternatives.
7. The book value of existing equipment in equipment-replacement decisions represents
past (historical) cost and therefore is irrelevant.
Review Questions

1. Amstel Company is a manufacturer of personal computer .Astel expects its competitors to

lower prices of PC. Astels management believes that it must respond by reducing price by
20% from Br. 1000 per unit to Br.800 per unit. At this low price, Astels marketing manager
forecast an increase in annual sales from 150,000 to 200,000 units. Astel management wants
a 10% target operating income on sales revenue. The total production cost at the moment for
150,000 units is Br. 135 million.
Required compute
a. The total target revenue
b. Total target operating income
c. Target operating income per unit
d. Current target cost per unit
CHAPTER THREE

MASTER BUDGET AND RESPONSIBILITY ACCOUNTING

Dear learners, after studying this chapter, you should be able to:

 Define master budget and explain its major benefits to an organization

 Explain relations ships among components of master budget
 Describe key advantages of budgets
 Prepare the operating budget and its supporting schedules
 Describe responsibility centers and responsibility accounting
 Explain how controllability relates to responsibility accounting
3.1 Introduction
This unit contains two different topics Master Budget and Responsibility Accounting. The first
portion is about master budget which is an important management accounting tool for planning
future activities and controlling current operation in the organization. Budgets are crucial to the
ultimate financial success of any organization. Budgets are so important, mainly because they
serve as road map towards achieving organizational goals. Budgets as a management accounting
tool helps management in planning, controlling and performance evaluation. In this unit you will
study how budget is used in planning the operation of an organization.

3.2 Budgeting and Characteristics of Budgets

There are different types of organizations in today world. Generally these organizations can be
divided as profit making organization and not for profit organizations. The main objective of
profit making organization is making profit. There for in a for profit oriented company, decisions
made by management are intended to increase or at least maintain profit. Success is measured to
a significant degree by the amount of profit the organizations earn. A not for profit organization
is an organization whose goal is something other than earning a profit for its owners. Usually its
goal is to provide service. In not for profit organization, decisions made by management
ordinarily are intended to produce the best possible service with the available resources. Success
in a not for profit organization is measured primarily by how much service the organization
provided and by how well these services are rendered. Most basically, the success of a not for
profit organizations is measured by how much it contributes to the public wellbeing. Since
service is vague and less measurable concept than profit, it is more difficult to measure
performance in not for profit organization. Despite these complications, management must do
what it can do to assure that resources are used efficiently and effectively

Most people associate the word ―budget‖ with the approving, rejecting or arguing over
various budgets. Tax payers demand that governments plan the effective use of their hard
earned tax dollars and budget not only allow government to plan spending , but also allow
tax payers to see exactly where and how their many is being spent. Government and
government agencies, however, tend to use budget only as a means of limiting spending.

In contrast, most business organizations use budget to focus attention on company operation
and financial not just to limit spending. Budget highlights potential problem and advantage
early, allowing management to take steps to avoid these problems or use the advantages
wisely. Thus, a budget is a tool that helps managers in both their planning and control
function. A budget is a formal written summery (statement) of management plan for a
specific future time period expressed in financial terms. It normally represents primary
means of communicating agreed up on objectives throughout the business organization.
Once adopted, a budget becomes an important basis of for evaluating performance. Thus, it
promotes efficiency and serves as a deterrent to waste and inefficient

Types of Budget and Budgeting Techniques The type of budget used by different
organization differs based upon the nature of their business and the purpose of the budget;
however, the general frame work is the same. In this section we will try to see the different
type of budget their advantage and disadvantage and in what circumstance organizations
prefers to adopt a specific type of budget and budgeting techniques.

(1) Strategic Plan: The most forward looking budget is the strategic plan, which sets the
overall goals and objective of the organization. Some organization won‘t classify the strategic
plan as an actual budget though because it does not deal with a specific time frame and it
does not produce forecasted financial statement. In any case, the strategic plan leads to long
range planning which produce forecasted financial statement for five or ten years. The
financial statements are estimates of what management would like to see in the company‘s
future financial statement. Decisions made in long range planning include addition or
deletion of department, acquisition of a new equipment or building and other long term
commitment.

(2) Capital Budget: Capital budget is a budget that details the planned expenditure for
facilities, equipment, new product, and other long-term investments.

(3) Master budget: A master budget is a short-term, comprehensive plan to achieve the
financial and operational goals of an organization. Master budget comprises of the
organizations overall plan for the given period and the budget for the various functional
areas the make up the organization.

Different organizations prepare budget using different techniques that may be grouped as
follows:

(1) Incremental budgeting: is a budget set based on past year‘s actual performance. In this
technique a budget for the coming year is simply this year budgeted or actual results plus or
minus some amount for expected change on planned operation or change in the market
price. This budgeting technique is easy and widely used, however it has its own draw back.
As the base is the current year performance or budget any anomaly in the current year
performance or budget may be incorporated in the budget.

(2) Zero based budgeting: In a dynamic business it often makes sense to 'start afresh' when
developing a budget, rather than basing ideas too much on past performance. In this
technique each budget is therefore constructed without much reference to previous budgets.
Preparing a budget afresh is usually required in most business organizations, where the
business environment is volatile that require continues effort of incorporating changes in
budget thinking.
(3) Rolling budgets: Given the speed of change and general uncertainty in the external
environment, shareholders seek quick results. US companies typically report to shareholders
every three months, compared with six months in the UK. Rolling budgets involve
evaluating the previous twelve months' performance on an ongoing basis, and forecasting the
next three months' performance.

(4) Strategic budgeting: This involves identifying new, emerging opportunities, and then
building plans to take full advantage of them. This is closely related to zero based budgeting
and helps to concentrate on gaining competitive advantage.

(5) Activity based budgeting: This examines individual activities and assesses the strength of
their contribution to company success. They can then be ranked and prioritized, and be
assigned appropriate budgets.

3.2 Process of Developing a Budge

Although each organization is unique in the way it puts together its budget, all budgeting
process share some common elements. After organizational goals, strategies, and long range
plans have been developed, work begins on the master budget, a detailed budget for the
coming fiscal year with some detail. The master budget is a comprehensive financial plan for
a business. It is made up of the Operating and Financial budgets, which are in turn made up
of supporting schedules (budgets).

To envision the master budget process, picture the financial statements most commonly
prepared by companies: The income statement, the balance sheet, the cash flow statement.
Then imagine the preparation of these statements before the fiscal period operational period.

3.3 Parts of A Master Budget

Master budget consists of two major parts, namely: the operating budget and financial budget.

1) Operating budget refers to the budgeted income statement and the supporting budget
schedules for various business functions in the value chain. The operating budget
basically shows the expected operating result of the organization in the upcoming
operational period.
2) The financial budget is part of the master budget made up of the capital expenditures
budget, the cash budget, the budgeted balance sheet, and the budgeted statement of cash
flow.

Overview of Master budget

3.4 Steps in developing an operating budget

The Operating Budget refers to the budgeted income statement and all the supporting schedules.
One way to think about this question is to understand that the organization has more control over
some aspects of the business (for example how much to produce) and less control over other
aspects, (the demand for its product and service). For most organizations sales is uncertain.
Therefore, beginning with sales forecast, the firm can plan the activities over which it has more
control. As better information about sales becomes available, it is reasonably easy to adjust the
rest of the budget. If, on the other hand, production is more uncertain than sales, the firm may
want to begin with a raw material and production forecast so as to reduce the uncertainty related
to production. To clearly understand the steps in development of an operating budget, conceder
the budget information gathered by the controller of Gibe Furniture Manufacturing company
during the process of budgeting for the upcoming fiscal year, 2011.

The summary of required budget information obtained from different operating units, such as
sales related information from the marketing department, production related information from
production department, direct and indirect labor related information from the human resource
department, and other manufacturing and non manufacturing overhead budgets from other
departments as well as assumptions taken for the development of an operating budget are given
as follows:

1) The only source of revenues is sales of tables and unit sold is the only revenue driver.
2) Work in Process inventory is negligible and is ignored.
3) Unit costs of direct materials purchased and finished goods sold remain unchanged
throughout each budget year.
4) There are two types of Direct materials : Lumber and Metal
5) There are two types of direct labor: Laminating labor and Machine labor. Direct labor
rates remain unchanged throughout each budget year.
6) For computing inventor able costs, Gibe Furniture allocates all manufacturing overhead
costs using manufacturing labor hours as the allocation base.
7) Numerical information
(a) Each table has the following product specifications:
Step 1: Preparing Revenue budget
The starting point for operating budget development for most business organizations is a revenue
budget. A revenue/Sales budget outlines the expected sales for each product in units and Birr.
This budget will be developed after the firm made a forecast of the demand for the company‘s
product by taking into account.

Difficulties in forecasting sales

Sales budget is developed based on the sales forecast. A sales forecast is a formal prediction of
the quantities expected to be sold in the budget period and the price at which the expected
volume of sales to be sold.‟ A sales forecast is based upon a variety of interlocking factors.
It is the foundation of the entire master budget. The accuracy of estimated production schedules
and of costs to be incurred depends on the detail ness and accuracy of the forecasted sales both
interims of monetary unit, and quantity.

Without forecasts of expected sales for the budget period a firm would not know how many units
to produce and could easily manufacture too many units or too few units which may lead to
overstocks or lost sales and hence customers.

Moreover, costly mistakes can be made by purchasing unnecessary materials and hiring
employees. The sales budget is the crucial foundation of the master budget. The major factors
affecting sales forecast are price policy, the general economic outlook, conditions within the
industry, governmental policies and the position of the company in the economy.

Methods used in forecasting sales vary widely from firm to firm. Each firm has specific
characteristic which influence the method to be employed-

The method (technique) could vary from simple, estimates based on past experience to
sophisticated statistical approaches and computer model. Whichever method is used, some
prediction must be made concerning how many units of each product can be sold and at what
unit selling price for the budget period. Some of the inputs for sales forecasting are discussed in
the following paragraphs.

Past pattern of sales - Sales from past periods can be broken down by product lines, regions and
sales people to provide a basis for estimating possible future sales. From thorough study of past
period sales, sometimes a pattern can be observed which guides to the would be sales amount.

For example during summer sales is always at peak for the year. Such seasonal variation in the
level of sales is very helpful in forecasting future sales. Different statistical tools can be
employed here. Such statistical methods are the high-low method, the regression analysis
method, the time series analysis method, the fitting curve method, and so on. Estimates made by
sales men- Since sales force has close relation (contact) to the customers and sales activity, they
may have reasonable estimate for the budget period.

The sales person prepares sales estimates for the budget period in light of his /her knowledge of
the past and his expectations for the future. General economic conditions and competitive
conditions - The higher level management who are better informed with respect to the total
economic picture consider these inputs in the estimates made by sales men.

The general price level, the state of inflation, and other economic conditions like boom,
recoveries etc. are considered in developing the final sales forecast. Results of market
researches- the results of market survey help managers in determining the potential demand
available and the market capacity.

Markets studies show customers preference for a particular product and may reveal which
product is more attractive than the other. Other factors such as advertising and promotion
budgets change in price and specific interrelationship of sales and economic indicators such as
gross domestic product (GDP) and industrial price indexes are important input factors in sales
forecasting.

Budgeted Sales = Budgeted sales volume X Budgeted Selling price

Step 2: preparing the production budget (in units)

After the revenues are budgeted, you would then prepare a Production Budget. The production
budget is prepared to show how many units must be produced in order to meet your budgeted
sales need and the target level of ending inventory balance for finished goods. The total number
of budgeted production requirement, is therefore, the sum of budgeted sales in unit and target
ending inventory.

However, if the firm is not new in operation, usually some of its production requirement can be
satisfied using the inventory kept of the beginning of the period. Therefore, the banging in vestry
should be deducted from the total production requirement to determine the exact units in the
production budget Formula wise you can put the production budget in unit as follow
After the sales and production budgets have been developed and the efforts of the sales and
production groups have been coordinated, the next stage is the development of the production
costs (direct material, direct labor and manufacturing overheads) at budgeted output level.

Step 3: Preparing the Direct Material Usage and Direct Material Purchase Budget

The number of units to be produced calculated in production budget Schedule is the key to
computing direct materials in quantity and Birr. The direct materials budget ties the production
to the Direct Materials that will need to be purchased in order to produce the estimated units.
Direct materials purchases needed for the budget period are determined using this equation.
Sep 4: Preparation of direct manufacturing labor cost budget
This budget will show the number of employee and total hours required in producing the
budgeted level of output along with the cost. The costs in this budget usually depend on wage
rate, production method and human resource plan.
Step 5: Preparing Manufacturing Overhead (MOH) Budget.
The Overhead budget shows the expected cost of all indirect manufacturing items. The total of
these costs depends on how individual overhead costs vary with respect to the cost driver. Gibe
Furniture treats both variables MOH and fixed MOH as inventor able costs.

Step 6: Preparing the Ending Inventory Budget

This budget is prepared for target ending raw material and ending finished goods inventory
Step 7: Preparing Cost of goods sold (CGS) budget

The following are inputs to prepare cost of goods sold budget

 Direct material usage budget

 Direct labor budget
 Manufacturing overhead budget
 Ending and beginning finished goods inventory
 Ending and beginning working in process inventory

Schedule 7: CGS Budget Beg.

FG Inv., Jan1, 2006 (275 x 5000) Br. 1,375,000

Step 8: Preparation of None Manufacturing overhead Cost Budget

The non-manufacturing cost budget includes the marketing and administrative departments‘
costs required to operate the company at its projected level of sales and production and to
achieve long term company goals.

Unless there is a change in the organizations production and sales or level of activity, the
nonmanufacturing cost budget is easily prepared by taking previous year‘s actual or budgeted
result after making the necessary adjustment for price change and otter similar changes between
periods.

Schedule 8: Operating Expenses Budget

Variable non-manufacturing costs: 13.5% X 20,384,000 Br. 2,751,840

Fixed non-manufacturing costs 1,400,000

Total Operating Expense 4,151,840

Step 9: Preparing the Budgeted income Statement.

The last effort in operational budget development is pulling all the budget schedules prepared in
all the above steps in to the income statement. The budgeted income statement, which can also
be called Performa income statement show the revenue costs of production, operating cost and
the resulting operational profit envisage in the budget period.
Financial Budgets
The remaining budgets that appear in the Master Budget make up the Financial Budget. The
Financial Budget typically consists of the capital expenditure budget, the Cash Budget, the
Budgeted Balance Sheet and the budgeted statement of cash flows. In this section the focus is
only on the cash budget and budgeted balance sheet, as the rest are discussed in detail in other
course modules in financial accounting and financial managements.

Cash budget: Cash budget is a schedule of expected cash receipt and disbursement. It predicts
the effects on the cash position at the given level of operation. Cash budget helps to avoid
unnecessary idle cash and unexpected cash deficiencies. They thus, keep cash balance in line
with needs, ordinarily; the cash budget has the following main sections. The beginning cash
balance plus cash receipt equals the total cash available before financing.

Cash receipts depend on the collection of accounts receivable, cash sales, and miscellaneous
recurring sources such as rental royalty receipts. Information on expected collectable of account
receivable is needed for accurate prediction.

Cash disbursement:

Organizations make cash disbursement for various reasons such as:

 Payment for direct martial purchased

 Salary paid for direct labor cost and other wages
 Other disbursements for property, equipment and other long term investment
 Interest on long term borrowing
 Income tax payment
 Others,
Short time financing requirement depends on how the total cash available for needs compare
with the total cash disbursement plus the minimum ending cash balance desired. If there is a
deficiency of cash, loan will be taken, if there is excess cash, an outstanding loan will be paid.

Additional information

 Long term debt is Br. 2.4 million at an annual interest rate of 10% with 60,000 interest
payable every quarter
 The company wants to maintain a Br. 100,000 minimum cash balance at the end of each
quarter
 The company borrows cash in multiple of Br. 1,000 at the beginning of each quarter and
repayment is made at the end of each quarter
 The company can borrow or repay money at an interest rate of 12% per year.
 Management doesn‘t want to borrow any money more short term cash than is necessary
 Interest is computed and paid when the principal is repaid
 Tax rate is assumed to be 36%.
 During the year the company paid Br. 420,640 income tax. This amount is the remaining
due for the year 2010, plus four quarter payment of each Br. 100,000
 Equipment amounting Br. 1,800,000 was bought in the 3rd quarter
 No land is bought or sold.
 Depreciation for the year is Br. 500,000.
 Long term notes payable is not repaid.
 No dividend is paid.
To prepare a cash budget you need to get adequate information about the cash receipt and
disbursement made by the organization during the budget period. Most of this information is
obtained from the different schedules prepared for the operating budget parts of a master
budget. In addition to cash receipts and payments for operational activities, information is
required on planned investing and financing activity of the firm on the budget period.
Information on the companies desired minimum cash balance is also required.

1. The ending balance of cash in one quarter is the beginning balance of cash for the next
quarter.
2. In the year for total column the receipt and disbursement are totaled for the four quarters,
however the beginning balance in the column is the beginning balance in the column are the
beginning balance in for quarter 4.
3. Depreciation is not a cash disbursement
4. The cash receipt and disbursement for operational activity appears in all the quarter as the
budgeted operation of the company will continue in without interruption. However when you
come to cash receipt and disbursement for investing and financing activities appears only on
some of the quarters. For example the firm acquired fixed asset costing Birr 1,800,000, that is
why the cash disbursement for investing activity appears only once in
5. When you cash receipt and payments related to financing activity the firm borrowed Birr
308,000 to finance the expected short term cash shortage at quarter III, as a result cash
receipt from financing activity appeared only in this quarter. The principal amount and the
interest on borrowed money are paid at quarter IV when the firm has excess cash on hand
beyond the required amount of cash for planned payments and minimum cash balance
requirement of the quarter, as a result cash payment for financing activity appears only in the
fourth quarter.
Using all the information given above on illustration to the cash budget for Gibe Furniture can be
prepared as follow

The Budgeted Balance Sheet

The budgeted balance sheet shows the financial position of the firm during the budget period.
Each item in the budgeted balance sheet is projected in the light of the details of the business
plane expressed in all the previous budget schedules. The budgeted balance sheet of Gibe
furniture prepared on the bases of previously developed budget is prepared as follows:

iii) Budgeted statement of cash flow:

Statement of cash flow presents cash flow from operating, investing and financing activity in
detail.

iv) Capital budgeting:

Is the process of making long term planning decision for investment capital budgeting also called
long term investment Long term investment involves the commitment of resource for projects
which have long term consequence. Such decisions usually involve large investment of money.
Capital budgeting decision have uncertain actual outcome that have long-term effect on the
organization. Poor long-term investment decision can affect the future stability of an
organization because it is often difficult for organization to recover money tied up in bad
investment. Mangers need a long term planning tool to analyze and control investment with
long-term consequence.

Summary
1) The master budget summarizes the financial projections of all the organizations budgets and
plans. It expresses management‘s comprehensive operating and financial plans—-the
formalized outline of the organization‘s financial objectives and their means of attainment.
Budgets are tools that by themselves are neither good nor bad. How managers administer
budgets is the key to their value. When adniinistere4 wisely, budgets compel management
planning, provide definite expectations that are an appropriate framework for judging
subsequent performance, and promote communication and coordination among the various
subunits of the organization.
2) The advantages of budgets include: (a) they compel planning, (b) they provide performance
criteria, and (c) they promote coordination and communication within the organization.
3) The foundation for the operating budget is generally the revenues budget. The following
supporting budget schedules are geared to the revenues budget: production budget, direct
materials usage budget, direct materials purchases budget, direct manufacturing labor budget,
manufacturing overhead costs budget, ending inventory budget, cost of goods sold budget,
R&D/design budget, marketing budget, distribution budget, and customer-service budget.
The operating budget ends with the budgeted income statement.
Review Question
Part I say true or False
1. Cash budget is developed based on the sales forecast.
2. Cost budget is developed based on the sales forecast that adjusted for next year
3. Mangers need a long term planning tool to analyze and control investment with long-term
consequence.
4. The foundation for the operating budget is generally the revenues budget.
5. Master budget is a short-term, comprehensive plan to achieve the financial and operational
goals of an organization.
Part II discussion
1) Write the step of budget preparation
2) What is budget

Part III workout

1. Serra Furniture is an Elite desk manufacture. It manufactures two products.
a) Executive desks – Oak desks
b) Chairman desks – Red Oak desks
Manufacturing overhead (both variable and fixed) is allocated to each desk on the basis of
budgetary direct manufacturing labor hours per desk. The budgeting variable manufacturing
overhead rate for March 1998 is Bir.35.00 per Direct manufacturing labor Hour. The budgeted
fixed manufacturing overhead for March 1998 is Bir.42, 500. Both variable and fixed
manufacturing overhead cost is allocated to each unit of finished goods.
Budgeted sale for March 1998 are 740 units of the executive line and 390 units of the chairman
line. The budgeted selling prices per unit in March 1998 are Bir.1, 020 for an executive line desk
and Bir.1600 for a chairman line desk

Take the following assumptions in your answer:

a) Works in Process inventories are negligible and ignored.

b) Direct material inventory and finished goods inventory are determined using the
FIFO method.
c) Unit costs of direct material purchased and finished goods are constant in March
1998.
Required:

Prepare the following budget for March, 2008

1. Revenue budget
2. production budget in units
3. Direct material usage budget and direct material purchase budget
4. Direct manufacturing labor budget
5. Ending inventory budget
6. Cost of goods sold budget.
Chapter Four

3. Flexible Budgeting, Standard Costing, and Variance Analysis

4.1 Introduction
In the previous unit you have studied the benefit of budget as a planning tool. Hence,
budgets are planning tools that are usually prepared prior to the start of the period being
budgeted. However, the comparison of the budget to actual results provides valuable
information about performance. Therefore, budgets are both planning tools and
performance evaluation tools. In this unit, therefore the discussion focuses on how budget
are used to evaluate feedback and variances aid managers in their control function.

In evaluating performance the budgeted performance are compared with actual operational
results and the resulting variance will be examined so as to identify the causes for variance
on the bases of which performance can be rewarded for favorable variance or corrective
actions will be taken to avoid unfavorable variance on the coming operational periods.

The unit highlights the importance of variance analysis and show how the budget initially
prepared at planning stage creates problem while comparing actual results with the budget.
In this unit you are also introduced with the advantage of flexible budget over the static
budget, steps in the preparation of flexible budget and evaluating performance using flexible
budget.

4.2 Budget and Variance analyses

The use of budget as performance evaluation tool focuses on determining the discrepancies
between the planned and actual performance at the end of the operating cycle.

Variance is the difference between an amount on an actual result and the corresponding
budgeted amount i.e., the actual amount of something and the amount it was supposed to be
according to the budget. The budgeted amount is a point of reference from which
comparison may be made. The difference between budget and actual result can be favorable
or unfavorable based upon the impact of the discrepancy on the overall profitability of the
firm. If the variance has an increasing effect on the operating income as compared to the
budgeted amount, it is said to be favorable variance. On the other hand unfavorable or
adverse variance occurs when the variance has a decreasing effect on the operating income
relative to the budgeted amount.

Variances assist managers in their planning and control decisions. It enables to exercise
Management by Exception (MBE), which is the practice of concentrating attention on areas
not operating as expected and giving less attention to areas operating as expected. Managers
regularly pay attention to areas with large variances. Variances are also used in performance
evaluation. For example Production line managers in a manufacturing company may have
quarterly efficiency incentives linked to achieving a budgeted amount of operating costs.

4.2.1 Static budget and Variance Analysis

A) Fixed or Static Budget

The static budget is the budget that is based on the projected level of output, prior to the start
of the period. In other words, the static budget is the ―original‖ budget. The static budget
variance is the difference between any line-item in this original budget and the
corresponding line-item from the statement of actual results. Often, the line-item of most
interest is the ―bottom line‖: total cost of production for the factory and other cost centers;
net income for profit centers.

 Static budget is a budget that is based on one level of activity.

Evaluating performance based upon the master budget which fixed and prepared at single
level of activity may not provide accurate picture of performance. This because usually the
planned and actual output or activities levels may not be equal, as a result the comparison is
performed at two different level of activity which hides the variance attribute to the actual
performance units as well as overall organization. For example, if a company budgeted to
produce and sell 12,000 units, but the actual performance showed only 10,000 units, the
comparison of revenue, cost and profit at the budget and actual level of output do reveals
only the variance resulted from the difference in the level of output. Therefore, unless the
analysis is re done by adjusting the budgeted level of output towards the actual units
produced and sold, the variance is not helpful to the management as performance evaluation
tool.

 Static Budget Variance [SBV] is the difference between an actual result and the
corresponding budgeted amount in a static budget.

Static budget based variance analysis provides level 0 and level 1 analysis:

Level 0 analysis

Actual results (operating income) XX

Less: Static-budget amount (operating income) XXX

Static- budget variance variances of op- income XXX

Level 1 Analysis

Level 1 analysis provides mangers with more detailed information on the operating in come
static budget variance.

Actual Static budget Static budget(2)

results(1) variance(3)

1-2

Units sold XX XX XX

Revenues XX XX XX
Variable costs XX XX XX

Direct materials XX XX XX

Direct mfg labor XX XX XX

Variable mfg OH XX XX XX

Total variable cost XX XX XX

Contribution Margin XX XX XX

Fixed costs XX XX XX

Operating in come XX XX XX

Level 1 analysis provides more information (detailed) than does level 0 analysis, mangers
might require still more detail about the causes of variance.

4.3 Flexible Budget

The flexible budget is a performance evaluation tool. It cannot be prepared before the end of
the period. A flexible budget adjusts the static budget for the actual level of output so as to
avoid the inherent limitation of using static budget for performance evaluation. The flexible
budget asks the question: ―If I had known at the beginning of the period what my output
volume (units produced or units sold) would be, what would my budget have looked like?‖
The motivation for the flexible budget is to compare apples to apples. If the factory actually
produced 10,000 units, then management should compare actual factory costs for 10,000
units to what the factory should have spent to make 10,000 units, not to what the factory
should have spent to make 9,000 units or 12,000 units or any other production level.

The flexible budget variance is the difference between any line-item in the flexible budget
and the corresponding line-item from the statement of actual results.
 Note: Static budget variance does not give much information about the variances between
actual results and budgeted amounts for each line item. Hence one has to prepare flexible
budget.

Performance evaluation using flexible budget

Comparing the flexible budget to a actual result accomplishes an important performance

evaluation purpose. There are basically two reasons why actual results might differ from
master budget.

1. Sales and other cost activities were not the same as originally forecasted.

2. Revenue or variable cost per unit of activity and fixed costs per period were not as
expected.

And any differences between the master budget and flexible budget are due to activity level
variances or sales volume variance. Thus flexible budget is used as a bridge between static
budget and actual results Flexible budget variances measure the efficiency of operations at
actual level of activity.

 Efficiency is measured on resources utilization rate.

 Flexible budget variance is the difference between the actual results and the flexible-
budget amount based on the level of output actually a achieved in the budget period.

 The sales-volume variance is the difference between the flexible budget amount and the
static budget amount.

 Flexible budget variances and sales volume variances are level 2 analysis

FB Variance = Actual results – Flexible budget amount

Sales volume variance = flexible budget amount – static budget amount

• The flexible budget variance pertaining to revenue is often called selling price
variance because it arises solely from differences between the actual selling price and
the budgeted selling price

Selling price variance = Actual – budgeted X Actual unit sold

Selling price selling price

Flexible Budget Variances in Detail for Direct-Cost in Puts

Flexible budget variances for direct costs inputs can be attributed to:

 Using more or less of resources than budgeted (Efficiency variance)

 Spending more or less of resources than budgeted (price variance)

Obtaining Budgeted input prices and input quantities

Two main source of information about budgeted input prices and budgeted in put quantities
are:

1. Actual input data from past periods

2. Standards developed by the company

• Price variance is sometimes called in put- price variances or rate variance (especially
when those variances are for direct labor).

Price variance = Actual price of – Budgeted X Actual quality of in put

input price of in put

• An efficiency variance is the difference between the actual quantity of input used (such
as yards or cloth of direct materials) and the budgeted quantity of input that should have
used, multiplied by the budgeted price. Efficiency variances are sometimes called usage
variances

Efficiency variance:

Actual quantity Budgeted quantity of X Budgeted price of in put

of input used – input allowed for
actual out put

• Inefficient: If it uses more inputs that budgeted for the actual output units achieved

• Efficient; if it uses fewer in puts than budgeted for the actual output units achieved.

• This level 3 information helps managers had better understand past performance and
better plan for future performance

Favorable direct material price variance could be due to one or more of the following reasons

 Good price negotiation by purchasing manger

 Purchased larger lot sizes than budgeted, thus obtaining quaintly discount.

 Materials price decreased unexpectedly due to say industry oversupply

 Standard wrongly (unrealistically set)

 The purchasing manager received unfavorable terms on non-purchase price factors

(Such as lower quality materials or minimal inspections by the suppler)

Unfavorable direct material price variance could be due to:-

 Poor price negotiation

 Purchase of higher quality materials

 Materials price unexpectedly increased due to external shocks.

 Purchased in smaller lot sizes than budgeted and did not get quantity discount.

 Change in supplier when lower priced supplier went out of business.

Favorable Direct Materials Efficiency variance could be due to:-

• Standard wrongly (unrealistically)  Workers did more extensive

set planning and scheduling for
materials
 Increased skills of workers
 Economics of scale in production
 Use of more automated machinery

Unfavorable direct manufacturing labor efficiency variance could be due to: -

 Standard wrongly (unrealistically) set

 Labor may be less efficient at higher output levels due to tiredness

 Scheduler assigned less skilled workers to production

 Machine break downs required more use of labor

 Lower quality materials purchased requiring more labor input to finish out puts.

Illustration
The following information is give below for YD Company in 2011

Items Actual results Static budget

Units sold 10,000 12,000

Revenue 1,850,000 2,160,000

Variable cost
Direct material 688,200 720,000

Direct manufacturing labor 198,000 192,000

Direct marketing labor 57,600 72,000

Variable manufacturing OH 130,500 144,000

Variable marketing QH 45,700 60,000

Fixed costs 705,000 710,000

Budgeted cost for three items

 Direct material

2 square yards of cloth input per output at $ 30 per square yard

 Direct manufacturing labor

0.8 manufacturing labor hours per output at $20 per hours

 Direct marketing labor

0.25 labor hours per output at $24 per hour

Actual cost for three items

 Direct material

22,200 square yards of clothe at $ 31 each

 Direct manufacturing labor

9000 manufacturing labor hours at $22 each

 Direct marketing labor

2,304 direct marketing labour hours at $25 each

Instruction

Determine level 0, level 1, level 2, and Level 3 analysis is applied only direct input costs i.e.,
direct materials, direct manufacturing labor and direct marketing labor

Solution

Level 0 analysis

Actual operating income $25,000

Budgeted operating income 262,000

Static budget variance of operating income 237,000 U

Level 1 analysis

Actual results Static budget Static budget (3)

(1) variance(2)=1-3

Units sold 10,000 2000 U 12,000

Revenues 1,850,00 310,000 U 2,160,000
Variable costs 1,120,000 68,000 F 1,188,000
Contribution 730,000 237,000 U 972,000
margin
Fixed costs 705,000 5,000 F 710,000
Operating income 25,000 273,000 U 262,000
Level 2 analysis

Actual Flexible Flexible Sales volume Static budget

results budget Budget variance
variance

Units sold 10,000 0 10,000 2,000 U 12,000

Revenues 1,850,000 50,000 F 1,800,000 360,000 U 2,160,000
Variable cost 1,120,000 130,000 990,000 198,000 F 1,188,000
U
Contribution 730,000 80,000 U 810,000 262,000 U 972,000
margin
Fixed costs 705,000 5000 F 710,000 0 710,000
Operating 25,000 75,000 U 100,000 162,000 U 262,000
income
Level 3 analysis

Direct costs (Actual price of input _Budgeted price of Input price

category in put )X Actual quantity of input Variance

Direct material (31-30) X 22,200 = 22,200 U

Direct (22-20) X9000 = 18,000 U
manufacturing
labor
Direct marketing (25-24) X 2,304 = 2,304 U
labor

Direct cost category (Actual input used -Budgeted input Efficiency variance
allowed for actual output units ) X
Budgeted price of input
Direct material [22,200- (10,000 units X 2 yards)] X30 66,000 U
(22,200 yards – 20,000 yards) X30
Direct mfg labor [9000 hrs- (10,000 units X 0.8hrs)] X20 20,000 U
(9000 hrs – 8000 hrs) X 20
Direct marketing [2304 hr – (10,000 units X 0.25 hrs)]24 4,704 F
labor (2304- 2500hrs) X 24
DM flexible budget variance = 22,200 U + 66,000 U = $ 88,200 U

DM fgL FBV = 18,000 U + 20,000 U = 38, 000 U

DM Mkting FBV= 2,304 U + 4,704 F = 2, 400 F

4.4 Standard Cost Systems

4.4.1 Meaning of Standard Costing
The word ‗standard‘ means a bench-mark or yardstick. The standard cost is a predetermined
or expected cost which determines what each product or service should cost under given
conditions. In other words, it is the expected cost of producing one unit. It is, in effect, a
budget for one unit. Standard costing may be defined basically as a technique of cost
accounting which compares the standard cost of each product or service with the actual cost
to determine the efficiency of operation so that remedial action may be taken immediately.
The institute of costs and management accounts of England defines standard costing as ―the
preparation and use of standard costs, the comparison with the actual costs, and the analysis
of variances to their cause and the points of incidence.‖ Variance is the difference between a
budget or standard amount and the actual amount during a given period.

Types of standard
a) Ideal standard – a standard that a company sets in which they meet their maximum
degree of efficiency. Does not take inefficient conditions & wastages into consideration.

b) Attainable standard – includes factors such as lost time and normal wastes and spoilages.

4.4.2 Advantages and Limitations of Standard Costing

Advantages of standard costing
1. The weakness of the traditional costing system can be estimated by compiling
standard costs more carefully.

2. Standard costs can be used as a yardstick against which actual costs can be compared.
It is an effective tool for planning production costs. Hence, cost control is greatly
facilitated.

3. Variance analysis helps management to have regular as well as better checks over
costs incurred. It makes the application of the principle of management by exception
more easy. That is, the management can concentrate its attention on variances only,
leaving the other aspects of cost control to be taken care of at the lower level.

4. It is a valuable guide to management in the formulation of production and price

policies in advance with certainty. It also assists management in the areas of profit –
planning, product –pricing, and inventory pricing, etc.

5. Standard costing makes the reporting of operating data more meaningful and also fast.
This makes the interpretation of management reports easy.

6. As the emphasis of the standard costing system is more on cost variations, it makes
the entire organization cost conscious. It makes the employees recognize the
importance of efficient operations so that costs can be reduced by joint efforts.

7. Labor, materials and machines can be effectively used, and economies can be affected
in addition to increase productivity. Standards may also be used as the basis for
introducing incentive schemes.

Limitations of standard costing

1. Setting of standards is a very difficult task. It requires a lot of scientific studies such as
time –study, motion study, etc., and therefore it is very costly. Small firms may find it
very difficult to operate such a system.
2. Standards are very rigid estimates and once set, are not changed for a considerable
time. This makes the standards highly unrealistic in certain industries which face
fluctuations in prices of products due to frequent changes.

3. The utility of variance analysis depends much more on the standard set. While a
loosely set standard may be ridicule the standards which are set very high may create
frustration in the minds of the workers. At the same time setting of correct standards
is also, it is difficult to apply this system when production takes more than one
accounting period.

4.2.3 Material Standards

The first step in developing material standards is to identify and list the specific direct
materials used to manufacture the product. This list is often available on the product
specification documents prepared by the engineering department prior to initial production.
In the absence of such documentation, material specifications can be determined by
observing the production area, querying of production personnel, inspecting material
requisitions, and reviewing the cost accounts related to the product. Three things must be
known about the material inputs: types of inputs, quantity of inputs used, and quality of
inputs used.

In making quality decisions, managers should seek the advice of materials experts, engineers,
cost accountants, marketing personnel, and suppliers. In most cases, as the material grade
rises, so does cost; decisions about material inputs usually attempt to balance the
relationships of cost, quality, and projected selling prices with company objectives. The
resulting trade-offs affect material mix, material yield, finished product quality and quantity,
overall product cost, and product salability. Thus, quantity and cost estimates become direct
functions of quality decisions.
Given the quality selected for each component, physical quantity estimates of weight, size,
volume, or some other measure can be made. These estimates can be based on results of
engineering tests, opinions of managers and workers using the material, past material
requisitions, and review of the cost accounts.

Specifications for materials, including quality and quantity, are compiled on a bill of
materials. Even companies without formal standard cost systems develop bills of materials for
products simply as guides for production activity. When converting quantities on the bill of
materials into costs, allowances are often made for normal waste of components. After the
standard quantities are developed, prices for each component must be determined. Prices
should reflect desired quality, quantity discounts allowed, and freight and receiving costs.
Although not always able to control prices, purchasing agents can influence prices. These
individuals are aware of alternative suppliers and attempt to choose suppliers providing the
most appropriate material in the most reasonable time at the most reasonable cost. The
purchasing agent also is most likely to have expertise about the company‘s purchasing habits.
Incorporating this information in price standards should allow a more thorough analysis by
the purchasing agent at a later time as to the causes of any significant differences between
actual and standard prices.

When all quantity and price information is available, component quantities are multiplied by
unit prices to obtain the total cost of each component. (Remember, the price paid for the
material becomes the cost of the material.) These totals are summed to determine the total
standard material cost of one unit of product. In genaral there are two types of standard for
direct material

a) Material Quantity standard:- Material Quantity standard is determined based on the

production or engineering department‘s estimate of the amounts and types of
materials needed for production of one unit of a product. DM quantity efficiency
variance indicates the difference between actual quantity of materials used and
standard quantity allowed times the standard unit cost of materials.

b) Direct Material price standard is based on the purchasing agent‘s knowledge of

suppliers‘ prices for one unit of direct material. DM Price variance is the difference
between actual and standard unit price times the actual quantity of materials used.

4.2.4 Direct Labor Standards

Development of labor standards requires the same basic procedures as those used for
material. Each production operation performed by either workers (such as bending, reaching,
lifting, moving material, and packing) or machinery (such as drilling, cooking, and attaching
parts) should be identified. In specifying operations and movements, activities such as
cleanup, setup, and rework are considered. All unnecessary movements by workers and of
material should be disregarded when time standards are set.

To develop usable standards, quantitative information for each production operation must be
obtained. Time and motion studies may be performed by the company; alternatively, times
developed from industrial engineering studies for various movements can be used. A third
way to set a time standard is to use the average time needed to manufacture a product during
the past year. Such information can be calculated from employees‘ past time sheets. A
problem with this method is that historical data may include inefficiencies. To compensate,
management and supervisory personnel normally make subjective adjustments to the
available data.
After all labor tasks are analyzed, an operations flow document can be prepared that lists all
operations necessary to make one unit of product (or perform a specific service). When
products are manufactured individually, the operations flow document shows the time
necessary to produce one unit. In a flow process that produces goods in batches; individual
times cannot be specified accurately.

Labor rate standards should reflect the employee wages and the related employer costs for
fringe benefits, FICA (Social Security), and unemployment taxes. In the simplest situation, all
departmental personnel would be paid the same wage rate as, for example, when wages are
job specific or tied to a labor contract. If employees performing the same or similar tasks are
paid different wage rates, a weighted average rate (total wage cost per hour divided by the
number of workers) must be computed and used as the standard. Differing rates could be
caused by employment length or skill level.

• DL efficiency variance indicates the difference between actual quantity of Labor hours
used and standard quantity allowed times the standard unit cost of Labor hour.

DL rate variances is the difference between actual and standard unit (rate) times the actual
quantity of labor used.

4.2.5 Mix and Yield Variances: Materials and Labor

 Mix variance arise because of difference in the standard cost of the actual mix of
inputs used and the standard cost of the mix of inputs that should have been used.
 If relatively more of the expensive input is used, the mix variance will be
unfavorable. If relatively more of a less expensive input is used, the mix variance will
be favorable.

 Direct Material/labour Yield Variance is a measure of cost differential between output

that should have been produced for the given level of input and the level of output
actually achieved during a period.

Yield Variance = (Standard yield – Actual yield) xSPxSQ

Illustration:- ABC Company makes tomatoes ketch up. To produce ketchup of the direct
consistency, color and test, ABC mixes three types of tomato: Latoms, Caltoms and Flotoms.
ABC production standard requires 1.6 tone of tomatoes to produce 1 tone of tomato ketchup,
with 50% of the tomato being latoms,30% cal toms and 20% flotoms. The direct materials
input standard to produce 1 tone of ketchup are

0.8 tone (50%*1.6) of latoms at $70 per tone -------- $56

0.48 tone (30*1.6) of caltoms at $ 80 per tone ----- 38.4

0.32 tone (20%*1.6) of flotoms at $90 per tone ------ 28.80

Total standard cost of 1.6 tones of tomatoes ----- $123.20

Budgeted cost of per tone of tomatoes ---------- $77

Standard for June 2015 shows that a total of 6400 tone of tomato were used to produce 4,000
tones of ketchup

Because ABC uses fresh tomatoes to make ketch up, no inventory of tomatoes are kept.
Purchases are made as needed, so all price variances relate to tomatoes purchased and used.
Actual result for June 2015 shows that a total of 6500 tone of tomato were used to produce
4,000 tones of ketchup.
3,250 of latoms at actual cost of $70 per tone--------------- $227,500

2,275 tone of caltoms at actual cost of 82 per tone -------- 186.550

975 tone of flotons at actual cost of $96 per tone --------- 93,600

6,500 tone of tomatoes----------------------------------------- $507,650

Required: Compute

a) The quantity(efficiency) for DM

b) Price(spending) variance for DM

c) The flexible Budget variance for DM

d) The yield and Mix variance for DM

Solution

Given the standard ratio of 1.60 tons of tomatoes to 1 ton of ketchup, 6,400 tons of
tomatoes should be used to produce 4,000 tons of ketchup. At standard mix, quantities of
each type of tomato required are as follows:

Latoms: 0.50 * 6,400 = 3,200 tons

Caltoms: 0.30 * 6,400 = 1,920 tons

Flotoms: 0.20 * 6,400 = 1,280 tons

a) DM Efficiency variance

Efficiency variance = Actual Input Quantity x Budgeted Price- Flexible Budget Budgeted
Input Quantity Allowed for Actual Output x Budgeted Price
Latoms: 3,250 x $70 = $227,500 3,200 x $70 = $224,000

Caltoms: 2,275x $80 = 182,000 1,920 x $80 = 153,600

Flotoms: 975 x$90 = 87,500 1,280 x $90 = 115,200

$497,250 $492,800

__________________________________________

$4,450 U

b) Price variance

Price variance = Actual Costs Incurred

( Actual Input Quantity x Actual Price ) - (Actual Input Quantity x Budgeted Price)

Latoms: 3,250 x $70 = $227,500 3,250 x $70 = $227,500

Caltoms: 2,275 x $82 = 186,550 2,275x $80 = 182,000

Flotoms: 975 x $96 = 93,600 975 x$90 = 87,500

$507,650 $$497,250

__________________________________________

$10,400 U
c) Flexible-budget variance= Price variance + Efficiency variance

$10,400 U +$4,450 U = $14,850 U

d) The Mix and yield variance for DM

i. The direct materials mix variances are as follows:

ii. The direct materials yield variances

The total direct materials yield variance is unfavorable because company used 6,500 tons of
tomatoes rather than the 6,400 tons that it should have used to produce 4,000 tons of
ketchup. Holding the budgeted mix and budgeted prices of tomatoes constant, the budgeted
cost per ton of tomatoes in the budgeted mix is $77 per ton. The unfavorable yield variance
represents the budgeted cost of using 100 more tons of tomatoes, (6,500 – 6,400) tons * $77
per ton = $7,700 U. company would want to investigate reasons for this unfavorable yield
variance. For example, did the substitution of the cheaper Caltoms for Flotoms that resulted
in the favorable mix variance also cause the unfavorable yield variance?

Causes of DM and DL variances

I. Causes of Direct Material Variances

• Raw material price fluctuations

• Poor planning resulting in emergency purchase

• Loss of discount from bulk purchase

• High transportation cost from frequent purchase

• Failure to take advantage of seasonal purchase

• Uneconomical size of order

• Poor quality material resulting in more wastage

• Careless in handling of material in stores and on shop floor

II. Causes of Direct Labor Variances

-Revision in pay scale - Use of incorrect grade of workers

-Industrial unrest - Use of trainees in place of regular workers

-Overtime working - Poor planning and scheduling

-Poor supervision -Poor maintenance of machines

-Poor quality of material - Increase in labor turnover

4.4.3 Overhead Cost Variances

Overhead costs are all manufacturing costs other than direct material and direct labor. They
are divided as variable overhead and fixed overhead costs. Variable overhead costs include
energy, machine maintenance, engineering support, and indirect materials & Labours. Fixed
overhead costs include plant leasing costs, depreciation on plant equipment, and the salaries
of the plant managers.

4.4.4 Variable overhead flexible budget variance

Variable overhead flexible-budget variance measures the difference between actual variable
overhead costs incurred and flexible-budget variable overhead amounts.
Variable Overhead
flexible-budget variance = Actual Costs
Incurred - Flexible-budget
amount

This variance can be further broken down into the Variable Overhead Efficiency Variance
and the Variable Overhead Spending Variance.

a) Variable Overhead Efficiency Variance

Variable overhead efficiency variance is the difference between the actual quantity of the
variable overhead cost-allocation base used and the budgeted quantity of the variable
overhead cost-allocation base allowed for the actual output X the budgeted variable overhead
cost per unit of the cost-allocation base.

{ }X
Variable Actual quantity of Budgeted quantity of Budgeted variable
Overhead variable overhead variable overhead cost- overhead cost
Efficiency = cost-allocation base - allocation base allowed per unit of
Variance used for actual output for actual output cost-allocation base
b) Variable Overhead Spending Variance

Variable overhead spending variance is the difference between actual and budgeted variable
overhead cost per unit of the cost-allocation base, multiplied by the actual quantity of
variable overhead cost-allocation base used.

{ }X
Actual variable Budgeted variable Actual quantity of
overhead cost overhead cost variable overhead
= per unit of - per unit of cost-allocation base
cost-allocation base cost-allocation base used

Illustration

Assume ABC company has manufactured and sold 10.000 quality Jackets. During the year
2015 ,the cost driver for variable manufacturing over head cost in the company is machine
hours used. The following are data related to the VMOH cost of the company.

Actual result Flexible budget amount

Out put unites (shirts) 10,000 unit 10,000 unit

Machine hour 4,500 4,000

VMOH cost $130,500 $120,000

Required

a) compute the Variable overhead flexible budget variance

b) compute the spending and efficiency variance and compare their sum with the result in‖
a‖
Solution

Cost allocation base Actual Result Flexible-Budge Amount

1. Output units (jackets) 10,000 10,000
2. Machine-hours per output unit 0.45 0.40
3. Machine-hours (1 * 2) 4,500 4,000
4. Variable overhead costs $130,500 $120,000
5. Variable overhead costs per machine-hour (4 $ 29.00 $ 30.00
/ 3)
6. Variable overhead costs per output unit (4 / $ 13.05 $ 12.00
1)
a) Variable overhead flexible budget variance= Actual costs incurred – Flexible budget
amount

$130,500 - $120,000 = $10,500 U

b) Variable overhead efficiency variance

c) Variable overhead spending variance

4.4.5 Fixed Overhead Variance

Fixed overhead costs are, by definition, a lump sum of costs that remain unchanged for a
given period despite potentially wide changes in activity within the relevant range. These
costs are fixed in the sense that, unlike variable costs, fixed costs do not automatically
increase or decrease with the level of activity within the relevant range. Examples of FMOH
costs include depreciation, supervisor‘s salary, factory Rent etc.

 Fixed overhead flexible-budget variance is the difference between actual fixed

overhead costs and fixed overhead costs in the flexible budget.

Fixed Overhead
flexible-budget variance = Actual Costs
Incurred - Flexible-budget
amount

 The fixed overhead spending variance is the same variance as the Fixed Overhead
Flexible-Budget Variance

Fixed OH Production-Volume Variance

Production-volume variance is the difference between budgeted fixed overhead and fixed
overhead allocated on the basis of actual output produced. This variance is also known as the
denominator-level variance.
Production-Volume Budgeted Fixed Overhead allocated
Variance = Fixed Overhead - for actual output units
produced
Illustration

Assume the following are data of FMOH cost for ABC Company in 2015.

Actual result flexible budget

FMOH cost $285,000 $276,000

Output unit 10,000 12,000

Machine hours 4,500 4,800

Requirements

a) Compute the flexible budget variance (spending variance)

b) Compute the production volume variance

Solution

a) Fixed overhead Flexible budget variance= Actual costs incurred –Flexible budget amount

$285,000 - $276,000= $9,000 U

The variance is unfavorable because the $285,000 actual fixed overhead costs exceed the
$276,000 budgeted for April 2014, which decreases that month‘s operating income by $9,000.
The variable overhead flexible-budget variance described earlier in this chapter was
subdivided into a spending variance and an efficiency variance. There is no efficiency
variance for fixed overhead costs. That‘s because a given lump sum of fixed overhead costs
will be unaffected by how efficiently machine-hours are used to produce output in a given
budget period. As we will see later on, this does not mean that a company cannot be efficient
or inefficient in its use of fixed-overhead-cost resources. If there is no efficiency variance,
the fixed overhead spending variance is the same amount as the fixed overhead flexible-
budget variance:
b) Production volume variance = Budgeted fixed overhead _ Fixed overhead allocated for
actual output units produced

=$276,000 – (0.40 hour per jacket * $57.50 per hour* 10,000 jackets)

= $276,000 – ($23 per jacket * 10,000 jackets)

$276,000 - $230,000 = $46,000 U

4.5 Sales Volume Variances

The sales-volume variance is the difference between a flexible-budget amount and the
corresponding static-budget amount. The sales-volume variance shows the effect on
budgeted contribution margin of the difference between actual quantity of units sold and
budgeted quantity of units sold .Managers can gain substantial insight into the sales-volume
variance by subdividing it into the sales-mix variance and the sales-quantity variance .Sales
quantity variance is further subdivided in to market share and market size variances.

4.5.1 Sales-Mix Variance

The sales-mix variance is the difference between (1) budgeted contribution margin for the
actual sales mix and (2) budgeted contribution margin for the budgeted sales mix. Measures
the effect of shifts between selling more or less of higher or lower profitable products

4.4.2 Sales Quantity Actual

Variance
Units of Actual Budgeted Budgeted
Sales-Mix Sales-Mix
=
The sales-quantity Sales-Mix X
All isXthe difference between (1) budgeted contribution Contribution
variance margin
Variance Percentage
Products Percentage Margin
based on actual units sold of all products at the budgeted mix and (2) contribution margin in per Unit
Sold
the static budget (which is based on budgeted units of all products to be sold.

4.5.2 Sales Quantity Variance

The sales-quantity variance is the difference between (1) budgeted contribution margin based
on actual units sold of all products at the budgeted mix and (2) contribution margin in the
static budget (which is based on budgeted units of all products to be sold

Actual Budgeted Budgeted Budgeted

Sales- Units of All Units of all
Quantity a) =Market Sales-Mix Contribution
Share Variance
Products Products X Percentage
X
Margin per Unit
Variance Sold Sold
The market-share variance is the difference in budgeted contribution margin for actual
market size in units caused solely by actual market share being different from budgeted
market share. The formula for computing the market-share variance is as follows
Budgeted
Market- Actual Actual Budgeted Contribution
Market Margin per
Share = X Market Market X
Variance Size in Share Share Composite Unit
Units for Budgeted
Mix

b) Market Size Variance

The market-size variance is the difference in budgeted contribution margin at budgeted

Budgeted
market share caused solely by actual market size in units being different from budgetedContributio
Actual Budgeted Budgeted Margin per
market
Market-Sizesize in units . The formula for computing the market-size variance
Marketis as follows
Market Market X X Composite U
Variance = Size Size Share for Budgete
Mix
Illustration: The Payne Company manufactures two types of vinyl flooring. Budgeted
and actual operating data for 2012 are as follows:

In late 2011, a marketing research firm estimated industry volume for commercial and
residential vinyl flooring for 2012 at 800,000 rolls. Actual industry volume for 2012 was
700,000 rolls.

Required:

1. Compute the sales-mix variance and the sales-quantity variance by type of vinyl

flooring and in total.

2. Compute the market-share variance and the market-size variance.

3. What insights do the variances calculated in requirements 1 and 2 provide about

Payne Company‘s performance in 2012?

Solution:

1. Actual sales-mix percentage:

Budgeted sales-mix percentage:

Budgeted contribution margin per unit:

2. Actual market share = 84,000 ÷ 700,000 = 0.12, or 12%

Budgeted market share = 80,000 ÷ 800,000 units = 0.10, or 10%

Budgeted contribution margin per composite unit of budgeted mix can also be calculated as
follows:
Note that the algebraic sum of the market-share variance and the market-size variance is
equal to the sales-quantity variance: $5,950,000F + $4,250,000U = $1,700,000F.

Both the total sales-mix variance and the total sales-quantity variance are favorable. The
favorable sales-mix variance occurred because the actual mix comprised more of the higher
margin commercial vinyl flooring. The favorable total sales quantity variance occurred
because the actual total quantity of rolls sold exceeded the budgeted amount. The company‘s
large favorable market share variance is due to a 12% actual market share compared with a
10% budgeted market share. The market size variance is unfavorable because the actual
market size was 100,000 rolls less than the budgeted market size. Payne‘s performance in
2012 appears to be very good. Although overall market size declined, the company sold more
units than budgeted and gained market share.
Summary
 A static budget is based on the level of output planned at the start of the budget period. A
flexible budget is adjusted (flexed) to recognize the actual level of output achieved in the
budget period. Flexible budget help managers gain more insight into the causes of
variances than do static budgets.
 The combination of price variances and efficiency variances helps managers gain insight
into two different (but not independent) aspects of performance. Price variances focus on
the difference between actual and budgeted input prices. Efficiency variances focus on
the difference between actual inputs and used and the budgeted inputs allowed for the
actual output.
 A standard cost is a carefully predetermined cost that is based on a norm of efficiency.
Standard costs can exclude past inefficiencies and they can take in to account changes
expected to occur in the budget period.
 Planning of both variable and fixed overhead costs involves planning to undertake only
essential activities and then planning to be efficient in that undertaking. The key
difference is that for variable cost planning ongoing decisions during the budget period
play a larger role, whereas for fixed cost planning most key decisions have been made at
the start of the period.
Review question

PART I- True or False

Instruction, dear learners, please write true if the statement is correct and write false if the

statement is wrong

6. The output variances refer to efficiency-whether the set objective is achieved or not and
the input variances refer to effectiveness – a measure of the means by which an objective
is achieved
7. Variance is the difference between actual results and budgeted data
8. All variance – favorable or unfavorable ultimately affect the operating income of the
firm.
9. Static budget is prepared for ranges of volume of activity levels sometimes referred as
relevant range.
10. Effective planning of variable overhead costs involves undertaking only those variable
overhead activities that add value for customers using the related product or service
11. With a standard costing system, the costs of every product or service planned to be
worked on during the period can be computed at the start of that period
12. Efficiency variances for direct-cost items are based on differences between actual inputs
used and the budgeted inputs allowed for actual output produced.
13. There is not an efficiency variance for fixed overhead costs.
PART II- Fill in the Blank Spaces

Instruction, Dear Learners, please fill in the blank spaces with appropriate words or phrases

1. _______ is based on the level of output planned at the start of the budget period.
2. ______ Variances which arise from change in input prices from the expected Prices
(budgeted prices.)
3. ______ Variances which arise from use of unit quantities.
4. The price and efficiency variances together are sometimes referred as ________
5. The flexible-budget variance pertaining to revenues is often called _________
6. The ___________ is the difference between budgeted fixed overhead and the fixed
overhead allocated on the basis of the budgeted quantity of the fixed overhead allocation
base allowed for the actual output produced
7. _________ is the difference between the actual quantity of input used (such as yards of
cloth of direct materials) and the budgeted quantity of input that should have been used,
multiplied by the budgeted price.
8. The __________ measures the difference between the actual variable overhead costs and
the flexible- budget variable overhead costs.
9. The _____________ is the difference between the actual amount of variable overhead
incurred and the budgeted amount allowed for the actual quantity of the variable
overhead allocation base used for the actual output units produced
10. The ___________ is the difference between actual fixed overhead costs and the fixed
overhead costs in the flexible-budget:
Workout

Sagittarius Corp. has established the following standards for the prime costs of one of its chief
product, dart boards.

Standard Q standard Price (Rate) Total Standard cost

Direct material 8.5 pounds Br.1.80/poundBr.15.30

Direct labor 0.25 hour 8.00/hour 2.00

Br.17.30

During May, Sagittarius purchased 160,000 pounds of direct material at a total cost of Br.304,
000. The total wages for May were Br.42, 000, 90% of which were for DL. Sagittarius
manufactured 19,000 dart boards during May; using 142,500 pounds of direct material & 5,000
direct labor hours.

Required: Compute the following variances for May.

a. Direct material price variances

b. Direct material usage variance
c. Direct material cost variance
d. Direct labor rate variance
e. Direct labor efficiency variance
f. Direct labor cost variance
CHAPTER FIVE

5 Pricing for a Product or Service

5.1 Introduction
Setting a price for a product or service can be a challenge, as many variables factor into
determination of a price. Additionally, accurate pricing can be based on values that can be
difficult to know without extensive research. As a result, many companies make costly
mistakes when incorrectly attempting to price a product or service. A large portion of pricing
is determined by the customer segment a company is targeting or the market it is entering. It
is important to have strongly supported and reliable knowledge of a targeted customer
segment before determining price.

It will help identify the characteristics, demographics, and buying habits of the targeted
customer. It is strongly suggested that this document, or other materials on business and
customer research, be used as a reference to the pricing tactics introduced in this circular.
This publication serves as an introductory guide for pricing products and services.

It presents some important terms and metrics that can be used when analyzing price. It also
introduces some methods for determining a price. While the principles suggested in this
curricular can be used for most products and services, there are some instances where the
business objectives also affect price. They, too, are described in this document. Throughout
the curricular, examples are provided to further demonstrate the curriculum presented.

5.2 Pricing Strategies

Cost-Based Pricing (Cost-Plus Pricing)

A basic method that can be used to determine price is one based on cost, often called Cost-
Plus Pricing. With this method, the first step is to accumulate all fixed and variable costs.
The next step is to estimate sales and determine fixed costs on a unit basis. The final step is to
sum up variable and unit fixed costs and add a set profit margin to determine final price. The
appeal of this method is that it is simple and does not require extensive research or efforts to
calculate. In general, cost-based pricing is not recommended because it has many risks. First,
this method does not consider perceived customer value so it is possible to determine a price
that is out of sync with customers.

Cost-based pricing can also be risky if one does not estimate costs accurately. For example, if
a business overestimates the amount of product sales, which is possible due to failure to
research perceived customer value, then the product‘s fixed costs per unit sold will be much
higher than expected and the pricing scheme might not be profitable. Additionally, if costs
suddenly change (e.g., due to commodity price fluctuations), a pricing scheme might not be
viable. As a result, cost-based pricing is usually not recommended except for very large value,
low volume sales.

Value-Based Pricing

The most effective way to price an object is based on the value it creates for customers and
the customers‘ perceived worth. Referred to as Value-Based Pricing, it requires significant
knowledge of a company‘s customers and their needs. To calculate value-based pricing, one
must compile all value propositions created by the product and calculate a monetary amount
for each.

Value propositions may include items such as the cost to replace a current product, labor, or
costs prevented by a new product, or any other values created by the product for its end user.
While other factors can indirectly affect price (e.g., customer knowledge of a product,
competitive landscape, etc.), price should still be directly proportional to the value created.
Value-based pricing can be challenging. Errors of overestimating or underestimating value
can be problematic for a business. If a company does not capture all value statements, it runs
the risk of losing profitability or leaving money on the table. If a company overestimates the
value created by a product or service, or customers are not knowledgeable of all the value
created, the price will be set too high, thus leading to lost sales. As a result, many businesses
will try an initial price and then use customer feedback to hone in on a more accurate figure.

While value-based pricing does not directly use concepts like costs or break-even point for
determining price, these terms can still play an important role in pricing. Knowing costs can
determine overall product profitability for a given price. Additionally, these terms can serve
as a check for a proposed price and whether it fits into an overall business strategy. One
optional step for value-based pricing is to examine all costs and confirm that the ultimate
price will create profitable outcomes for the business.

Retail Pricing

There are many instances when a business will not sell directly to a customer. The business
will instead sell products to a retail business, which in turn will sell them to customers.
Although retail businesses do not have the manufacturing costs described in earlier examples,
they will have labor and overhead costs that must be covered when setting prices. As a
result, they do not pay the same price a retail customer does.

The term Wholesale Price refers to the price a retailer pays for a product. Retail Price refers
to the price that a retailer sets for its customers.

Generally, these two prices are directly related. The retail price is usually determined by
multiplying the product‘s wholesale price by a set percentage. The term Markup is used to
refer to this relationship.

Retail price is typically two times the wholesale price, or a 100 percent markup. The
occurrence is so common that the term Keystone Pricing has been branded to describe it
(though high-end retailers, and others, may use different markup values).
Generally, the retail price should reflect the value of a product to customers, and should be
set accordingly. One effective tactic that businesses use is to employ value-based pricing to
determine the retail price and then use a set markup value to determine the wholesale price.

5.3 Business Objectives

A business will have varying objectives based on business status, health, and other
circumstances. These objectives can affect how a business sells products to its customers, and
in return, will have an indirect effect on price. Since there is not a direct correlation between
business objectives and pricing, there is no equation to model how they affect pricing.
However, it is important to be aware of these situations so that a company can respond
appropriately.

1. Maximizing Profitability
For many companies, the goal when setting price is to maximize profitability. To affect
profitability, pricing can be used to influence either the number of units sold or costs. For
example, some companies will employ a strategy to sell more units at a lower price, even if it
means less revenue per sale. This occurs because a company can often receive discounts from
suppliers for buying in large quantities.

This concept, referred to as Economies of Scale, is sometimes employed by companies to

lower costs and increase profitability, even if it decreases revenue slightly. Before attempting
this strategy, a company must be able to produce and sell the needed quantities, be aware of
its own capabilities, and be knowledgeable about customer demand. Promoting Future Sales
Companies may choose to sell products that Many products that lead to further sales and
business are sold. This is especially true of base products that require additional products or
accessories to function in the future (e.g., printers and ink cartridges).

To increase profitability, companies will often try different pricing schemes to ensure future
or repeat customers. Sometimes a company will sell a base product for less than its actual
value, or even for a loss, knowing it will lead to future sales or revenue. For example, soda
manufacturers will often highly subsidize or even give a soda fountain to restaurants, in
exchange for a contract to buy soda from that producer. In return, these restaurants, which
purchase large volumes of soda, will buy enough product to more than make up for the
initial losses the producer has incurred. Inversely, some companies may offer a base product
at a higher premium with the enticement of lower ongoing costs for the complementary,
add-on products.

2. Switching Cost
Switching Cost is a term used to measure how easy or difficult it is to switch to a
competitor‘s product or service. Going back to our printer example, once a person purchases
a printer, he or she is then required to buy printer cartridges that fit that model, usually from
the same manufacturer.

3. Beating Out Competitors

Almost every business has competitors with whom it is competing for a finite number of
customers and sales. To succeed, a business must distinguish itself from its competitors. One
tactic businesses use is lowering their price to be in line with or lower than a competing
product. While lowering price is one way for a business to compete, it is not the only
method, or even the best tactic, for differentiating or setting its product apart from
competitors. Other methods businesses can use for differentiation are product quality,
features, or customer service.

Some companies successfully set themselves apart by pricing above their competitors and
causing their products to be perceived as luxury or high quality, a tactic sometimes referred
to as Premium Pricing. The best way to address competition is through extensive research of
competitors, as well as evaluation of one‘s own business. Having a clear idea of strengths and
shortcomings compared with competitors will guide a business to the best strategy for
differentiation and pricing.
4. Gaining Exposure/Entering a New Market
When entering a new market, it is sometimes more important to increase sales and market
share than to maximize profitability.

Lowering price can be an effective method to attract new customers. This can lead to
additional customers trying a product and staying loyal to it in the future. There are some
risks that should be taken into account before attempting this pricing strategy. First, lower
prices mean lower profitability.

A company needs to ensure it has the cash flow to sustain a low profit margin for an
extended period of time. Additionally, when a company returns prices to a higher, normal
level, it can lead to customer backlash. Finally, lowering prices can encourage competitors to
follow suit, leading to a costly price war. It is important to consider all these variables before
attempting this pricing strategy.

Summary
Accurate and effective pricing is a critical step for a business to reach profitability. Pricing
strategies should be developed for all products and services and should rely heavily on
understanding the customers‘ needs and perceived values.

This publication serves as an early guide to pricing by introducing important concepts and
terms, presenting methods for determining pricing, and discussing various business
objectives and their effects on pricing.

Review question

a. What are objectives of setting pricing strategies?

b. What are objectives of business organization according to setting of pricing strategies?
c. How retile pricing is applied?
d. What is difference between value based and cost based pricing strategies?
e. What is responsibility of accountant in pricing product and services?