NATIONAL OPEN UNIVERSITY OF NIGERIA

SCHOOL OF MANAGEMENT SCIENCES

COURSE CODE: ACC 313

COURSE TITLE: MANAGEMENT ACCOUNTING

1
ACC 313

MANAGEMENT ACCOUNTING

COURSE GUIDE

Course Developer/Unit Writer ICAN Study pack

Adapted by: Mrs. F. E. Onyebuenyi NOUN
Course Editor: Dr. I.D. Idrisu NOUN
Programme Leader: Dr. I.D. Idrisu NOUN
Course Coordinator: Mr. E. U. Abianga NOUN

CONTENT

2
1.0 INTRODUCTION

ACC 313-Management Accounting is designed to give you self instruction to

you as you study Bachelor of Science (B. Sc) in Accounting. It is adapted
from the Institute of Chartered Accountants of Nigeria study materials to
prepare you for your B. Sc Accounting examination of School of Management
Sciences of the National Open University of Nigeria .

2.0 COURSE AIM

The aim of this course is to introduce you to Management Accounting

approaches and processes.

3.0 COURSE OBJECTIVES

By the end of this course, you should be able to:

(i) Provide relevant information to assist management of organization in various sectors;

And at operational and strategic levels in planning, decision making and in controlling
operations;
(ii) Analyzing problem situations, purpose and/ or evaluate alternative courses of action ;
(iii) Know relevant quantitative techniques in solving problems;
(iv) Assist management in identifying and applying appropriate measurement techniques;
(v) Use information and communication technology to solve problems and preparation of
reports.

COURSE CONTENT
Nature and purpose, Decision making, Planning, Control, Divisional performance
evaluation, application of quantitative methods, Contemporary issues in Management
accounting

4.0 WORKING THROUGH THIS COURSE

This course, ACC 313-Management accounting, expects you to do a lot of

reading and practicing, in order to cover the materials in the course material.
This means that you should devote much time to this course by reading
through this material and getting more information from numerous texts and
journals. These abound in every library and from the internet. The course
material has been made easy to read and user-friendly. You will need to work
in groups with other students in order to discuss, compare notes and thoughts
as well as to exchange and share ideas. Below are the lists of all the
components of the course:

5.0 COURSE MATERIALS

The National Open University of Nigeria will provide you with the following
items:
 Course Guide
 Study Units- Course material

3
 TMA Assignments

In addition, at the end of every unit, is a list of texts for your references and for
further reading. It is not compulsory for you to read all of them. They are only
essential supplements to this course material.

6.0 STUDY UNITS

The study units in this course are as follows:

MODULE I: MANAGEMENT ACCOUNTING-INTRODUCTION

Unit 1: Introduction and Scope of Management Accounting

Unit 2: Management Accounting and Management Information System
Unit 3: Cost Accounting Concepts and Principle
Unit 4: Costing Methods
Unit 5: Planning and Management Control System

MODULE II: COST, BUDGET AND DECISION MAKIN

Unit 6: Cost Estimation and Behaviour
Unit 7: Decision making under Uncertainty
Unit 8: Budgeting and Budgeting Control
Unit 9: Standard Costing
Unit 10: Cost of Capital

MODULE III: QUANTATIVE METHODS AND MANAGEMENT

ACCOUNTING

Unit 11: The Application of Quantative Methods to Management Accounting

Unit 12: Working Capital Management
Unit 13: Capital Investment Decision
Unit 14: Decision Making under Risk and Uncertainty
Unit 15: Divisional Performance Evaluation

MODULE IV: PRICING, RATIO, COST AND CURRENT TREND IN

MANAGEMENT ACCOUNTING

Unit 16: Transfer Pricing Systems

Unit 17 Pricing Decisions
Unit 18: Ratio Analysis
Unit 19: Cost Control and Cost Reduction
Unit 20: Current Trends in Management Accounting

Module 1:

Unit 1- discusses the introduction and scope of management accounting-

definition, as it relates cost to accounting, financial accounting, techniques
used in management accounting for planning, controlling and decision making.
It also deals with roles of management accounting in an organization and basic

4
management accounting issues such as business objectives and goal
congruence.

Unit 2- deals with management information system role in relation to

management accounting information attributes, management report and
feedback

Unit 3- treats definition of basic cost accounting, principles of accounting-

material costing, labour costing and overhead costing, It discusses concept of
activity based costing as well,

Unit 4- covers a detailed description of costing methods, job costing, batch

costing and contract costing. It also explains process costing, joint – product,
by-product and service costing.

Unit 5- treats short-term and long-term planning. It discusses strategic, tactical

and operational planning: control system and the basic knowledge of closed
loop and open loop systems and decisions are also treated

Module 2:

Unit 6- treats you to the importance of cost behavior: definition of variable cost
in linear and non-linear form and techniques used in estimation and prediction
of all cost are discussed. It also treats the effect of inflation in costing.

Unit 7- covers a comprehensive discussion on marginal technique and the

preparation of operative statements under marginal and absorption costing
techniques. It deals also with cost-volume-profit analysis for decision making,
break-even charts and project analysis including limiting factors and its affects
decision making. Application of relevant cost, opportunity cost, incremental
cost and differential cost to decision making are also discussed.

Unit 8- presents objective of budgeting. Stages in developing budget and their

interrelationships, cash budget and its importance in an organizational
functional budgets and master budget, control limits, activity and efficient
ratio: need for budgetary control and vital importance of the human of human
aspect of budgeting is treated. The major techniques used in budgeting such as
flexible budgets, zero-based budgeting, activity based budgeting, continuous
budgeting, and programme planning and budgetary systems are also covered.

Unit 9- discusses the difference between cost and standard costing: types of
standard and capacity levels. It also covers standard costing techniques and the
associated objectives, how to apply the various principles required for the
computation of variances; the concept of standard hour and computation of
capacity, efficiency and activity ratio: and how to apply the principle of
marginal costing in standard costing.

Unit 10- treats cost of capital and source of capital funds to an enterprise, the
different cost of funds and their computations, various cost models, various

5
cost concepts as they relate to cost of capital-and the relationship between cost
of capital and gearing. It also covers contributions for the cost of capital as
well as acceptability of projects.

Module 3:

Unit 11 discusses the application of quantitative methods of learning curve

theory and the situation where it may be applied; computation of average and
incremental labour for different output levels, advantages and limitations of the
learning curve theory: various ways of classifying stock: various stock control
techniques and their applications: weakness of the various stock control
methods and the situations when it will be appropriate to adopt linear
programme techniques. It also discusses the various linear programming
techniques and their applications, the meaning and usefulness of the term
‘shadow price’.

Unit 12- explains working capital management in the following areas:

definition and its component: the need for managing current assets and current
liabilities; the proper mix of short term and long term financing for current
assets; factor that affect credit policies: techniques of inventory management;
technique used in cash management and the preparation of cash flow
statement.

Unit 13- discusses opportunity cost of an investment, concept of payback

period, accounting rate of returns, net present value: the limitation s of the
various concepts, how to calculate PBP, ARR, NPV and IRR; superiority of
NPV over the IRR; exclusive project with unequal lives, capital rationing; the
concept of profitability index, and the treatment of inflation in capital
investment appraisal.

Unit 14- issues relating to decision making under risk and uncertainty are
discussed. It covers such matters as risk and uncertainty. Payback risk
premium and finite horizon methods; the application of probability in project
appraisal; the calculation and explanation of expected value: standard deviation
and coefficient of variation as measures of risk and their limitations; the
construction of decision tree when there is a range of alternatives and possible
outcomes; the description and calculation of the value of perfect and imperfect
information; the maximum, maxima regret decision rules; sensitivity analysis
and its application to project analysis; portfolio analysis and its implication for
project appraisal.

Unit 15- discusses the concept of decentralization, responsibility accounting

and the various divisional performance evaluation techniques. It also discusses
the concept of value for money audit.

Module 4:

6
Unit 16- discusses the objectives and methods of transfer pricing system. The
merits and demerits of the methods are discussed. It also discussed the factors
to be considered when setting transfer prices for multinational transactions and
the nature and meaning of dual transfer pricing system.

Unit 17- discusses the objective of price decision and factors affecting it. It
also discusses the relationship between selling price, various pricing methods
and their application; the use of differential calculus to find optimum price and
the different pricing policies.

Unit 18- discusses the concept of ratio analysis and explains the benefits and
limitations of ratio analysis. The computation of various ratios including value
added ratio.

Unit 19- discusses the concept of cost control and cost reduction. It also
discusses the main differences and limitations between cost control and cost
reduction; the scope and factors of cost reduction. The various cost techniques
are also discussed.

Unit 20- discusses current trend in management accounting involving the

following: advanced management technology, total quality management,
throughput accounting, back-flush accounting, target costing, lifecycle costing,
teardown accounting analysis and strategic management accounting

7.0 ASSESSMENT

There are two aspects to the assessment of the course: first is the tutor-marked
assignment; and secondly, the examination. Within each unit are self-
assessment exercises, which are aimed at helping you to check your
assimilation as you proceed. Try to attempt each of the exercises before
finding out the expected answers from lecture.

8.0 TUTOR-MARKED ASSIGNMENT (TMAS)

This is your continuous assessment and accounts for 30% of your total score.
You are expected to answer at least four TMA’s, three of which must be
answered and submitted before you sit for the end of course examination.

9.0 FINAL EXAMINATION AND GRADING

With this examination written successfully, you have completed your course in
Basic research and one believes you would apply your knowledge (new or up-
graded) in your project. The ‘end of course examinations’ would earn you
70% which would be added to your TMA score (30%). The time for this
examination would be communicated to you.

10.0 HOW TO GET THE BEST FROM THIS COURSE

7
In distance learning, the study units are specially developed and designed to
replace the conventional lectures. Hence, you can work through these
materials at your own pace, and at a time and place that suits you best.
Visualize it as reading the lecture.

This is one of the great advantages of distance learning. You can read and
work through specially designed study materials at your own pace, and at a
time and place that suits you best. Think of it as reading the lecture that a
lecturer might set you some readings to do, the study unit will tell you when to
read other materials. Just as a lecturer might give you an in-class exercise,
your study units provide exercises for you to do at appropriate points.

Each of the study units follows a common format. The first item is an
introduction to the subject matter of the unit, and how a particular unit is
integrated with the other units and the course as a whole.

Next is a set of learning objectives. These objectives allow you to know what
you should be able to do by the time you have completed the unit. You should
use these objectives to guide your study. When you have finished the unit, you
must go back and check whether you have achieved the objectives. If you
make a habit of doing this, you will significantly improve your chances of
passing the course.

The main body of the unit guides you through the required reading from other
sources. This will usually be either from a Reading Section of some other
sources.

Self-tests are interspersed throughout the end of units. Working through these
tests will help you to achieve the objectives of the unit and prepare you for the
assignments and the examination. You should do each self-test as you come to
it in the study unit. There will also be numerous examples given in the study
units, work through these when you come to them too.

The following is a practical strategy for working through the course.

(1) Read this course guide thoroughly.

(2) Organize a study schedule. Refer to the course overview for more details. Note the
time you are expected to spend on each unit and how the assignments relate to the
units. Important information e.g. details of your tutorials, and the date of the first day
of the semester will be made available. You need to gather all this information in one
place, such as your diary or a wall calendar. Whatever method you choose to use, you
should decide on and write in your own dates for working on each unit.

(3) Once you have created your own study schedule, do everything you can to stick to it.
The major reason that students fail is that they get behind with their coursework. If
you get into difficulties with your schedule, please let your tutor know before it is too
late for help.

(4) Turn to unit 1 and read the introduction and the objectives for the unit.

8
(5) Assemble the study materials. Information about what you need for a unit is given in
the ‘Overview’ at the beginning of each unit. You will always need both the study
unit you are working on and one of your references, on your desk at the same time.

(6) Work through the unit. The content of the unit itself has been arranged to provide a
sequence for you to follow. As you work through the units, you will be instructed to
read sections from your set books or other articles. Use the unit to guide your reading.

(7) Review of the objectives for each study unit and confirm that you have achieved them.
If you feel you are not clear about any of the objectives, review the study material or
consult your tutor.

(8) When you are confident that you have achieved a unit’s objectives, you can then start
on the next unit. Proceed unit by unit through the course and try to face your study so
that you keep yourself on schedule. Check that you have achieved the unit objectives
(listed at the beginning of each unit) and the course objectives (listed in the Course
Guide).

(9) You now take the e-TMA online

(10) After completing the last unit, review the course and prepare yourself for the final e-
examination.

11.0 SUMMARY

This course ACC 313 is designed to give you some knowledge which would
help you to understand management accounting. After going through this
course successfully, you would be in a good position to pass your examination
at the end of the semester and use the knowledge gained to function in
accounting and help you to contribute to the development of scholarly thoughts
in management accounting.

We wish you success in this interesting course and hope you will use what you
have learnt in this Bachelor of Science in Accounting in contributing to your
organization and the society at large.
We also hope you would appreciate the unique role and opportunity you have
to make a difference in using the knowledge derived from this course in
solving problems.

We, therefore, sincerely wish you the best as you enjoy the course.
GOOD LUCK.

9
Course Code ACC 313

Course Title MANAGEMENT ACCOUNTING

Course Developer/Writer ICAN STUDY PACK

Adapted By Mrs. F. E. Onyebuenyi

School Of Management Sciences
National Open University of Nigeria
Lagos.

Course Editor Dr. I. D. Idrisu

School Of Management Sciences
National Open University of Nigeria
Lagos.

Course Coordinator Mr. A. U. Abianga

School Of Management Sciences
National Open University of Nigeria
Lagos.

Programme Leader Dr. I. D. Idrisu

School Of Management Sciences
National Open University of Nigeria
Lagos.

10
CONTENTS

MODULE I: MANAGEMENT ACCOUNTING-INTRODUCTION

Unit 1: Introduction and Scope of Management Accounting

Unit 2: Management Accounting and Management Information System
Unit 3: Cost Accounting Concepts and Principle
Unit 4: Costing Methods
Unit 5: Planning and Management Control System

MODULE II: COST, BUDGET AND DECISION MAKING

Unit 6: Cost Estimation and Behaviour

Unit 7: Decision making under Uncertainty
Unit 8: Budgeting and Budgeting Control
Unit 9: Standard Costing
Unit 10: Cost of Capital

MODULE III: QUANTATIVE METHODS AND MANAGEMENT

ACCOUNTING

Unit 11: The Application of Quantative Methods to Management Accounting

Unit 12: Working Capital Management
Unit 13: Capital Investment Decision
Unit 14: Decision Making under Risk and Uncertainty
Unit 15: Divisional Performance Evaluation

MODULE IV: PRICING, RATIO, COST AND CURRENT TREND IN

MANAGEMENT ACCOUNTING

Unit 16: Transfer Pricing Systems

Unit 17 Pricing Decisions
Unit 18: Ratio Analysis
Unit 19: Cost Control and Cost Reduction
Unit 20: Current Trends in Management Accounting

11
MODULE I: MANAGEMENT ACCOUNTING-INTRODUCTION

Unit 1: Introduction and Scope of Management Accounting

Unit 2: Management Accounting and Management Information System
Unit 3: Cost Accounting Concepts and Principles
Unit 4: Costing Methods
Unit 5: Planning and Management Control System

UNIT 1 INTRODUCTION AND SCOPE OF MANAGEMENT

ACCOUNTING

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Definition of Management Accounting
3.2 Comparison of Management Accounting, Cost Accounting and Financial
Accounting
3.3 Management Accounting Techniques
3.4 The Roles of the Management Accountant
3.5 Business Objectives
3.6 Alternative Goals
3.7 Goal Congruence
4.0 Summary
5.0 Conclusions
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

This unit will delve into the introductory aspect of management accounting. Its
relationship to other accounting areas and the role it plays in various organisation

2.0 OBJECTIVES

In this unit, the readers will be able to understand:

 The scope and principles of management accounting
 Management accounting as it relates to cost accounting and financial
accounting
 The techniques used in management accounting for planning, controlling, and
decision-making
 The roles of management accounting in an organization
 The basic management accounting issues, such as business objectives, goal

12
congruence.

3.0 MAIN CONTENT

3.1 DEFINITION OF MANAGEMENT ACCOUNTING

There are many definitions of Management Accounting by various organizations.

However, that of the Chartered institute of Management Accountants (CIMA) had
gained general acceptance:

"Management Accounting - An integral part of management is concerned with

identifying, presenting and interpreting information used for:
(a) Formulating strategy;
(b) Planning and controlling activities;
(c) Decision-making;
(d) Optimizing the use of resources;
(e) Disclosure to shareholders and other external parties to the entity;
(f) Disclosure to employees; and
(g) Safeguarding assets".

The above ensures that there is effective:

(a) formulation of plans to meet objectives (strategic planning)
(b) formulation of short-term operations plans (budgeting/profit planning,)
(b) acquisition and use of finance (financial management),
(c) recording of transactions (financial accounting and cost accounting),
(d) communication of financial and operating information,
(f) corrective action to bring plans and results into line (financial control), and
(g) reviewing and reporting on systems and operations (internal audit, management
audit) (CIMA Terminology).

The Management Accounting Practices Committee (MAPC) of the National

Accounting Association (NAA) in the United States defined Management Accounting
as "the process of identification, measurement accumulation, analysis, preparation,
interpretation and communication of financial information used by management to
plan, evaluate, and control within an organisation and to ensure appropriate use of
and accountability for its resources':

Management accounting may also be defined as "the application of professional skills

in the preparation and presentation of accounting information in such a way as to assist
management in the formulation of policies and in the planning, and control of the
operations of the undertaking" (Sizer 1996).

Management accounting also comprises the preparation of financial reports for non-
management groups such as shareholders, creditors, regulatory agencies and tax
authorities.

13
In the above definitions, we could see that policy-making, planning and control are
generally descriptions of all the functions of management. It means that any
information which could be useful to managers and which was evaluated in monetary
terms could be a management accounting responsibility.

In order to carry out this task efficiently, the management accountant will:
(a) use data from the financial and cost accounting systems,
(b) conduct special investigations to gather required data,
(c) use accounting techniques and other appropriate techniques from statistics and
operational research,
(d) take account of the human element in all activities,
(e) be aware of the underlying economic logic.
All of these will be done in order to produce information which is relevant for the
intended purpose. From all the above, it would appear as if all accounting are
management accounting!

Management accounting assists the management to plan, control and make decisions.
The elements involved in the decision making, planning and control processes are as
follows:
(a) identifying the objectives that will guide the business;
(b) search for a range of possible courses of action that might enable the objectives
to be achieved;
(c) gather data about the objectives;
(d) select appropriate alternatives courses of action that will enable the objectives
to be achieved;
(e) implement the decisions as part of the planning and budgeting process;
(f) compare actual and planned outcomes; and
(g) respond to divergences from plan by taking corrective action. This will enable
actual outcomes conform to planned outcomes or modify the plans, if the
comparison indicate that the plans are no longer attainable.

3.2 COMPARISON OF MANAGEMENT ACCOUNTING, COST

ACCOUNTING AND FINANCIAL ACCOUNTING

Cost Accounting (commonly termed, costing) may be defined as:

"The establishment of budgets, standard costs and actual costs of operations,
processes, activities, or products and the analysis of variances, profitability or the
social use of funds".

Financial accounting is defined as:

"The classification and recording of the monetary transactions of an entity in
accordance with established concepts, principles, accounting standards and legal
requirements and their presentation by means of profit and loss account, balance sheet
and cash flow statements during and at the end of an accounting period," (CIMA).

14
The main differences between management accounting and financial accounting are as
follows:
(a) Rules and regulations - Financial accounting reports adhere strictly to
statutory (legal) requirements, for example, Companies and Allied Matters Act,
1990 (CAMA), professional pronouncements (ICAN) and accounting standards
(IAS, SAS). On the other hand, management accounting reports need not
adhere strictly to these rules and regulations.

(b) Degree of details - Management accounting reports are much more detailed
than Financial accounting reports. Whereas financial accounting report, for
instance, may show the total profit made by an organisation, while management
accounting report lays more emphasis as to the department, branch, division or
segment that contributed to the profit.

(c) Time focus - Management accounting reports are futuristic and predictive in
nature, while financial accounting reports are historical, that is, past.

(d) Period of preparation of reports - Financial accounting reports are usually

rigidly prepared for periods such as monthly, quarterly, semi-annually or
annually. On the other hand, management accounting reports can be prepared
anytime the management of the organisation needs it. Hence, its reports are
flexible.

(e) Estimates and approximations - Since management accounting

reports are futuristic, it entails usage of estimates and approximations while
financial accounting reports are historical, the use of estimates and
approximations are reduced to the barest minimum.

(f) Objectives - The objective of financial accounting report is stewardship while

management accounting reports are used for planning, controlling and decision-
making.

(g) Inter-disciplinary relationship - Management accounting spills over to other

courses, such as Economics, Statistics, Psychology, Quantitative Techniques,
Production Management, etc. On the other hand, financial accounting reports
are strictly restricted to pure financial accounting issues.

(h) Dual Concept - Financial accounting is based on the dual concept of debit and
credit while in management accounting, this is not necessary.

(i) Taxation - Management accounting is not prepared for taxation purposes while
financial accounting is prepared for taxation purposes.

(j) Monetary and non-monetary concept: Financial accounting reports are

expressed in monetary terms while management accounting reports are

15
expressed in monetary and non-monetary terms.

3.3 MANAGEMENT ACCOUNTING TECHNIQUES

Planning
The management accountant's main contribution to planning lies in the
preparation of budgets.

Control
Control in the management sense has been defined as “the process by which managers
assure that resources are obtained and used effectively and efficiently in the
accomplishment of the organization’s goals”. As involves the setting of goals and
objectives, control may be viewed as its counterpart in the management process.

Cost Control
The book keeping aspect of management accounting is also a useful tool for cost
control in small businesses. It facilitates a permanent record of costs incurred in
conducting the business. It cannot be over-emphasised that the adequacy and reliability
of accounting information contained in the records of the business concern are
essential for successful planning and control. For instance, the record-keeping function
may be viewed as necessity for effective pricing decisions. If prices are set on the basis
of full-cost plus mark-up, it is imperative that one has accurate information on the
actual cost of the product to be sold. Similarly even if market prices or market-
adjusted prices are adopted, it is still essential to have a record of actual costs in order
to determine the firm's profit margin. Clearly, the importance of accurate data for
marginal pricing decisions is evident.

Standard Costing
The use of standard costs has the added advantage of encouraging a greater degree of
cost-consciousness within the organisation. Standards are set against which actual
costs are compared, in order to determine variances from the standard. Unfavourable
variances can then be investigated in order to determine possible explanation for the
deviation. In this manner, problem areas may be detected and dealt with expediently.

However, the benefit to be derived from a standard costing system must always be
weighed against the cost of establishing it. Hence, one may discover that while
standard costs may be effectively and efficiently employed within a small
manufacturing firm, the relative costs of setting-up and implementing such a system
for a local bakery may be prohibitive.

Credit Control
This is another area of great importance in management accounting. Naturally in the
case of the small businesses which operate strictly on a cash basis, this area would
appear to be unimportant. However, it is probably not uncommon to find that small
retailer or manufacturer who supplies several regular customers will provide credit
facilities as a normal part of trading activities.

16
In such instances, proper credit control is essential for ensuring that cash proceeds are
realized on a timely basis. Appropriate credit terms, supplemented with accurate
record keeping and skilful ratio analysis, can enable the owner-manager to identify
“bad-risk” customers and appropriate action.

Decision Making
Management accounting techniques are useful for effective decision making. An
understanding of the concepts of relevant costs, cost-volume-profit relationships and
the contribution approach to decision making may facilitate more efficient and
effective decision by enabling the immediate determination of relevant factors that
have to be considered. Guidelines, such as the need to cover fixed costs or the concept
of a positive contribution margin, are very helpful in making certain decisions such as
whether to discontinue a product line, make-or-buy decisions, etc.

Financial Management
When the management accountant becomes a financial manager, he is very much a
line manager and not many financial management techniques are in effect, only
management techniques. His cash and credit control are akin to production control, his
internal audit, a form of inspection; while his cashier, wage and invoice clerks make
up his work force.

Book-Keeping and Management Accounting

Book-keeping has become so much associated with accounting thinking. In the
popular usage, many people use it to measure the worth of "accounting" in a book such
as this. The fact is that management accounting is much more concerned with the
economics of business than with the recording of past monetary accounting.

Uncertainty and Management Accounting

Management is concerned with the future and the only thing certain about the future is
that it is uncertain. Management accountants then should incorporate this uncertainty
into their works, preferably in the form of probability assessment. Strangely enough,
this has hardly been done up to the present time, perhaps because accountants are used
to handling the exactly known figures that arose in the past. However, this trend is
changing and as the emphasis in management accounting swings away from
accounting, towards management, probability concepts will certainly become another
feature of management accounting.

New Techniques in Management Accounting

Indeed, it should be observed that a whole group of techniques has recently emerged in
the world of management accounting. Many of these emerged as 'a result of using a
mathematical approach to the measurement of economic performance and efficiency,
and were developed in the field of operations research. These techniques include linear
programming, and a range of probability-based techniques that embrace topics such as
decision theory and queuing. Increasingly, statistics are also playing important part in
the work of the management accountants.

17
3.4 THE ROLES OF THE MANAGEMENT ACCOUNTANT

It is the duty of the management accountant to:

(a) To plan a profitable future for the business;
(b) To install and maintain an accounting system to monitor the performance of the
business;
(c) To record transactions by producing accounting statements; and
(d) Generate information to meet the following requirements;
(i) To allocate costs between cost of goods sold and inventories for internal
and external profit reporting;
(ii) To help managers make better decisions; and
(iii) For planning, control and performance measurement.

3.5 BUSINESS OBJECTIVES

In order to assist management by providing information that aid decision-making and

control, the management accountant must be aware of the firm's objectives.

Profit Maximisation
Profit maximisation means maximising the naira income of firms. The reasons for
identifying the maximisation of the present value of future cash flows as a major
objective are:
(a) it is equivalent to maximising shareholders value;
(b) it is unlikely that any other objective is as widely applicable in measuring the
ability of the organisation to survive in the future;
(c) although it is unlikely that maximising the present value of future cash flow that
can be realised in practice, it is still important to establish the principles
necessary to achieve this objective; and
(d) it enables shareholders as a group in the bargaining coalition to know how
much the pursuit of other goals is costing them by indicating the amount of cash
required to achieve their objectives.

3.6 ALTERNATIVE GOALS

Although, profit maximisation may be a primary goal, proprietors may have secondary
objectives which may include:
(a) maximisation of sales revenue or achieving a target level of sales,
subject to a minimum profit constraint,
(b) long run growth,
(c) long run survival,
(d) maintaining or increasing market value,
(e) increasing the status of the firm, and
(f) earning satisfactory (as opposed to maximum profit). This is known as profit
'satisficing'.

18
3.7 GOAL CONGRUENCE

One of the most important functions of management is to harmonise as far as is

practicable the goals of the participants and sub-units with those of the organisation as
a whole. This function is known as 'Goal Congruence'.

The management accounting system should encourage all employees, including

management to act in a manner which contributes to the overall objectives of the
organisation, that is, the employees' objectives and the company's objectives would in,
ideal circumstances, coincide. The system and the approach adopted by the
management accountant should motivate staff by means of genuine participation, good
communication, and rapid feedback.

Goals of Groups-other than Owners

An assumed objective of maximising the wealth of owners, to the exclusion of other
groups in a firm has been widely criticised in recent years. It is argued that the firm is
a coalition of groups, each pursuing its own objectives, and each of which is in a
position to exert influence on those responsible for taking decision within the firm.
Groups in the "coalition" might include the proprietors (shareholders in the case of
limited liability companies), managers, trade unions, creditors, various employees and
government. Groups other than the proprietors are able to exert pressure on the
decision makers in the firm.

The Goals of Individuals

These individuals have their own personal goals. Similarly, group of individuals that
form the functional divisions of the business, each group identifying with its own
goals. The sales manager will want to have large stocks of all products so that no
customer is refused or has to wait long for delivery. The production manager will want
to have long production runs to reduce set-up costs and training. The purchasing
manager prefers to buy large quantities of materials, to take advantage of bulk discount
and lower transport costs. The financial manager will want to maintain records of the
working capital tied up in raw materials or finished goods stocks.

4.0 CONCLUSIONS

Management accounting has to do with provision and interpretation of information,

which help management in planning, controlling, decision-making and assessing
performance.
The management accountant must be aware of the behaviourial implications of his
activities and information without losing sight of goal congruency.

5.0 SUMMARY
Management accounting system is multi-disciplinary in nature in that statistics and
operational research techniques may be utilised in the design process.
The Management accountant must reflect all uncertainties and variability of the

19
situation because of the unpredictable nature of activities in the business environment.
The Management accountant should take into consideration the changing value of
money due to the effects of inflation.

6.0 TUTOR MARKED ASSIGNMENT

1. The application of professional skills in the preparation and presentation of

accounting information in such a way as to assist the management to plan,
control and make decision is known as_________________

2. State two major roles of management accounting in an organisation.

3. The classification and recording of the monetary transactions of an entity in

accordance with established concepts, principles, accounting standards, balance
sheets and cash flow statements, during and at the end of an accounting period
is called________

4. “The establishment of budgets, standard costs and actual costs of operations,

processes, activities or products and the analysis of variances, profitability or
the social use of funds” is called______

5. Mention two ways in which management accounting differs from financial

accounting.

6. Identify and describe two different users of accounting information.

7. Describe two different functions of management accounting.

8. What is Goal Congruence?

9. Mention two techniques used by management accountants.

10. Mention two main sub-objectives of a profit-making organization.

7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

20
UNIT 2: MANAGEMENT ACCOUNTING AND MANAGEMENT
INFORMATION SYSTEM

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Management Information Systems (MIS) and Control
3.2 Management Accounting Reports and Feedback
3.2.1 The Qualities required for a good MIS
3.2.2 Managers use Information
3.2.3 Types of Information Necessary
3.3 Comparison between Data and Information
3.4 Qualities of Management Information
3.5 Risk and Information Presentation
3.6 Levels of Information
3.7 Reporting by Exception
3.8 Timing of Information
3.9 Value of Information
3.10 Computers (Information Technology)
3.11 Classes of Reports
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION
There exist a thin line between management accounting and management information
system. Information is of utmost important to any organisation, therefore, mangers
have need for an effective information system to be able to execute its work well and
achieve a given goal.

2.0 OBJECTIVES

In this unit, the readers will be able to understand:

 Management information system role in relation to management accounting
 Management reports and feedback
 Information attributes.

3.0 MAIN CONTENT

3.1 MANAGEMENT INFORMATION SYSTEMS (MIS) AND CONTROL

A management information system as the term may imply, is a system of providing

21
and communicating information, which will enable managers do their job. The
management accountant plays a vital role in assisting management to carry out the
responsibilities of planning, controlling, communicating, decision-making, directing
and organising through the provision of management information. Thus, management
information is vital to the role of management. Our concern, however, is with how
good or bad such systems are, and whether there are any theoretical 'rules', 'laws', or
'principles' which can be applied to improve the quality of information provided at an
acceptable cost.
One aim of the management accounting syllabus is to examine the ability of readers to
design and evaluate systems for planning and control, that is, to understand MIS
concept.

These are relevant to the work of management accountants since their job is to provide
information. It is important to state as follows:
(a) Managers must have information in order to do their work. Every organisation
with managers must have an MIS:
(i) the MIS might be a good one, or it might provide poor-quality
information. In the long run, a poor MIS will result in poor management
decisions: and
(ii) the MIS might be a formally designed and planned system or it might
have grown up in any fashion. Whenever computers are used to provide
information, there will probably have been some attempt at a formal
design of; at least, part of the organisation’s MIS.

(b) The aim of management accounting should be to provide a carefully designed,

good-quality MIS. There are many ways, however, in which management
accounting can be misleading. For example, is using full costs for decision
making, or charging uncontrollable costs to a manager’s performance report.
The awareness of the possible pitfalls is important.

3.2 MANAGEMENT ACCOUNTING REPORTS AND FEEDBACK

By providing information that is relevant to planning and control decisions, for

example, budgetary control information, budgeting information, relevant costs for one-
off decisions, profitability reports for profit monitoring such as, management
accounting, like any other MIS, should help managers to plan and control the
resources of their organisation. Much of management accounting is concerned with
the recording of actual costs for comparison with expectation or budget. This control
information is known as “feedback”.

3.2.1 The Qualities required for a good MIS

A good MIS needs to tell managers about the consumption of the organization’s
resources and the revenues or other benefits from the use of those resources. It should
provide quality information to managers at all levels in the management hierarchy.

22
3.2.2 Managers use information:

(a) By relating them to other knowledge they already have; and

(b) By asking for other information before making a decision. Using information
with reference to experience and knowledge is a quality of a good management.

3.2.3 Types of Information Necessary

A manager needs to know the types of information necessary for its intended purpose:
(a) What are his resources? Stock of raw materials, spare machine capacity, labour
availability, the balance of expenditure remaining for a certain budget, target
date for completion of a job.

(b) A what rate are his resources being consumed? For example, how fast is his
labour force working; how quickly are his raw materials being used up; how
quickly are other expenses being included?

(c) How well are the resources being used? How well are his objectives being met?
A manager uses resources based on the information given to him. The board of
a company decides how much of available funds should be allocated to any
particular activity and the same problem faces the manager of a factory or
department, or even a foreman, that is, which machines should he use, which
men should be put on certain jobs, etc. Having used information to decide what
should be done, a manager then needs feedback (or control information from
environment) to decide how well it is being done.

3.3 COMPARISON BETWEEN DATA AND INFORMATION

The terms 'data' and 'information' are often used interchangeably. Technically, data
differs from information.

Data is defined as groups of non-random symbols which represent quantities, events,

actions and things. Data are made up of characters which may be special symbols,
alphabetic and numeric.

Information is a form of data that has been processed and which is meaningful to the
user. It must be of real or perceived value for its intended purpose. It also follows that
what is information for one purpose or level in the organisation may be used as data
for further processing into information for a different purpose and level.

Data can be gathered from both internal and external sources which is frequently
derived from the day to day operations of the organisation.

It is pertinent to note that data which have been processed using specific identified
techniques (planning, decision, controlling, etc.) are compared with alternatives

23
generated in order to produce the required information which will be communicated to
the user.

3.4 QUALITIES OF MANAGEMENT INFORMATION

Management information is expected to possess the following attributes:

(a) Accuracy - The information must be communicated with sufficient confidence

in its accuracy to enable the manager to make valid decisions.
(b) Completeness - The information to be given to the manager should be
complete so that a decision is not made in ignorance of some of the key facts.
(c) Timeliness - Information should be produced at the right time so as to enable
useful decisions to be taken.
(d) Concise - The manager should be provided only with the information which is
useful for the purpose of his need and of a quantity for which he is capable of
absorbing.
(e) Clarity - The information to be provided to manager should be readily
intelligible. It must reduce ambiguity to the barest minimum.
(f) Cost/benefit analysis - The cost of the information to be obtained should be
less than the benefit to be derived from the information.

3.5 RISK AND INFORMATION PRESENTATION

Risk to a greater or lesser degree is present in all planning and decision making
situations. It may be as follows:
(a) the possibility of machine failure,
(b) the difficulties of forecasting inflation or exchange rates, and
(c) the effects of competition, changing tastes, government actions, etc.

Therefore, it is important that the preparer of information for planning and decision
making purpose presents the information in a manner which helps the manager to
understand the effects of risk on the problem being considered, how risks are likely to
affect the range of possible outcomes.

The effects of uncertainties can be presented in reports, statements and analyses in the
following ways:
(i) Results and outcomes are presented as ranges of values rather than single point
estimates.
(ii) Three points estimates (high, low and most likely) for analysis and presentation
purposes are used.
(iii) Probabilities are associated with the values and outcomes. This is so because of
its subjective nature. However, probability has been tested to provide possible
valuable insights to the underlying risks.
(iv) Sensitivity analysis may be used. This is a process by which the factors
involved in the situation, for example, sales volume, cost per unit, selling price
per unit and so on are varied one at a time and the effect on the outcome noted.

24
(v) Confidence limits may be applied more so when forecasts are involved.

3.6 LEVELS OF INFORMATION

Levels of information within an organisation (as distinct from information provided by

an organisation to external users, such as shareholders, the general public, pressure
groups, competitors, suppliers, customers, etc.) can be analysed into three:
(a) Strategic information - This is used by top management to plan organisations'
objective. Such information includes future market prospects, the availability
and cost of raising new funds, total cash needs, etc. Readers will note that
strategic information is orderly used as the management for decision-making,
called strategic planning.

(b) Management control information, also known as tactical information, is used by

middle management to ensure that the resources of the business are efficiently
and effectively employed, (use monitored) to achieve organisation strategic
objectives. Examples are productivity measurements (output per man hour or
per machine hour); budgetary control or variance analysis; profit result within a
particular department of the organisation; labour turnover statistics within a
department; short-term purchasing requirements, etc. Please note that a large
proportion of this information will be generated within the organisation, that is,
as feedback and is likely to have an accounting emphasis. Tactical information
is usually prepared regularly - perhaps weekly, or monthly (whereas strategic
information is communicated irregularly). Tactical information is used for the
decision-making called management control.

(c) Operational information is used by 'front-line' managers such as

foreman or head clerks to ensure that specific tasks are planned and carried out
properly within a factory or office. In the payroll office, for example,
operational information relating to day-rate labour will include the hours
worked each week by each employee, his rate of pay per hour, details of his
deductions and for the purpose of wages analysis, details of the time each man
spent on individual jobs during the week. Operational information relates to a
level of decision-making called operational control.

Time scale of using Information

"Historic" information might be used immediately (for operational control) but less
frequently for management control and only rarely for strategic planning. Information
can be collected and stored for future use, although presumably, there will be a limit to
its useful life.

Strategic planning may use information gathered several years previously and
associate it with current information from within the organisation and from the
environment, so as to analyse past trends in order to predict the future.

25
Management control may also use information several years old (to compare past and
current performance) but historic information is more likely to have a limited useful
life.

Operational control information has a short life-span in the design of a management

information system. Some thought must be given to how long information (or data)
should be stored, and to what uses they will eventually be put. One advantage of
computers has been the facility to store large volumes of data for a long period in a
manageable volume of space.

3.7 REPORTING BY EXCEPTION

There are physical and mental limitations to what a manager can read, absorb and
understand properly before taking action. An enormous mountain of information, even
if it is relevant, cannot be handled. Reports to management must, therefore, be clear
and concise, and in many systems control action, works basically on the 'exception'
principle. This is especially true of tactical information for management control.

Slight variations between actual result and the plan may be considered acceptable, and
corrective action is only applied when results exceed established tolerable levels.

Information Flow
Information should be communicated to the managers who need to use it for control
action. The structure of information flow - that is, how information is transmitted,
from where to whom - is an important consideration in management information
systems.

Information flow may be:

(a) vertical (down or up), or
(b) horizontal.

Vertical Communication
Communicating downwards, that is, from superior to subordinate may be:
(a) delegation of work, which involves giving information about objectives, job
instructions;
(b) information about procedures and practices in the organisation;
(c) telling the subordinate what the role of his job is in relation to the objectives of
the company as a whole, that is, job rationale;
(d) informing the subordinate how well or how badly he is doing his job; and
(e) indoctrination of the company's goals.

In practice, items (c), (d) and (e) are often too much neglected. The size of the
downwards communication loop is normally very small between a superior and his
immediate subordinate. Some information may come from higher management, for
example, statements about the goals of the organisation. But communication from the
top are often too general in character and too remote from what the employee thinks of

26
as practical reality to have any value.

Communicating upwards, that is, from subordinates to superiors may be analysed into
five types:
(a) Information by subordinates above himself, his performance and his problems;
(b) Information about others and their problems;
(c) Comments about organisational practices and policies;
(d) Suggestions about what should be done and how it could be done; and
(e) Reports on what has been done.

It is normal for communication upwards to be restricted so that a subordinate deals

with his immediate superior only

This communication-loop' will be larger if there is:

(a) a formal grievances procedure, that is, a channel for official complaints; and
(b) a formal suggestions procedure, that is, a system of encouraging suggestion for
improvement from employees.

Because reporting upwards is usually very restrictive, there are many inherent
communication problems (noise). A boss is unlikely to be given information by his
subordinates which affects him adversely, and it is also probable that bosses will be
told either what they want to hear or what the subordinates want them to hear.

The whole-hearted, well-informed support of all employees involved in

producing information is essential to the success of a system. Filling-in time sheets, for
example, can be done with widely differing attempts at accuracy by the people
concerned.

Horizontal Communication
Horizontal communication is between people at the same hierarchical level in the
organisation. It is necessary in two ways:

(a) formally: to co-ordinate the work of several people and perhaps several
departments, who have to co-operate to carry out a certain
operation. For example, a production department manager or foreman might
need to work in co-operation with a service department manager or foreman;
and an accountant may require the help of a management scientist or
statistician;
(b) informally: to furnish emotional and social support to an individual 'or a
course.

It is important that formal co-operation should not lead to a situation where a manager
accuses another of boundary crossing. Horizontal communications should be an
organised procedure or should be made only as a request for assistance, or as a
response to such a request.

27
The information requirements of superiors and subordinates do not always coincide, in
practice. What a subordinate wants to know is not always what a superior is prepared
to tell him and vice versa. The greater this conflict, the more the likelihood of
horizontal communication; as an escape value and also perhaps to get some essential
work done which would not otherwise be properly performed.

3.8 TIMING OF INFORMATION

Information which is not available until after a decision is made will be useful only for
comparisons and longer-term control.

The time value of information may be gauged by:

(a) the latest event (time) which the information covers: and
(b) the comparison control stage for which it will be used.

For example, weekly planning meeting in week two requires information about
production in week one in order to influence control action by week three at the latest.

The criteria for the time value of information apply to both regular information (daily,
weekly, monthly etc.) and ad hoc information (which is gathered on request or at
irregular intervals). In planning for the future, for example, what resources will be
required, management gives consideration to the 'planning horizon', which is the time
at which something will get done if a decision is taken now Future planning calls for
forecasts about the situation at that future date. To make the planning decision,
management must have the information it requires first. If the information is late, there
will be a delay in implementing the future plan.

Information prepared too frequently can be a serious disadvantage. If for example, a

decision is taken at a monthly meeting about a certain aspect of a company's
operations, information to make the decision is only required once a month and weekly
reports would be a time consuming waste of effort.

If control-information is provided later than it should be, perhaps because control

reports are too infrequent, then the consequence would be unnecessary losses that
could have been avoided and would thus be a much more difficult job to get actual
results back on the course for achieving targets.

Confidence / Risk
Information must be trusted by the managers who are expected to use it. An important
problem is, therefore, how much uncertainty analysis should be incorporated into
reporting systems, in order to make the information realistic. In the past, there has
been a reliance on historic cost data and a reluctance to recognize uncertainty in
estimating.

An important issue in the design of a confidence information system is to decide from

28
what source data should be collected and to what extent uncertainties in cost
estimation and sales demand, etc. should be analyzed. Historic costs provide valuable
information for budgetary control but they have restricted value for both routine and
once-only planning decisions.

Data generated by routine operations of the organisation can usually be collected

easily and cheaply. Special information from non-routine data often requires a lot of
planning and involves considerable expense, (much of it must be collected from
sources outside the organisation). For this reason, accounting systems are often unable
to supply non-routine data. This situation may change as data base information
systems are developed with computer technology and non-routine data can be stored
and accessed should a special purpose arise. The use of probability distributions
(perhaps from an analysis of historic information) and expected values or sensitivity
analysis, should feature in management amounting information more regularly than it
does in practice at the moment.

A risk decision taker, who wished to minimise his risk, for example, by taking a
decision where the standard deviation of expected profit is low or by using the
minimax cost or minimax regret criteria may value information more highly than a risk
seeker, who may be content to base his decision on expected values only.

Management accountants have the jobs of providing useful information to guide

management planning and control decision and 'as the usefulness of quantitative
decision models becomes more widely understood by managers, the demand for
information as model inputs will grow' (Source: Report of the American Accounting
Association Committee on Managerial Decision Model 1969).

Sources and Comprehensiveness of Information

Production of large volume of information is not necessarily an advantage and the
principle of exception reporting has already been described. Too much information
will confuse rather than help the manager receiving it. Information, however, must not
only be relevant and easily understood, but also need be detailed.

All sources from which relevant information may be obtained should be

tapped and the sources may either be:
(a) internal, that is, from within the company; or
(b) external, that is, from the external environment, including information about
competitors.

3.9 VALUE OF INFORMATION

For information to have value, it must lead a decision-maker to take action which
results in reducing costs, eliminating losses, increasing sales, better utilisation of
resources, prevention of fraud (audit requirements) or providing management with the
consequences of alternative courses of action. Information which is provided but not
used has no value.

29
A decision taken on the basis of information received also has no actual value. It is
only the action taken as a result of a decision which realize actual value of the
information for a company.

Value may, therefore, be considered as:

(a) Intrinsic: information has a value inherent in itself, for example, a company
knows there is a new machine which could increase output by 30%
(b) Potential: If a decision is taken to buy the machine in the example above, there
is the possibility of making a certain profit and this is the potential values of the
information.
(c) Actual: If the machine is bought, the actual extra profit earned will be the
actual value of the information.

The expected value of information would be assumed to be the maximum amount, a

user would be willing to pay for it. After the event, value measured in retrospect is of
little value because it does not help the decision in advance as to whether the
information is worth the cost of its collection. The information required for the
preparation of statutory reports has a latent value because it prevents the consequences
of what would happen if the company failed to produce them. The cost of collecting
information bears no relation to its value. An item of information which leads to an
actual increase in profit of N90 is not worth having if it costs N100 to collect it.

The cost of collecting information typically consists of:

(a) the costs of the MIS designers and installers; the wages and salaries of
employee operating the system; professional fees, for example, consultancy
fees;
(b) the costs of equipment used in the information system and supplies, such as,
paper consumed; and
(c) training costs;

Value and Frequency

The value of information must also relate to the frequency of its provision and to the
level in the management hierarchy where it is sent and used:
(a) front-line supervisors need more regular control information perhaps weekly or
daily; and
(b) middle managers and senior managers might need information less frequently,
say monthly, half yearly or yearly.

The benefits (value) from feedback of control information are usually a once only
gain. Once the fault has been identified and put right, there should be no scope for
further improvement, and repeated feedback of control information should be of little
value until the system gets out of control again. Arguably, continuous monitoring and
reporting may be unnecessarily costly. At the very least, the principle of reporting by
exception should be used.

30
The value of information also relates to:
(a) the ability of the receiver to understand it and use it;
(b) the purpose or decision for which it is intended to help; and
(c) the quality and availability of other information from different sources as
complements.
A user will value information more if it changes his decision from what it would
otherwise have been to a more optimal decision on the basis of the information
provided.

3.10 COMPUTERS (INFORMATION TECHNOLOGY)

Computers enable more data to be processed than would be possible by manual

methods, and in most mid-sized companies, a management information system
depends, at least to some extent, on their use. The costs of computers are high and it is
necessary to decide whether the values of information which would be obtained using
them is worth the cost of their installation and operation.

Although, computers often justify their expense, there may always be some areas,
where their application will be uneconomical. If a detailed study of costs and value is
made, it will be clear where computer could be used to advantage. No company should
embark on a programme to develop a major computer information system except to
meet a specific properly evaluated need. It is also necessary to remember that although
computers can process large volumes of data quickly, the information actually reported
to management should be concise and selective. A computer should be a means of
boiling a mass of data down to key facts on which action should be taken.

3.11 CLASSES OF REPORTS

Management Report
This refers to various statements prepared solely for the use of management , for
example, the budget, sales reports, etc. Management reports have no set standards and
format.

Corporate Report
(a) Objective: the fundamental objective of corporate reports is to communicate
economic measurements or an information about the resources and performance
of the reporting entity useful to those having reasonable rights to such
information.
(b) Users of corporate reports:
(i) The management;
(ii) Existing and potential shareholders;
(iii) Existing and potential holders of debentures and loan, providers
of short-term loans and finance;
(iv) labour unions and employees, including existing, potential and past
employees;
(v) Financial and investment analysts;

31
(vi) The government and government agencies;
(vii) The auditors;
(viii) The public at large;
(ix) The competitors.

(c) Corporate Reporting in Nigeria: Under The Companies and Allied Matters
Act, 1990 the directors of a company are required to prepare annually and to lay
before the shareholders in general meeting, audited accounts, together with a
report by the directors.
(d) Contents of the Annual Report: The contents of the annual report and
accounts of a company can broadly be categorised as those complying with the
requirements of professional bodies or industry associations, standards and
other regulatory framework or laws.

In addition to information falling under broad categories, it is common to find, in a

company's annual report and accounts, certain information which is published, not
because it is required by law or by any professional organisation but as a matter of
commercial convention and prudence. An example of this is the chairman's statement.

The annual report and accounts of companies published usually consist the following:
(a) The Chairman's statement
(b) The Director' s report
(c) Basic financial statements, that is:
(i) the statement of accounting policies;
(ii) the balance sheet:
(iii) the profit and loss account; and
(iv) the notes on the accounts;
(d) A statement of cash flow;
(e) The auditors' report;
(f) The Audit Committee's report;
(g) A statement of value added. In some cases, this is presented in the form of
pictorial illustration;
(h) A five year financial summary;
(i) Some other information such as directors shareholdings and shareholders with
more than 10% of the equity shares;
(j) An employment report;
(k) A statement of transactions in foreign currencies; and
(1) A statement of the future prospect.

4.0 CONCLUSIONS

Various packages are utilized for the purpose of managing information and they
include: executive information system which permits rapid information retrieval and
work by exception reporting and 'drilling down' the data and sensitivity analysis which
ensures the assessment of the effects of uncertainty.

32
5.0 SUMMARY
Management accounting is but one facet of the general information system of a firm.
Information is managed in order to ensure speed, accuracy, filing and retrieval
abilities, and decision making capabilities.

6.0 TUTOR MARKED ASSIGNMENT

1. Distinguish between data and information

2. State three qualities of information

3. What is a Management Information System?

4. Describe Tactical Information?

5. That information used by “front-line managers” such as head clerks is known

as________

6. That information used by senior managers to plan the objectives of their

organizations and to assess whether the objectives are being met in practice is
called_______

7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

33
UNIT 3 COST ACCOUNTING CONCEPTS AND PRINCIPLES

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Basic Definitions and Cost Concepts
3.2 Installation of a Costing System
3.3 Material Costing - Purchasing, Receipt and storage
3.3.1 Materials Control
3.3.2 Just-In-Time (JIT) Systems
3.3.3 Materials Requirement Planning (MRP)
3.4 Inventory Control
3.4.1 Carrying Costs or Holding Costs
3.4.2 Costs of Obtaining or Ordering Stock
3.4.3 Costs of being without Stock (Stock-out Costs)
3.4.4 Benefits of a good Inventory Control System
3.4.5 Economic Order Quantity
3.5 Material Costing - Pricing Issues and Stocks
3.6 Labour Costing
3.6.1 Personnel Engagement
3.6.2 Time Keeping for Control
3.6.3 Time Keeping for Accounting
3.7 Labour Remuneration
3.7.1 Just-In-Time (JIT)
3.7.2 Time Based Systems
3.8 Direct Expenses
3.9 Overheads
3.10 Activity Based Costing (ABC)
3.11 Cost Pools and Drivers
3.12 Activity Based Accounting (ABA)
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION
This unit will be treating the definition of cost accounting, principles of costing and
the concept of activity based accounting.

2.0 OBJECTIVES
In this unit, the readers will be to understand:
 The definition of basic cost accounting
 The principles of costing – material costing, labour costing and overhead

34
costing
 The concepts of activity based costing.

3.0 MAIN CONTENT

3.1 BASIC DEFINITIONS AND COST CONCEPTS

(a) Cost: A cost may be defined as 'the amount of expenditure (actual or notional)
incurred on or attributable to a specified thing or activity.

(b) Cost Unit: This is a unit of product or service in relation to which costs are
ascertained. The unit chosen is most relevant for the activities of the
organisation.

Examples:
Units of production Tables, TV sets, litres of paint, a job, a
contract, a crate of beer, tonnes of cement.

Units of service Consulting hours, guest-nights,

kilowatt hours, passenger-mile.

The primary classification of cost unit is as follows:

(a) direct cost; and
(b) indirect cost

(c) Direct Costs: These costs consist of direct materials, direct labour, and direct
expenses which can be directly identified with a job, a product or a service.

Examples:
Direct materials Raw materials used in the product; part and assemblies
incorporated into the finished product; bricks, timber,
cement, used on a contract

Director labour Wages paid to factory workers for work that are directly
related to production; salary paid to foreman.

Direct expenses Expenses incurred directly for a specific job, project or

saleable service, for example, royalties paid on barrel of
crude oil produced, tonnage of lime stone, etc.

The total of: Direct materials + direct labour + direct

expenses = Prime cost

(d) Indirect Costs: These are materials, labour and expenses which cannot be
directly identified with the product. These are also called overheads and can be
classified into administration, finance, selling, distribution and production.

35
Note
Prime cost + overheads = Total cost

(e) Cost Centre: This is a production or service location, function, activity or item
of equipment for which costs are accumulated (CIMA). Thus, in the cost centre
coding system, costs are gathered together according to their incidence. The
gathering together of the indirect costs results in the establishment of the
overheads relating to each cost centre which is an essential preliminary to
spreading the overheads over cost units.

(f) Cost Allocation: To assign a whole item of cost, or of revenue, to a single cost
unit, cost centre, account or time period (CIMA). It can also be defined as the
allotment of costs that are directly identifiable with, incurred by a production or
service cost centre.

(g) Apportionment: This process involves the sharing of indirect cost between two
or more cost centres or units on the basis of benefit derived by them using
relevant bases of apportionment. “To spread revenues or costs over two or
more cost units, cost centers accounts or time periods”, (CIMA). This process,
which is common for indirect costs, involves the splitting or sharing of a
common cost over the receiving cost centre on some basis which is deemed to
reflect the benefits received. The following table gives examples of typical
bases of apportionment.

Basis of Apportionment Costs which may be apportioned on this

basis
Floor Area Rates, Rent, Cooling, Cleaning, Lighting,
Building, Depreciation
Volume or space occupied Cooling, Lighting, Building Depreciation
Number of employees in each cost centre Canteen, Welfare, Personnel, General
Administration, Industrial Relations
Safety
Book or Replacement value of plant, Insurance, Depreciation
equipment, premises, etc.
Store Requisition Store-keeping
Weight of materials Store-keeping, material handling

(h) Overhead Absorption: "A means of attributing overhead to a product or

service based, for example, on direct labour hours, direct labour costs or
machine hours" (CIMA). This is calculated thus:

Total cost centre overhead

Total units of base to be used

(i) Conversion Cost: This is the term used to described the costs of

36
converting materials purchased into finished or semi finished products. It is thus
total production cost minus initial material input cost, that is, the sum of direct
wages, direct expenses and absorbed production overhead. Economists define
conversion cost as total cost less material costs, that is, all overhead are
included not just production overheads.

(j) Added Value Or Value Added: This can be defined as "Sales value less the
cost of purchased materials and services. This represents the value of an
alteration in form, location, or availability of a product or service", (CIMA).

(k) Marginal Costing: Marginal costing can be defined as: "the accounting system
in which variable costs are charged to cost units and fixed costs of the period
are written-off in full against the aggregate contribution. Marginal costing is
also known as 'contribution approach', and 'direct costing'. Its special value is in
recognising cost behavior and, hence, assisting in decision making" (CIMA).

Arithmetically, Marginal cost is:

Direct material + Direct labour + Direct expense + Direct variable expense +
Indirect variable expense.

The term marginal cost, at times, refers to the marginal cost per unit and also to
the total marginal costs of a department or batch or operation. One can deduce
its meaning from its context.

(l) Cost Objects: A cost object is any activity for which a separate
measurement of costs is desired. In essence, if the user of accounting
information wants to know the cost of product/service, that service/product is
called a "cost object". Examples are the cost of a product, the cost of rendering
a service to a bank customer or hospital patient, the cost of operating a
particular department or sales territory, or indeed anything for which one wants
to measure the cost of resources used.

(m) Avoidable Costs: These are savings in costs as a result of not altering or
adopting a given alternative, for example, advert, insurance, donation, etc.
Readers must note that only avoidable cost are relevant for decision making
purposes. The decision rule is to accept those alternatives that generate
revenues in excess of the unavoidable costs.

(n) Unavoidable Cost: Are those costs that cannot be saved. Therefore
unavoidable costs are irrelevant for decision making, for example, depreciation,
security cost, etc.

(o) Sunk Cost: This is a cost already incurred and therefore irrelevant to decision
making. It is synonymous with historical or past cost, for example, salaries and
wages paid, cost of machines already bought.

37
(p) Relevant Cost: A relevant cost is a future cash flow arising as direct
consequences of a decision.

(q) Opportunity Cost: This is referred to as foregone alternative cost.

(r) Incremental Cost (also known as differential cost) is the difference between
costs and revenue for the corresponding items under which each alternative
being considered.

(s) Target Costing: "A product cost estimate derived by subtracting a desired
profit margin from a competitive market price. It may be less than the planned
initial product cost, but will be expected to be achieved by the time the product
reaches the mature production stage" (CIMA). Target costing is a market driven
approach where market research establishes the performance requirements and
target selling price required to gain the desired market share for a proposed
product. The required profit margin subtracted from the target selling price to
arrive at the target cost for the product is cost which in the long run must be
met. Thus, accounting is driven by the requirements of the market place.

(t) Costing System: This refers to a collection of procedures used in

assigning cost to cost object. Typically, costing systems are classified as: direct
costing system, traditional absorption costing system and activity output based
costing systems.

3.2 INSTALLATION OF A COSTING SYSTEM

A costing system is not an arrangement which should be imposed on a business, rather

it should be developed from a careful consideration of the business itself, and its
special needs. It should, therefore, evolve out of the business and be adapted to it. The
aim should be to make the costing system as simple as possible and acceptable to the
accounting staff. Obviously, to be of any value, it must produce helpful results
promptly.

The following are essential to its success:

(a) There must be an efficient system of stores and stock control;
(b) There must be a well-designed wages procedure including the method of
allocating labour cost to production;
(c) There must be a sound plan for the collection of all indirect expense (overhead)
under suitable headings, and for its absorption to products or service
departments on a predetermined basis;
(d) The cost and financial accounts should preferably be one integrated system. If
not, the separate systems must allow for ease of reconciliation;
(e) Standard printed forms should be introduced wherever possible, giving the
name and containing instructions as to what use is to be made of it; and
(f) The status of the cost accountant should be defined and his responsibilities and
duties made clear. Adequate authority should be given to allow him access to

38
all relevant records.

3.3 MATERIAL COSTING - PURCHASING, RECEIPT AND STORAGE

3.3.1 Materials Control

Materials control involves the following procedures:

(a) Stock control;
(b) Purchasing;
(c) Reception;
(d) Storage; and
(e) Issue to production.

Stock Control
Management must give careful consideration to the stock levels to be maintained. This
applies to:
(a) Raw materials;
(b) Bought-in components;
(c) work-in-progress; and
(d) Finished goods.
Decisions on stock holding will be influenced by:
(a) Cash available;
(b) Storage space available;
(c) Storage costs such as premises costs, insurance of stocks and possibly interest
on capital invested in stocks;
(c) Delivery delays;
(d) Risks of stock losses, that is, wastage, pilferage, and obsolescence;
(e) Minimum ordering quantities imposed by purchasing policy;
(f) Purchase ordering (procurement); and
(g) Required service level to works or customer (whether it is essential that the
stores shall be able to meet every requirement on demand, and if not what
percentage of failure to meet demand can be tolerated).

Centralised Buying
In large businesses, buying is usually decentralised. In essence, each department is
responsible for its own purchasing. However, most businesses operate a buying
department, that is, centralised buying, which is usually a very satisfactory
arrangement.

Advantages of centralised buying are;

(a) A firm policy can be initiated with regard to conditions of purchasing e.g. terms
of payment;
(b) Standardisation of articles is facilitated;
(c) Expert buying staff are concentrated in one department;
(d) The number of people authorised to make purchase commitments is reduced;
and

39
(e) Combined purchasing power may result in reduced prices of commodities.

Disadvantages of centrahsed buying are:

(a) The creation of a special department may lead to high administration costs;
(b) The purchasing procedure is much less flexible than that geared to special
departments; and
(c) Bureaucracy may lead to sub- optimal decisions.

Store Records
Two records are usually kept on materials received, issued or transferred, namely:
(a) on the Bin cards, and
(b) in the stores ledger. The Bin cards are written up in the stores, but the stores
ledger is usually kept in the profit centres or in the accounts office.

The advantages in this procedure are:

(a) The Storekeeper is required to do the minimum amount of clerical work;
(b) The accounting records are maintained more accurately and in
a better condition by an experienced stores clerk than by an assistant in the
stores; and
(c) The balances on the bin cards in the stores can be easily
compared with the balances in the ledger.

Centralised Storage
The advantages of operating central stores as compared with sub-stores are as follows:
(a) Economy in staff and concentration of experts in one
department;
(b) Reduced clerical costs and economy in records and stationery.
(c) Better supervision is possible;
(d) Staff become acquainted with different types of stores which is very useful. If
anyone is absent from work;
(e) Better lay-out of stores;
(f) Stocks are kept to minimum, thus reducing storage space;
(g) Inventory checks facilitated;
(h) Fewer obsolete articles; and
(i) The amount of capital invested in stock is reduced.

The disadvantages are:

(a) Increased transportation costs;
(b) The stores may be situated at some distances from many
departments, thus causing inconveniences and delay;
(c) Breakdowns in transport or hold-ups in central stores may cause
production stoppages in departments; and
(d) Possible loss of local knowledge.

Periodic Stocktaking
Periodic stocktaking main objective is to find out the physical quantities of all types of

40
materials, that is, raw materials, finished goods, work-in-progress, etc. at a given date.

Factors to be considered are:

(a) Staff should be adequately available to receive clear and precise instructions on
the procedures.
(b) The stocktaking should be organised into clearly defined
physical areas and the checkers should count or estimate all materials in the
area.
(c) Technical assistance should be available to identify materials, etc. in order to
avoid far greater errors that are possible because of wrong classification rather
than wrong counting.
(d) Effort should be made to ensure that only valid stock items are included and
that invalid items are identified and excluded.
(e) Stock sheets should be given random independent checks to verify their
incorrectness.
(f) The quantities of each type of materials counted should be compared against the
stock record to expose any gross errors which may be due to stocktaking errors
or faults or errors in the recording system.
(g) The pricing and extension of the stock sheets, where done manually, should be
properly checked. Where the pricing and value calculations are done by
computer, the only action necessary would be to input quantities and stock and
part numbers.

Continuous Stocktaking
In order to avoid some of the disruptions caused by periodic stocktaking and to be able
to use competent and reliable staff, many organisations operate a system whereby a
proportion of stock is checked daily so that over the year, all stock is checked at least
once. Where continuous stocktaking is adopted, it is invariably carried out by staff
independent from the store officers.

Continuous stocktaking is essential when an organisation uses the Perpetual Inventory

system. This is a stock recording system whereby the stock balance is shown on the
record after every stock movement, either issue or receipt. Continuous stocktaking is
important to ensure that the perpetual inventory system is functioning correctly and
that minor stock mistakes are corrected.

Changes in Production and Purchasing Systems

There are a number of changes that takes place in industry which alters dramatically
the way products are made and the organisation of production. These changes
naturally influence supporting activities such as purchasing and storage.

3.3.2 Just-In-Time (JIT) Systems

JIT systems aim at producing the required items, of high quality, at the time they are
required. JIT systems are characterised by the pursuit of excellence at all stages with a
climate of continuous improvement.

41
JIT systems were developed and considered as one of the main contributions to the
success recorded by the Japanese manufacturing outfit.

Attributes of JIT are as follows:

(a) a move towards zero inventory,
(b) elimination of non-value added activities,
(c) an emphasis on perfect quality, that is, zero defects,
(d) short set-ups,
(e) a move towards a batch size of one,
(f) 100% on-time deliveries,
(g) a constant drive for improvement, and
(h) demand-pull manufacture.

It is these latter attributes which gave rise to the name of Just-in-Time. It is also
relevant to say that production only takes place when there is actual customer demand
for the product so JIT works on a pull-through basis which means that products are not
made to go to stock.

Exception to this is the traditional manufacturing approach of production-push where

products are made in large batches and moved into stock.

There are two aspects to JIT systems, JIT purchasing and JIT Production.

JIT Purchasing
This should match the usage of materials with the delivery of materials from external
suppliers. This means that material stocks can be kept at near-zero levels. For JIT
purchasing to work, it requires the following:
(a) Assurance that suppliers will deliver exactly on time.
(b) That suppliers will deliver materials of 100% quality and quantity so that there
will be no rejects, returns and consequent production delays.

The assurance of suppliers is all -important and JIT purchasing means that the company
must have good working relationships with her suppliers. This is usually achieved by
doing more business with fewer suppliers and placing long term purchasing orders in
order that the suppliers have assured sales and can plan to meet the demand.
JIT Production
JIT production, as earlier mentioned, works on a demand-pull basis and seeks to
eliminate all wastes and activities which do not add value to products. It considers the
lead times associated with making and selling a product. These include:
(a) Inspection time
(b) Transport time
(c) Queuing time
(d) Storage time
(e) Processing time.
Of these, lead times, only processing time adds value to product whereas all others add

42
cost.

The aim of ET systems is to convert materials to finished products with a lead time
equal to processing time in order to eliminate all activities which do not add value.
Away of emphasising the importance of reducing throughput time is to express the
above lead times as follows:

Throughput time = Value-added time + Non-valued added time

In using activity based system to identify and prioritise the need for cost reduction,
many organisations have found it convenient to categorise activities as either value
added or non value added.

Value added activity may be as an activity which customers

perceive as adding usefulness to the product or service they purchase.

Non-value added activity relates to an activity where there is an opportunity to reduce

cost (cost reduction) without necessarily reducing the product's service need to the
customer.

Under the JIT pull system, components are not made until requested
by preceding process. Consequent upon this, there may be idle time at
certain work station but this is considered preferable to adding to work-in-progress
inventory.

Implementation of JIT Production System

The following implementation stages are essential to achieve the targets of low
inventories and on time deliveries.
(a) The production processes must be simplified and reduced to the barest
minimum.
(b) JIT systems require quality awareness programmes, statistical checks on output
quality and continual staff training.
(c) The layout of the factory must be rearranged so that the production process is
separated away from a batch production functional lay-out. Conventionally,
factory machines are grouped by function. Their movement from one area of
the factory to another often stopping along the way in a storage area constitutes
non-value adding activities.
(d) The employees must be fully involved. It is relevant to state that one of the
most important behavioral implications of JIT is that the status quo is
continually challenged and there is a never ending search for improvements.

Benefits of JIT
(a) It reduces the investment on inventory.
(b) Due to low-inventory storage, there will be savings in the space required.
(c) Higher quality would result in customer satisfaction due to better deliveries.
(d) Elimination of waste and inefficiency improves performance.

43
(e) Due to the flexibility of JIT and the ability to supply small batches, companies
are able to respond more quickly to market changes and satisfy market needs.

3.3.3 Materials Requirement Planning (MRP)

Materials requirement planning is a computerised approach for coordinating the

planning of materials acquisition, information and production in enhancing smooth
production flow.

MRP main feature are:

(a) Estimation of the quantity and timing of finished goods demanded by the
customers.
(b) The system determines the requirements for each product into
its various components for efficient scheduling.

The operation of an MRP system requires the following:

(a) A master production schedule specifying both the timings and
quantities demanded.
(b) A Bill of Material file (BOM) which shows the breakdown of
each finished product into sub-assemblies components and raw materials.
(c) An inventory file containing the balance on hand, scheduled
receipts and numbers already allocated for each sub-assembly, component and
type of raw material.
(d) A master parts file containing planned lead times of all items
to be purchased and internally produced components.

MRP has evolved into MRP II which integrates material resources planning, factory
capacity planning and labour scheduling into a single manufacturing control system.

3.4 INVENTORY CONTROL

Inventory control is the system used in a firm to control its investment in stock. This
includes:
(a) the recording and monitoring of stock levels;
(b) forecasting future demands; and
(c) deciding when and how many to order.

The objective of inventory control is to minimise, in total, the costs associated with
stock. These costs can be categorised into three groups:

3.4.1 Carrying Costs or Holding Costs:

(a) Interest on capital invested in stocks.

(b) Storage charges (rent, lighting, heating, refrigeration, and air conditioning.
(c) Stores staffing, equipment, maintenance and running costs.
(d) Material handling costs.

44
(e) Audit, stocktaking, stock recording costs.
(f) Insurance and security.
(g) Deterioration and obsolescence.
(h) Pilferage, evaporation and vermin damage.

3.4.2 Costs of Obtaining or Ordering Stock

(a) Clerical and administrative costs of purchasing, accounting and goods reception
(b) Transportation costs
(c) Where goods are manufactured internally, the set-up and tooling costs
associated with each production run plus the planning, production control costs
associated with the internal order.

3.4.3 Costs of Being Without Stock (Stock - out Costs)

(a) Lost contribution through the lost sale caused by the stock out.
(b) Loss of future sales because customers may go elsewhere.
(c) Cost of production stoppages caused by stock-outs of work-in-progress and raw
materials.
(d) Extra costs associated with urgent, often small quantity, replenishment orders.

The basic reason why stocks are held in the first instance is to avoid stock out costs.

3.4.4 Benefits of a Good Inventory Control System

Benefits of a good inventory control system are:

(a) Ensures proper execution of policies covering procurement and
use of materials and make possible rapid shifts in business to meet changes in
market conditions
(b) Obtains economies through a reduction in needless variety of items carried in
stock.

(c) Eliminates delays in production caused by non-availability of required materials

and tools.
(d) Avoids over accumulation of inventories and tools and thereby maintain the
minimum investment consistent with production needs and procurement
policies.
(e) Reduces inventory losses caused by inadequate inspection of incoming
materials, damage, deterioration, obsolescence, waste or theft.
(f) Provides "balanced - stores" records to serve as a reliable basis
for effective production planning, economical procurement, cost accounting and
preparation of financial reports.

Over-stocking are stocks which are excess to current needs and it results in capital
being tied up unnecessarily and increased costs of storage and obsolescence. Under-
stocking may result in costly production holdups, which may mean increased costs of

45
goods. It also interrupts production, making machines and men idle and causing sales
loss.

3.4.5 Economic Order Quantity

In economic order quantity a formula is applied to incorporate

relationships between ordering/obtaining and holding costs and order quantities. It is
the quantity to be ordered that would minimize both ordering cost and holding cost

Assumptions in Economic Order Quantity (EOQ) Model

(a) The rates of demand are known,
(b) Ordering cost is known and constant,
(c) Stockholding cost is known and constant,
(d) There is instantaneous replenishment, that is, the delivery is done once.

Nevertheless, the EOQ calculation is a useful starting point in establishing an

appropriate reorder quantity.
The EOQ formula is given below and its derivation given in 'Quantitative Techniques',
continuum.

EOQ =

Where D = Demand per annum

Co = Ordering cost per order
Cc = Carrying cost per unit per annum

Readers are advised to have a look once again at ICAN Study Pack
Intermediate paper 4, Cost Accounting and Foundation paper 2 - Q/A for more in
depth discussion. Refer also to chapter 11 of this study pack.

ILLUSTRATION 3 – 1

Typical methods of calculating the major control levels: Reorder level. Minimum level
and Maximum level are illustrated below using the following data:

Average usage 200 units per day

Minimum usage 120 units per day
Maximum usage 260 units per day
Lead time 20 – 26 days
EOQ (previously calculated) 6,000 units

SUGGESTED SOLUTION 3 – 1

Reorder level = Maximum usage x maximum lead time

= 260 x 26

46
= 6,760 units

Minimum level = Reorder level – (average usage in average

Lead time)
= 6,760 – (200 x 23)
= 6,760 – 4,600
= 2,160 units

Maximum level = (Reorder level + EOQ) – (minimum

Anticipated usage in minimum lead time)
6,760 + 6,000 – (120 x 20) = 10,360 units

ILLUSTRATION 3 – 2

The forecast demand for XYZ Limited is 2,500 units per month, the ordering cost is
N450 per order, the units cost is N10 each and it is estimated that carrying costs are
15% per annum. Calculate EOQ for XYZ Company Limited.

SUGGESTED SOLUTION 3 – 2

C0 = N450
D = 2,500 x 12
Cc = N10 x 15%
= N1.5 per item per annum
Thus EOQ = = 4,243 units
Notes:
(a) It will be seen that it is necessary to bring the factors involved to the correct
time scale. The EOQ formula given above is for replenishment in one batch.
Where replenishment takes place gradually, for example, they are made, the
formula changes slightly as follows:

EOQ (with gradual replenishment) =

Where: R = Replenishment rate per annum.

ILLUSTRATION 3 – 3

The following information has been gathered with regard to material X of BODE Ltd.
Units
Normal month usage 24,600
Maximum anticipated monthly usage 27,000
Minimum anticipated monthly usage 6,400
Delivery period from suppliers:
Maximum 3 months
Normal 2 months

47
Minimum 1.2 month
Re-order quantity (EOQ) 10,000 units

Required:
(a) Calculate:
(i) Re-order level
(ii) Minimum stock level
(iii) Maximum stock level.

(b) Comment on four factors, which may have to be taken into accounts in setting
the maximum stock level

(c) The company required 80,000 units per year which will be used at a constant
rate. The purchasing manager is considering what size to be used. The holding
cost is 20% of the purchase price. The cost per order is N2,500 while the
purchase price is N24 per unit. Calculate Economic Order Quantity, using the
formula.

SUGGESTED SOLUTION 3 – 3

(a) (i) Re-order level

Maximum usage x maximum re-order period
= 27,000 x 3 = 81,000 units

(ii) Minimum stock level

= Re-order level – (normal usage x normal re-order period)
= 81,000 – (24,600 x 2) = 31,800 units

(iii) Maximum stock level

= Re-order level + Re-order quantity – (minimum usage x minimum re-
order period)
= 81,000 + 10,000 – (6,400 x 1.5)
= 81,400 units

(b) Factors to be considered in setting maximum level include:

(i) The availability of storage space
(ii) The nature of the stock material
(iii) Seasonal nature of the material
(iv) Lead time, that is length of period between placing and receiving orders.
(v) Rate of consumption of the material.

(c) Annual demand = D = 80,000

Holding cost = 20% x N24 = N4.8 = cc
Ordering cost = C = N2,500

48
EOQ =

EOQ =

= 9,129 units

3.5 MATERIAL COSTING – PRICING ISSUES AND STOCKS

There is no point in detailed analysis of pricing systems for charging purposes unless
the basic records are accurate and up to date. The system of issues, job recording,
scrap records, material returns, material transfers, defective material returns,
inspection records etc. must be continually monitored to ensure its relevance and
accuracy.

Objectives of Material Pricing

There are two main objectives of material pricing:
(a) To charge to production on a consistent and realistic basis the cost of materials
used; and
(b) To provide a satisfactory basis of valuation for inventory on hand.

Factors that affect Materials Pricing

Factors that affect materials pricing are:
(a) Frequent changes in prices for bought-in materials and components;
(b) The stock of any given material is usually made up of several deliveries which
may have been purchased at different prices;
(c) The frequent impossibility (and undesirability from a costing view point) of
identifying items with their delivery consignment; and
(d) The sensitivity of profit computations to the adopted pricing method where
materials form a large part of total cost.

General Features of Pricing Systems

When an issue is made from Stores, the Materials Requisition would be passed to the
cost department for pricing and an extension of appropriate ledger entries made:

Dr: Work-in-progress control A/C

(direct material issues)
Or
Overhead control A/C
(indirect material issues)

Cr: Store Ledger control A/C

To be able to use some of the pricing systems described below (For example, the FIFO
and LIFO methods) the stock recording system has to be comprehensive enough not

49
only to record overall quantities and prices, but also the number or quantity received in
any one batch. This is so that issues can be nominally identified against batches which
is necessary to establish the appropriate price to be charged.

Methods of Pricing Store Issues

(a) First in First out (FIFO)
Under this method, issues are valued at the price of the oldest batch in stock
until all units of the batch have been issued when the price of the next oldest is
used. In essence, as the issues are received, they are charged out to production.

(b) Last in First out (LIFO)

Under this method, issues are charged out at the price of the most recent batch
received and continue to be charged until a new batch is received, that is, the
last issues received are charged out first to production.

(c) Average price method

The average price method is a perpetual weighted average system where the
issue price is recalculated after each receipt taking into account both quantities
and value.

(d) Specific or unit price

The item issued can be identified with the relevant invoice where the actual cost
can be charged. This is usually only possible with special purpose items bought
for a particular job.

(e) Standard price

This is defined as:
"A predetermined price fixed on the basis of a specification of a product or
service and of all factors affecting that price" (CIMA). A standard or planned
price is an average price predicted for a future period and all issues/returns
would be made at the standard price for the period concerned. It uses the
expected purchase price as a standard.

(f) Replacement price

Under this method, issues are charged out at the buying price on the day of
issue. There are many variants to this approach. For example, buying prices
may be established by means of a price index or actual prices updated on a
monthly basis.

(g) Base stock method

This is not strictly a method of valuing issues, it assumes that initial purchases
were to provide a buffer or base stock and that this base stock should appear in
all subsequent stock valuations at its original cost.

A disadvantage of the base stock method is that the resultant stock values could

50
be totally unrealistic.

3.6 LABOUR COSTING

3.6.1 Personnel Engagement

Management will determine the optimum number of workers for each

department. Adequate communication must exist between the
personnel department, the factory and the wages office. The personnel department will
maintain records of past and present employees and, in particular, should obtain
reasons for all terminations of employment.

3.6.2 Time Keeping for Control

It is important that good time keeping is enforced. This is usually affected by time
clocks at the entrance to the factory or the individual departments.

3.6.3 Time Keeping for Accounting

It is essential to relate labour costs to individual jobs and processes and to achieve this,
it is necessary for each worker to record the time he spends on each individual activity.
The methods of time booking in existence are:
(a) Daily time sheet,
(b) Weekly time sheet,
(c) Job tickets,
(d) Job cards attached to each job, and
(e) Mechanical time booking.

The daily and weekly time sheets are prepared by the worker and should account for
all working hours.

The job ticket may be completed by the worker or the cost office relating to one
activity forming part of a job. As the activity is finished, the ticket is submitted to the
cost office which summarises all the tickets relating to a particular job in order to
ascertain the total costs thereof.

The job card actually circulates with the job and so it is not possible to ascertain labour
costs until the job is completed and the card returned to the cost office. In some
systems, the job card is returned weekly for cost control and is replaced by a 'balance
card' for subsequent time records. There are a number of mechanical devices available
today with which workers can 'clock' their time to specific jobs.

An analysis of labour is required for costing purposes for the following categories of
costs:
(a) production jobs, analysed by the numbers,
(b) indirect labour such as idle time or cleaning up,

51
(c) time taken setting up machinery analysed by job numbers.

3.7 LABOUR REMUNERATION

3.7.1 Just-In-Time JIT)

The modern forms of production organisation, such as Just-In-Time systems mean

more and more workers will be paid time rates and will not have their pay dependent
on individual output levels.

3.7.2 Time Based Systems

Basic System
Workers would be paid for the number of hours worked at a basic rate per hour up to
say, 40 hours in a week. Time worked in addition to 40 hours would be treated as
overtime and is usually paid at a higher rate, for example 'time and a quarter' (that is
11/4 x basic rate per hour) depending on the number of extra hours worked and when
the overtime was worked.

It is important to say here that although workers' pay is not related to output, this does
not mean that output performance is not relevant and fundamental. It is normal
practice to monitor output and performance closely by factory floor supervision and
managerial control systems so that workers are paid for actually working and not
merely attending or hanging around.

Advantages of time based system are:

(a) Easy to understand and administer
(b) Simplifies wage negotiations in that only one rate needs to be determined unlike
the continuous complex negotiations over individual rates.

Disadvantages:
(a) There is no incentive to increase output.
(b) All employees in the grade are paid the same rate regardless
of performance.
(c) It requires effective supervision.

High Day Rate System

This system is designed to provide a strong incentive by paying rates higher than the
normal rates in exchange for above average output and performance. For the
application of the rate system to be successful, it is necessary to ensure that the output
levels are the result of detailed work studies and that there is agreement with the
labour force and the unions involved on the required production level.

Merits of the High Day Rate System are:

(a) It attracts higher grade workers.
(b) It provides a direct incentive without the complications of individual

52
piecework rates.
(c) It is simple to understand and administer.

Demerits of High Day Rate System are:

(a) It encourages agitation for better remuneration to attract the best workers.
(b) It brings about problems when the original target production figures are not
met.

The system is also called 'Measured Day Work'.

Common Bonuses in Time-Based Systems

In addition to the time rates outlined above, bonuses or extra payments are frequently
made.

Example of bonuses are:

(a) Shift bonus: A worker agrees to work shifts particularly where rotating shifts
are used, he receives an extra amount.
(b) Timekeeping bonus: A person's timekeeping has been good over the week, a
bonus may be paid.
(c) Continuous working bonus: The plant achieves continuous
production without strikes, go slows or stoppages, necessitating a weekly bonus
payment.
INCENTIVE SCHEMES

General Features of Incentive Schemes

Under this scheme, payments are related to output in some way or another. There are
lots of variations. Some schemes apply to individuals while others apply to groups of
workers. Some have a direct and immediate relationship to output whilst others are
indirect In an organised and well planned system, both the firm and the employees can
benefit. The employee from the extra income arising from increased production, and
the firm from the reduced overheads per unit of the increased production. Regrettably,
not all schemes achieve this objectives. The following factors should be considered:

(a) Workers efforts should be taken into consideration and payment should be
made without delay.
(b) Employees should be able to calculate their own bonus, hence, simple scheme
should be introduced.
(c) Performance levels should be demonstrably fair, that is, they should be in reach
of the average worker, working reasonably hard.
(d) There should be no artificial limit on earnings and earnings should be
safeguarded when problems arise outside the employee's control.
(e) The scheme should not be introduced until there has been full consultation and
agreement with employees and unions.
(d) Performance levels, rates, etc must be considered, so that it will be on for a
reasonable length of life. Rapid changes especially artificial one curtail earnings
and therefore, destroy trust and cause problems.

53
(g) Employees should be consulted and agreement reached before the
implementation.

ADVANTAGES AND DISADVANTAGES OF INCENTIVE SCHEMES

Advantages
(a) It increases production, thereby increasing wages but also reducing overheads
per unit, particularly where there are substantial fixed overheads.
(b) It enables a firm to remain competitive in inflationary periods.
(c) It improves morale by ensuring that extra effort is rewarded.
(d) It attracts efficient workers towards the opportunity of earning
higher wages.

Disadvantages
(a) There are problems in establishing performance levels and rates with frequent
and continuing disputes.
(b) Some incentive schemes are expensive to administer and complex.
(c) Some group of workers, although relatively unskilled, may earn high wages
through incentive schemes whilst others engaged on skilled work may become
resentful when differentials are eroded.

Types of Incentive Scheme

(a) Individual Incentive Schemes
Incentive schemes which relate to an individual worker seem to be the more
usual and successful, probably because of the immediate and direct relationship
between effort and reward.

(b) Straight Piecework

The worker would be paid an agreed rate per unit for the number of units
produced. On occasions, the number of operations would be the basis of
payment, or where various types of articles are produced, a piecework time
allowance per article would be set and the worker paid for the piecework hours
produced.

(d) Group Incentive Schemes

It has been observed that individual based incentive schemes are common and
successful but using group scheme will be much ideal in some type of business.
Such businesses are:
(i) Road surfacing or local mining
(ii) Cars or domestic appliances.

Any of the incentive methods (piecework, differential piecework,

premium bonus systems, etc.) can be used, with appropriate adoption,
for group scheme. In addition, because of the wider scope of a group scheme,
incentives based on cost savings, delivery dates, quality norms are used.

54
MERITS AND DEMERITS OF GROUP SCHEMES

Merits
(a) It engenders closer co-operation in the group and a team spirit.
(b) It is simple to administer, especially with recording of labour times, production
rates etc.
(c) Support-workers, not directly associated with production, can easily be
included in the scheme.
(d) It reduces the number of rates to be negotiated.
(e) It encourages more flexible working arrangements within the group.

Demerits
(a) It is less direct than individual schemes. Provision of some incentive is difficult.
(b) It causes friction as it rewards both efficient and less
hardworking members of a group with same bonus.
(c) It is difficult to obtain agreement on proportions of the bonus
which group members will receive.

Trends in Labour Costing

Labour costs were a major proportion of total cost in the past. This means that it was
worthwhile carrying out a thorough analysis of labour costs and making the necessary
detailed accounting entries. The position today is very different Factories are highly
automated and labour is a small (and reducing) proportion of total cost. In these
circumstances simpler costing systems are being used for labour with some companies
eliminating direct labour accounting completely, and treating labour as part of
overhead.

It is important to note that:

(a) Incentive scheme may increase the labour cost per unit but as long as the
reduction in overhead cost per unit is sufficient, the scheme should be
worthwhile.
(b) Incentive schemes are not only applicable to manufacturing. The Federal
government is attempting to introduce 'Performance Related Pay' across the
public sector and civil servants, local government officials, teachers and others
are being targeted.
(c) It is a common costing practice to charge overtime wages above basic rate to
overheads rather than direct wages. For example, if the basic rate is N4 per hour
and overtime is paid at 'time and a quarter', then N4 per hour would be charged
to direct wages and N1 per hour charged to overheads.

An incentive scheme is any method of remuneration based on labour performance.

Such incentive schemes may relate to individuals or groups.
(a) Profit sharing
(b) Co-partnership
(c) Benefits-in-kind

55
Labour Reports
Regular reports should be prepared to indicate the efficiency (or otherwise) of labour.
These will include:
(a) Labour turnover report
(b) Comparison of labour time and costs with output
(c) Lateness reports
(d) Idle time reports
(e) Overtime reports.

Labour Cost Accounting

A brief description of the system is as follows:
(a) Clock cards (attendance records) are reconciled with time sheets (record of
work done),
(b) The employee's total 'gross' pay is credited to the payroll control account and
debited either to the work-in-progress control account for the amount allocated
to productive jobs, or to an overhead control for total non-productive time.
Readers are referred to the general accounting entries under general features of
Pricing Systems. The amount attributed to each individual job or overhead code
will be charged to the appropriate job card or overhead analysis account - these
being subsidiary records supporting the work-in-progress and overhead control
accounts. There are a number of alternative methods of making these bookings
in practice.
(c) Deductions from gross pay such as national insurance contributions, loan
refund and taxation will be debited to the payroll control account and credited
to control or suspense accounts pending disbursements to the relevant
authorities.
(d) The net wage paid to each employee will be credited to the
cash account and debited to the payroll control account which is thus cleared,

Labour Turnover
(a) Ratio Calculation
The labour turnover ratio is calculated using the standard formula:

Number of Employees that left and Replaced x 100%

Average Number of Employees

This formula is one of several which could be used but is chosen because it is
not affected by those leaving for whom no replacement is intended, for
example, redundancy, natural wastage. The average number of employees thus
remains fairly constant over the year, indicating quite clearly changes in the rate
at which personnel are leaving.

(b) Costs of Labour Turnover

These include:
(i) Costs of filling the vacancy, such as advertising, interviewing costs;
(ii) Costs of training, for example, induction courses, supervisor time;

56
(iii) Loss of production due to the difference in skill between the trained
employee and the trainee;
(iv) Higher scrap and wastage costs during initial training.

(c) Possible Remedies

Naturally, there is little that can be done to prevent employees leaving. Events
such as illness or pregnancy are outside the immediate control of the company
and can be classed as unavoidable. In order to reduce the avoidance loss to
manageable proportions, possible courses of action are as follows:

(i) Personnel Selection Deployment Procedures

These should be reviewed in order to ensure that not only are suitable
employees taken into the firm, but that every effort is made to fit them
into the right job.

(ii) Training and Development

Revision of the training and development programmes are advised to
ensure that employees have sufficient scope for promotion and personal
betterment.

(iii) Remuneration
The number of firms paying highly competitive wages is on the increase.
An investigation into the effect of possible wage increase is indicated.

(iv) Working Conditions and Welfare Facilities

A gradual decrease in the level of personnel can be traced in part to a
lack of consideration on the part of management to the social needs of
the employees.
Improvements in working conditions; welfare facilities and leisure
activities can assist in the development of a more stable work force.

ILLUSTRATION 3 – 4

From data below, you are required to compute the total earnings of the three
employees of Sangodiya Industries Limited for the month of July 2005.

Employee Units produced Rate per hour Time allowed per hour
Gemila 80 4.00 2.50 hrs
Chuks 100 3.00 3.00 hrs
Ahmed 60 3.50 4.00 hrs

Hours spent by employees

Gemila 100 hours
Chuks 250 hours
Ahmed 120 hours

57
Required: Calculate the gross pay for each of the employees based on the following
methods:
(i) Halsey using 50% of time saved
(ii) Halsey – Weir
(iii) Rowan

SUGGESTED SOLUTION 3 – 9

Calculation of Time Saved

Gemila Chuks Ahmed
Time Allowed (TA) 200 hrs 300 hrs 240 hrs
Time Taken (TT) 100 hrs 250 hrs 120 hrs
Time Saved (TS) 100 hrs 50 hrs 120 hrs

Time Allowed (TA) (80 x 2.50) (100 x 3.00) (60 x 4.00)

Halsey Scheme – (50% of Time Saved)

Gamila Chuks Ahmed

N N N
Normal pay (100 x 4) 400 (250 x 3) 750 (120 x 3.50) 420
Bonus (50% of TS) x N4 = 200 75 210
Total Earning 600 825 630

Halsey – Weir System – (331/3 of TS)

Normal pay 400 750 420

Bonus 1/3 of 100 x N4 133.33 50 140
533.33 800 560

Rowan System =
Gamila Chuks Ahmed
Normal pay 400 750 420
Bonus (100/200 x 100/1 x 4) 200 125 210
600 875 630

3.8 DIRECT EXPENSES

Direct expenses are those costs other than materials or labour which can be identified
directly with a particular cost unit. In many types of businesses, direct expenses will be
insignificant and as a matter of convenience, all expenses will be treated as indirect. In
other instances, particularly where work is carried out at a number of sites, such as
civil engineering, it will be possible to allocate the majority of the expenses directly to
a particular cost unit.

58
Examples
(a) Plant hire, if the plant is hired to manufacture a specific cost unit.
(b) Sub-contracting, where the jobs are sent out for special work
(c) Travelling expenses to sites, particularly for contractors.
(d) Royalty payments as royalties are charged as a rate per unit.
(e) Salesmen's commission as this is often based on the sales value of units.

3.9 OVERHEADS

Overheads are those costs which cannot be related to an individual cost unit. They are
identified, therefore, in the first instance with:
(a) Classification of cost in the ledger.
(b) Departments or cost centres where they can be controlled.
Overhead Charges
These can arise from the following:
(a) Material requisitions for small tools, consumable stores and other stock items
which are not customarily identified with production jobs.
(b) Time sheets for labour bookings to non-productive work, idle time etc.
(c) Supplier: invoices for goods such as stationery and for service such as
electricity, rent telephone charges etc.
(d) Petty cash vouchers for small disbursements.

Overhead Analysis
(a) Overheads are collected and analysed.
(b) Overheads are allocated to (identified with) production and service
cost centres.
(c) Overheads are apportioned to (shared among) production and service
centres.
(d) Service cost centre overheads are re-apportioned to productive cost centres.

(e) Cost units are charged according to the benefits they have received from each
cost centre. This means that they are allocated on an equitable basis.

Allocation and Apportionment

Some overheads arise solely because of the existence of a particular cost
centre. These overheads are direct, in view of the fact that, cost centre is concerned
and can be allocated to it.
The majority of overheads are not caused solely by one cost centre and it is, therefore,
not possible to allocate costs directly to individual cost centres. In these cases, it is
only possible to apportion costs on a reasonable basis.

Bases of Apportionment
There are many bases for apportioning overheads and the choice of a suitable basis is
largely a matter of common sense. Examples of overheads together with the manner in
which they might be apportioned are:
(a) Cooling and heating costs - number of compressors and radiators in each cost

59
center
(b) Rent-relative floor area in each cost centre
(c) Depreciation of machinery - capital values of machines.
(d) Canteen, Supervision, personnel - number of employees.
(e) Telephone costs- number of extensions
(f) Power- technical estimate.

Re-apportionment of Service Cost Centre Costs

Having charged all overheads to individual cost centers (production and
service), it is necessary to re-apportion all service costs center costs to the production.
The following are examples of the service cost centres to be found in a typical
engineering factory:
(a) Maintenance room
(b) Inspection
(c) Stores
(d) Canteen
(e) First aid
(f) Production.
The cost of the various departments will be apportioned to the productive cost centres
on the basis of the benefit received by each cost centre.

Reciprocal Service Cost

Where there are a number of service departments, they may supply their
services to one another as well as to productive departments. Finding an equitable
basis of apportionment may prove difficult because of the number of variable factors
involved. One of the following methods can be applied:
(a) Simultaneous equation
(b) Repeated distribution
(c) Apportioning the costs of the service centre which received least benefits from
other service centres first and then repeating the process until all service
department costs are apportioned.

OVERHEAD ABSORPTION

Definition:
“A means of attributing overheads to a production service based, for example, on
direct labour hours, direct labour cost or machine hours" (CIMA).

Having analysed overheads to productive cost centers, a fair share of these overheads
is charged to each of the cost units passing through a cost centre. This process is
termed 'overhead absorption'. In order to absorb overheads into cost units, the process
entails the computation of an overhead absorption rate. This is computed by the
following formula:

60
Total cost centre overheads
Total units of base to be used

There are many bases for absorption. Some of them are as follows:
(a) % of Direct materials cost
(b) Direct labour hours
(c) % of Direct labour cost
(d) % of Prime cost
(e) Machine hours
(f) Units of output/production.

The absorption rate is normally based on budget cost and output figures.

Budgeted output [units] 30,000 25,000

Total budgeted overheads N400,000
Calculate the overheads absorbed by production according to:
(a) % of Direct materials cost
(b) Direct labour hours
(c) % of Direct labour cost
(d) Machine hours

Argument for Absorption Overheads

(a) The main argument for absorbing overheads costs is that they must be
recovered if the firm is to make profit and the best way to recover overheads
costs is to charge each department and ultimately, each product with a share of
them,
(b) Another problem is the nature of the overheads which are charged to products.
They will usually be combination of two different classifications:
(i) Those which vary with the level of output (variable overheads)
(ii) Those which remain at a constant level, regardless of the level of
production (fixed overheads)

Pre-determined Overheads Absorption Rates

To obtain accurate costs, it is necessary to wait until the end of the accounting period
to obtain the total costs and the total units of the base of absorption. In seasonal types
of business, it will be necessary to wait for the end of an accounting cycle in order to
obtain the necessary information.

In practice, it is not usually possible to wait until the end of an accounting period
before preparing costing information and it is necessary to use estimated figures. Such
estimates are termed "pre-determined overhead absorption rates" and are calculated in
the following way:

Budgeted overheads for future period

Budgeted units of base for future period.

61
Over And Under Absorption
With pre-determined overhead rates, it will almost always be found that actual
overheads incurred differ from the amount of overheads absorbed. This over-or under-
absorption may be caused by two factors:
(a) Difference between actual and budgeted overheads
(b) Difference between actual and budgeted units of base.

Blanket Absorption Rate

A blanket absorption rate is one which is applied to a whole factory Such a rate fails to
distinguish between cost units which incur a large amount of overhead in mechanised
processes and those which incur a smaller amount of overhead in manual processes. A
blanket absorption rate can produce completely erroneous results.

Non-Production Overheads
The same principle with respect to production overheads shall also apply to non-
production overheads.
(a) Selling overheads should not be absorbed into the cost of goods produced since
the selling cost is part of administration overheads. The source documents for
these entries are material requisitions [indirect materials], time sheet [non-
productive time], the invoice analysis for purchase on credit and possibly, an
analysis of petty cash payments. There will also be some overheads derived
from internal calculation such as depreciation charges.
(b) The total factory overheads are analysed to cost centres on sheets sometimes
called standing order numbers. This is a two way analysis, each standing order
number containing a particular type of cost and analysing it across productive
and service cost centres.
(c) Non-productive overheads are analysed on similar sheets called cost account
numbers.
(d) The total of the standing order numbers are summarised into a departmental
distribution summary and this in turn forms the basis for the computation of the
overhead absorption rate of the department concerned.
(e) Overhead absorbed [applied] is entered on the individual job or process record
and debited in total to the work-in-progress account. The corresponding credit
can be made to the overhead control account.
(f) The individual job or process records may show only works cost, or percentage
additions may be made for the non-productive overheads.

Depreciation
Depreciation charges are intended to represent the diminution in the value of a fixed
asset due to use or lapse of time. Provision for depreciation may be calculated by any
of the following methods:

(a) Straight-line: Under which the cost of an asset, possibly after deducting its
forecast residual value, is written off by equal annual installments over its
useful life. For example, an asset may have cost 5,000 and is expected to be

62
used for five years after which it will be sold as scrap for 200. The annual
depreciation charge will be:

N5,000 - N200 = N960

5
(b) Reducing Installment: Under which depreciation is calculated each year at a
fixed percentage of the residual asset value. For example, you are to depreciate
the asset costing N5,000 at 15% per annum. In this case, the first year's
depreciation would be 15% x N5,000 = N750. The second year's charge would
be 15% x [N5,000 -750] = N637.5 and so on.

(c) Production unit: This is a method entirely based on use. An estimate is made of
the number of units to be processed by a machine during its lifetime, and the
cost of the machine is divided by that number of units to give a unit rate of
depreciation. The depreciation charge for any year will be found by multiplying
the number of units produced by the unit rate.

(d) Production hour: This is similar to the production unit method, but using the
forecast number of working hours in the effective life of the machine instead of
the number of units it will produce.

The maintenance of an asset register will facilitate the calculation of depreciation,

provide continuous record of residual values, and enable depreciation charges to be
allocated to cost centres.

Interest: This is usually omitted from costing records. It is advisable to bring interest
into account in special report for decision making where it is significant.

Taxation: This should be considered in decision making when comparing alternative

courses of action especially under investment appraisal.

3.10 ACTIVITY BASED COSTING [ABC]

This has developed to resolve the defects that conventional absorption costing absorbs
support overheads into product costs. Traditionally all overheads were absorbed on
production volume [measured as labour or machine hours] although, many support
overheads vary, not with production volume, but with the range and complexity of
production.
ABC is a recent approach to product costing, pioneered by Professors Kaplan and
Cooper of Harvard University. ABC is aimed at using only cause and effect cost
allocations. It is an attempt to reflect more accurately in product costs, those activities
which influence the level of support overheads.

This includes such items as inspection, production planning, set-up tooling and other
costs. Traditionally, all overheads were absorbed in production volume as measured by
labour or machine hour.

63
Traditional volume related overhead absorption tends to over-cost products made in
the long run and under cost products made in the short run. ABC seeks to overcome
this problem in the following ways:
(a) short-term variable costs
(b) Long-term variable costs

(a) Short-term variable costs

ABC recognises that there could be several costs drivers wherever labour hours,
machine hours and material costs are used in different proportions by products.
In most organisations, there will only be a small proportion of overheads that
can be classed as short-term variable costs.

(b) Long-term variable costs

These are overhead costs which do not vary with production volume but vary
with other measures of activity, for example, costs for support activities such as
stock handling, production scheduling to the range and complexity of the
products manufactured.

ABC requires that these costs be traced to products by transaction based cost
drivers. Most support overhead can be classified as longterm variable costs and
thus traced to products using appropriate cost drivers such as making
procurement order. In the traditional system, most of these would be classified
as fixed.

(c) Fixed costs Using

ABC, these are classified as costs which do not vary, for a given
time period with any activity indicator. An example would be the salary of the
Managing Director. Research conducted by Kaplan and Cooper (1992) suggests
that these are a relatively small proportion of the total costs.

3.11 COST POOLS AND DRIVERS

Cost Pools
Cost pools can be defined as "The point of focus for the cost relating to a particular
activity in an activity-based costing system" (CIMA).

There are difficulties in choosing realistic cost drivers Kaplan and Cooper (1992)
warns:
"There are no simple rules that pertain to the selection of cost drivers. The best
approach is to identify the resources that constitute a significant proportion of the
products and determine their cost behaviour If several are long-term variable costs, a
transaction based system should be considered"

64
Cost Drivers
"Any factor which causes a change in the cost of an activity e.g. the quality of parts
received by an activity is a determining factor in the work required by that activity and
therefore affects the resources required. An activity may have multiple cost drivers
associated with it" (CIMA).

It may be decided that an activity based system is required then the appropriate cost
drivers are chosen and the costs associated with each activity are gathered together in
cost pools.

Cost pools are similar in principle to cost centres in traditional system. Costs are
pooled, or collected, on the basis of the activity that drives the costs regardless of
conventional departmental boundaries. For example, if the cost driver is a number of
set-ups, then all costs relating to activity of setting-up will be pooled together.

Cost pools are not necessarily related to departmental boundaries nor do they include
all the activity of a single department as the cost drivers may differ for the various
activities carried out within the same department.

Selecting Cost Drivers

Basically, there should be a direct cause relationship between the consumption of
overheads and the chosen cost driver. There should be a causal relationship between
the amount of resource use, and therefore, the level of cost, and the volume of the
selected cost driver. The relationship is not necessarily a short-term one. This is
because salaries and related personnel costs make up a significant proportion of most
support overheads and these costs are not easily adjusted in the short-run, hence;
Kaplan (2001) defines it as 'long-run variable costs'.

Factors that affect Cost Drivers

The factors that most likely affect cost drivers are;
(a) Accuracy
The greater the level of accuracy required of product costing, the more the cost
drivers.

(b) Correlation
The more closely a cost driver correlates with activity use, the fewer distortions
in products cost and the fewer cost drivers.

(c) Homogenity
The cost pool should be homogenous. It can fairly be represented by one cost
driver. Where this is not possible, the pool may need to be sub-divided and
numerous cost drivers used and the resultant effect make the system more
complex and costly to administer.

(d) Inspection
This is the extent that one cost can be fairly applied to diverse products. If the

65
cost driver, 'number of inspections' was used to trace Inspection costs to
products, distortions will be introduced. If inspections take varying amounts of
time for different products, inspection hours may be a better cost driver or there
may be a need for several cost drivers to trace cost fairly.

Cost Drivers used in Practice

Conventionally, the cost pools and cost drivers chosen must suit the organisation, the
products or services and the objectives of the ABC system. As a consequence, they
will vary from organisation to organisation and there are, no universally applicable
examples.

Example of Cost Driver Calculation and Use

An organisation introduced ABC and has separated its main activities into reasonably
homogenous cost pools. Cost drivers have been selected for each pool.

(a) It provides realistic product costs most especially in Advanced Manufacturing

Technology [AMT] factories where support overheads are a significant
proportion of total costs.
(b) It enhances the tracing of overheads to the product. In modem factories, there
are a growing number of non-factory floor activities. ABC is concerned with all
activities.
(c) It recognises activities which cause cost, and not products.
(d) It focuses attention on the real nature of cost behaviour and helps in reducing
costs and identifying activities which do not add value to the product.
(e) It also recognises the complexity and diversity of modern production by the use
of multiple cost drivers, many of which are transaction based rather than based
solely on production volume.
(f) It provides a 'reliable indication of long-run variable product cost which is
relevant to strategic decision making.
(g) It is flexible to trace costs to processes, customers, areas of managerial
responsibility, as well as products costs.
(h) It also provides useful financial measures, for example, cost driver rates and
non-financial measures - transaction volumes.

Demerits of ABC
These include:
(a) the preference for particular cost drivers - it is a simplistic assumption that a
chosen cost driver is an adequate summary measure of complex activities.
(b) the assumption of a direct linear relationship between the usage of a cost driver
and the amount of overheads. It is widely known that very few costs are truly
variable, whether in the short or long term.
(c) the issue of common costs - it is difficult to attribute costs to single activities;
hence, some costs support several activities.
(d) tracing difficulties - It is not always apparent which product should carry the
traced overhead.
(e) Complexity - A full system having numerous cost pools and cost drivers is

66
more complex and consequently more expensive to operate. This need not be a
problem provided that the benefits outweigh the costs.

3.12 ACTIVITY BASED ACCOUNTING [ABA]

Activity Based Accounting is a new approach to internal accounting. It focuses on

analyzing, recording, controlling and reporting on the costs and wider performance of
activities rather than the conventional emphasis on merely the costs of departments
and cost centres.

Activity based accounting includes:

(a) Activity Based Costing [for product costing],
(b) Activity Based Budgeting or Activity Cost Management [for cost planning
and control] and
(c) Activity Performance Measurement [for performance monitoring using both
financial and non-financial indicators]. All these approaches are covered in
detail later in the study pack. It has strong behavioural influences and is widely
used to promote cost reduction and increase efficiency

4.0 CONCLUSIONS

Cost accounting system largely focuses on the analysis of past costs and operations.
The prime cost is the addition of the total direct material plus direct labour plus direct
expenses while the total indirect costs is referred to as overhead.

Overheads are determined by defining cost centres and then allocating and
apportioning costs to the cost centres using bases of apportionment which are deemed
to reflect the benefits received. These overheads are spread over cost units by adopting
overhead absorption rates usually based on labour or machine hours.

Where all costs whether variable or fixed are included in production costs, the system
is "absorption costing" and where fixed costs are excluded from production costs and
charged as period costs, the system is referred to as "marginal costing".

The major material pricing systems are FIFO, LIFO, replacement price, weighted
average price and standard price.

ABC collects overheads into cost pools and traces these to products using cost drivers
with overhead being long term variable costs that vary more with product complexity
and diversity than production volume.

Cost pools are homogeneous and are single cost drivers that relate directly to the
amount of resources used.

ABC has strong behavioral influences and is widely used to promote cost reduction
and increase efficiency.

67
5.0 SUMMARY

This unit has attempted to a large extent to discuss the various principles, concepts and
elements of cost accounting. And also show their relationship.

6.0 TUTOR MARKED ASSIGNMENTS

1. Peju Limited had an opening stock value of 300 units valued at N8.80 each on 1
April, 2005. The following receipts and issues were recorded during the month
10 April Receipt 1000 units N8.60 per unit
23 April Receipt 600 units N9.00 per unit
29 April Issue 1700 units.

Using the LIFO method, what was the total value of the issue on 29 April 2005?
A N14,840
B N14,880
C N14,888
D N15,300
E N15,960

2. Prime cost is:

A all costs incurred in manufacturing a product
B the total of direct costs
C the material cost of a product
D the cost of operating a department
E the cost of administrative and direct expenses.

3. Femi Limited has a component with a safety stock of 1000, a re-order quantity
of 6000 and a rate of demand which varies between 400 and 1400 per week.
The average stock is approximately:
A 4000
B 4600
C 5000
D 7000
E 6500
4. The process cost apportionment is carried out so that
A cost may be controlled
B cost units gather overheads as they pass through cost centre
C whole items of cost can be charged to cost centres
D common costs are shared among cost centres
E costs are shared equally.

5. Over-absorption overheads occurs when

A absorbed overheads exceed actual overheads
B absorbed overheads exceed budgeted overheads

68
C actual overheads exceed absorbed overheads
D budgeted overheads exceed absorbed overheads
E over-absorbed overheads exceed budgeted overheads.

6. Give three examples of absorption rate.

7. What is Activity Based Costing?

8. What is labour turnover?

9. What is the formula for pre-determined absorption rate?

10. What is blanket absorption rate?

7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

UNIT 4 COSTING METHODS

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Costing Method Defined
3.2 Categories of Costing Methods
4.2.1 Costing Methods and Costing Principles

69
3.3 Job Costing
3.4 Batch Costing
3.5 Contract Costing
3.5.1 Contract Plant
3.6 Process Costing
3.6.1 Determination of Cost Unit
3.6.2 Process Losses
3.6.3 Normal Process Losses
3.6.4 Abnormal Process Losses
3.6.5 Valuation of Opening Work-In-Progress (WIP)
3.6.6 Valuation of Closing Work-In-Progress (W1P)
3.6.7 The Concept of Equivalent Units
3.7 Joint Product
3.7.1 Joint Product Costing
3.7.2 Apportioning Joint Costs
3.7.3 The Notional Sales Value Method
3.7.4 Joint Products in Service Organizations
3.8 By-Product Costing
3.9 Miscellaneous Revenue
3.9.1 Comparative Value
3.9.2 Standard Price
3.9.3 Service / Function Costing
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignments
7.0 References/Further Readings

1.0 INTRODUCTION

In this unit, It must be clearly understood that whatever costing method is employed,
the basic principles relating to analysis, allocation and apportionment of costs will be
used.

2.0 OBJECTIVES

In this unit, readers will be able to understand:

 Costing methods
 Job costing, batch costing and contract costing
 Process costing, joint-product and by-product; and
 Service costing.

3.0 MAIN CONTENT

70
3.1 COSTING METHOD DEFINED

This is a method that is used to determine the amount or value of the economic
resources used in producing a product or providing a service.
Costing method should be designed to suit the objective of a business enterprise. The
objective could be to determine the unit cost of a product from the manufacturing
process; the contract cost in a construction outfit; the cost of executing specific jobs,
etc.

3.2 CATEGORIES OF COSTING METHODS

A costing method is designed to suit the way goods are processed or manufactured or
the way that services are provided. It follows, therefore, that each firm will have
costing methods which have unique features. Nevertheless, there will be recognizably
common features of the costing systems of firms which are broadly in the same line of
business.

Conversely, firms employing substantially different manufacturing methods, for

example, a food processor and a jobbing engineering factory, will have distinctly
different costing methods.

Categories of Costing Methods

There are two broad categories of product costing methods, namely: specific order
costing and continuous operation/process costing.

(a) Specific order costing

This is defined as: The basic cost accounting method applicable where work
consists of separately identifiable contracts, jobs, or batches." (CIMA).

The main sub-divisions of specific order costing are:

(i) Job costing
(ii) Contract costing
(iii) Batch costing

Specific order costing is employed where each cost unit is different from any
other cost units and where certain job re-occur from time to time and it is
desirable to determine their costs afresh each time they occur.

(b) Continuous operation/ process costing (sometimes called unit costing). This is
defined as; "The costing methods applicable where goods and services result
from a sequence of continuous or repetitive operations processes, Costs are
averaged over the units produced during the period, being initially charged to
the operation or process," (CIMA).

COSTING METHODS CHART

Continuous/ Specific
operation order
71
cost costing
Fig. 4.1 Costing Methods depicted by categories.

The dotted line indicates an area of overlap between the two major categories.
Although each batch is separated and identifiable and may be different from any other
batch, within a given batch there will be a number of identical cost units over which
the total batch costs will be averaged.

3.2.1 Costing Methods and Costing Principles

A unique difference between the principles of costing with regard to specific order
costing and operation costing, is that, with operation costing, all costs, that is, labour,
materials and overheads are allocated or apportioned to a cost centre from which these
costs are shared out over the cost units produced. This differs from specific order
costing,

3.3 JOB COSTING

Job costing is defined as: "A form of specific order costing in which costs are
attributed to individual jobs." (CIMA).

Requirements of Job Costing

The main purposes of job costing are to establish the total cost of a job, the profit or
loss on each job, and to provide a valuation of work-in-progress.

A successful job costing system. requires:

(a) A good and reliable system of production control.
(b) Effective works documentation.
(c) An adequate and efficient time booking system using either time cards or
piecework cards.
(d) A clearly defined costing system that ensures costs incurred are captured
accurately.

ILLUSTRATION 4 - 1

72
The data below relate to a single accounting period in a jobbing engineering works of
Uoroho Engineering Limited.

Extracts from Job Cost Cards

Opening Charged Closing
W-I-P during W-I-P
Period
N N N
Materials 5,310 16,420 6,315
Labour 7,625 26,630 8,085
Production overhead 5,415 16,760 4,630

The financial accountant supplied the following information relating to the same
period:
N
Materials purchased 19,575
Marketing and admin. overheads 6,390
Production overheads 15,310
Sales 73,165

The opening stock of material was N9,200. All completed jobs are invoice
immediately to customers. Please note that the Cost Department recovers selling and
administrative overheads at the rate of 10% of the cost of completed jobs.

Using the above information, you are required to write up the Cost ledger and prepare
a Costing Profit and Loss Account for the period, assuming that the firm operates an
interlocking system with separate financial and cost accounts. Financial control
balance brought forward and work-in-progress were N22,950 and N18,350
respectively.

SUGGESTED SOLUTION 4 – 1

Cost Ledger

Cost Control Ledger Account

N N
Balance b/f 22,950
Sales 73,165 Purchases 19,575
Marketing + Admin. 6,390
Balance c/d 26,785 Prod. Overheads 15,310

73
Wages 26,630
Profit 9,095
99,950 99,950
Balance b/d 26,785

W.I.P Control
N N
Balance b/f 18,350
Material 16,420 Cost of Sales 59,130
Wages 26,630 Balance c/d 19,030
Prod. Overhead 16,760
78,160 78,160
Balance b/d 19,030

Stores Control
N N
Balance 4,600 W.I.P 16,420
Cost Control Ledger 19,575 Balance c/d 7,755
24,175 24,175
Balance b/d 7,755

Production Overhead Control

N N
Cost Control Ledger 15,310 W.I.P 16,760
Overhead Adjustment 1,450
16,760 16,760

Wages Control
N N
Cost Control Ledger 26,630 W.I.P 26,630

Marketing and Admin. Overhead Control

N N
Cost Control Ledger 6,390 Cost of Sales 5,913
Overhead Adjustment 477
6,300 6,390

Cost of Sales
N N
W.I.P 59,130

74
Marketing + Admin. 5,913 Profit and Loss 65,043
65,043 65,043

Overhead Adjustment
N N
S&D 477 Production Overhead 1,450
Profit and Loss 973
1,450 1,450

Costing Profit and Loss Account

N N
Cost of Sales 65,043 Sales 73,165
Profit c/d 9,095 Overhead Adjustment 973
74,138 74,138
Profit b/f 9,095

3.4 BATCH COSTING

Batch costing is the application of the principle of cost accumulation in circumstances

where a quantity of identical articles are manufactured as a batch.

Generally, the procedures for costing batches are similar to costing jobs. The batch
would be treated as a job during manufacture and the costs collected. It is significant to
state that on completion of the batch, the cost per unit is calculated by dividing the
total batch cost by the number of good units produced. In like manner, the cost of the
bad units are absorbed by the good units. Batch costing is prominent in the engineering
component industry footwear and clothing manufacture.

In essence, cost per unit = Total batch cost

No. of good units produced

ILLUSTRATION 4 – 2

Yetunde Company Ltd. manufactures Footwear and Clothing materials and has the
following budgeted overheads for the year, based on normal activity levels.

Department Budgeted Overhead

Overhead Absorbed Base
Leathering N36,000 3,000 labour hours
Machining N86,000 5,000 machine hours
Welding N40,000 3,600 labour hours

75
Sewing N30,000 2,000 labour hours

Marketing and Administrative overheads are 20% of factory cost. An order for 500
footwear, made as batch 1202, incurred the following costs:

Materials: N6,214
Labour: 256 hours Blanking Shop at N10.50/hour

850 hours Machining Shop at N11.00/hour

180 hours Welding Shop at N10.50/hour
350 hours Assembly Shop at N9.60/hour

N1.050 was paid for a hire of an equipment. The time booking in the machine shop
was 1,286 machine hours.
You are required to calculate the total cost of the batch, the unit cost and the profit per
assembly if the selling price was N200.

SUGGESTED SOLUTION 4 – 2

The first step is to calculate the overhead absorption rates (OAR) for the production
departments.

Leathering = N36,000 = N12.0 OAR per labour hour

3,000
Machining = N86,000 = N17.2 OAR per machine hour
5,000
Welding = N40,000 = N11.1 OAR per labour hour
3,600
Sewing = N30,000 = N15.0 OAR per labour hour
2,000

Total cost – Batch No. 1202 N

Direct Material 6,214
Direct Expense (Equipment hired) 1,050

Direct Labour 256 x 10.50 = 2,688

850 x 11.00 = 9,350
180 x 10.50 = 1,890
350 x 9.60 = 3,360 17,288
Prime Cost 24,552

Production Overhead Absorption N

Leathering 256 x 12.0 = 3,072

76
Machining 850 x 17.2 = 14,620
Welding 180 x 11.1 = 1,998
Sewing 350 x 15.0 = 5,250 24,940
Factory Cost 49,492
Marketing and Administrative Overhead
(20% of factory cost) (N49,492 x 0.20) = 9,898
Total Cost 59,390
Total Cost/Unit = 59,390
500
N
= 118.78
Profit/Unit = 81.22
Selling Price = 200.00

3.5 CONTRACT COSTING

Contract costing has many similarities to job costing and is usually applied to work
which is:
(a) Undertaken according to customer’s specification
(b) Relatively long duration
(c) Site based, out of main office
(d) Frequently of a construction nature

In view of the long time scale and size of construction contracts, the necessity arises
for periodic or intervals valuations to be made of work done and for progress payments
to be received from the client.

3.5.1 Contract Plant

One of the characteristic of most contract work is the amount of plant used. This
includes cranes, trucks, excavators, mixers, and lorries. The usual ways in which plant
costs are dealt in the accounts are:
(a) Lease plant. The lease rental is charged directly to the contract.
(b) Plant purchases. Two methods may be used.
(i) The plant depreciation.
(ii) Contract account concerned are charged when plant are transferred to the
company.

Architect's Certificate in Relation to Construction Contracts

A contract provides for the client to make progress payments at specific intervals, for
example, when foundation are completed, first floor completion, etc.

You are to assume that a contract has been completed up to 90%, a certificate will be
issued by the Architect. This certificate is called Architect certificate. The unpaid
balance of 10% will be retained after the successful completion of the work. This fee is
called retention fee.

77
Profit contract
The purpose of contract costing is to show the profit and loss on each completed
contract. When a contract is still in progress at the end of the financial year, a portion
of the profit earned is provided in the financial statement (that is part of the total
contract profit) in order to avoid excessive fluctuations in company results from year
to year. Also, it is relevant to provide a realistic figure of the value of work-in-progress
for balance sheet purposes.

Provision should be made for anticipated losses.

A format of the contract income calculation is as follows:

N N
Total Contract Value XX
Less: Costs incurred to date XX
Estimated costs to completion XX
Rectification and guarantee work XX
Total estimated contract costs XX
Estimated contract profit or (loss) XX

Guidelines on Calculating Interim Profits

There exists various guideline for calculating interim profit on incomplete contracts.
However, profit taken contract should reflect the degree of completion. If the contract
is at early stage (say, less than 40% complete) no profit should be taken. Interim
profits, however calculated, should only be taken when the final contract outcome can
be assessed with reasonable confidence.

There are many ways of calculating interim profit.

(i) Profit taken:

= or of the Notional profit x

where the Notional Profit is:

value of work Certified Less Cost of work Certified.

(ii) Profit taken

= Process payments to date x estimated total profit on completion
Contract price

(iii) Profit taken = Value of work certified x estimated total profit

Contract price

78
(iv) Profit taken = Value of work certified — cost of work certified
Or
Profit taken = Cost of work done x Estimated total profit
Estimated total cost of contract

Profit and Loss Account for Interim Profits

Having calculated an appropriate interim profit, the necessary turnover and cost of
sales figures must be derived, for insertion in the published profit and loss account of
the firm. The turnover and cost of sales figures are based on the formulae used for the
interim profit calculations and must obviously produce the agreed profit.

ILLUSTRATION 4 – 4

OWOJORI Nigerian Limited began work on 1 January 2000 on a contract for the
building of an extension to new Lagos Polytechnic amounting N1,800,000. The
retention on contract is agreed at 10%. On November 2000 the certificate of work
approved amounted to N1,200,000. The following information is available.
N
Materials sent to site 450,000
Labour engaged on site 360,000
Plant installed at cost 180,000
Direct expenditure 72,000
Establishment charges 150,000
Materials returned to stores 15,000
Cost of work not y et certified 90,000
Materials on site at 31 December 2000 45,000
Wages accrued at 31 December 2000 15,000
Direct expenses accrued at 31 December 2000 3,000
Value of plant at 31 December 2000 120,000

You are required to complete the Contract Account, showing the amount of profit
likely to be taken into annual accounts to 31 December 2000 and to calculate the value
of work in progress.

79
SUGGESTED SOLUTION 4 – 4

OWOJORI NIGERIA LIMITED

CONTRACT ACCOUNT

N N N
Direct Materials 450,000 Materials returned to store 15,000
Direct Wages 360,000 Stock c/d 45,000
Accrued c/d 15,000 375,000 Plant c/d 120,000
Plant installed 180,000 Cost to date 1,050,000
Direct expenses 72,000
Accrued c/d 3,000 75,000
Establishment charges 150,000
1,230,000 1,230,000
Cost brought down 1,050,000 Contract work certified 1,200,000
Notional Profit c/d 240,000 Cost of work not yet certified 90,000
1,290,000 1,290,000

P&L a/c (profit taken) 144,000 Notional profit b/d 240,000

Profit provision c/d 96,000
240,000 240,000
Stock b/d 45,000 Direct wages accrued b/d 15,000
Plant b/d 20,000 Direct expenses b/d 3,000
Cost of work not
yet certified 90,000 Profit provision b/d 96,000

CONTRACTEE ACCOUNT – LAGOS POLYTECHNIC

Work Certified 1,200,000 Cash 1,080,000
Balance C/D (retention 10%) 120,000
1,200,000 1,200,000

CALCULATION OF WORK-IN-PROGRESS
N
Contractee 120,000
Cost of work no yet certified 90,000
210,000
Less: Profit provision 96,000
WIP 114,000

OR
N
Cost up to date 1,050,000
Profit taken 144,000
1,194,000
Less cash received 1,080,000
WIP 114,000

80
CALCULATED OF PROFIT TAKEN

Notional Profit x x

x x

= N144,000

3.6 PROCESS COSTING

Process costing is a costing method where manufacturing activities are continuous and
the units of output are substantially uniform. Process follows a chain of sequential
order. It is used in a various companies including: soap, beverage, paper making,
paints and pharmaceutical, beverage processing and others. The characteristics of
process costing systems include:
(a) There must be a clearly defined process cost centres and all costs accumulated
(material, labour and overheads) by the cost centres.
(b) There must be accurate records of units produced and the cost incurred by each
process.
(c) The total costs of each process over the total production of that process,
including partly completed units must be averaged.
(d) The charging of the cost of the output of one process as the raw materials input
cost of the following process.
(e) There must be clearly defined procedures for separating costs where the process
produces two or more products, that is, joint products or where by-products
arise during production.

It must be noted that output costing describes the costing of a simple process, whereas,
process costing describes the costing of a chain of sequential processes.

3.6.1 Determination of Cost Unit

It must be emphasised that, the cost unit to be determined should be relevant to the
organisation and its product. The appropriate unit arises having regard to the process
and the cost and selling price of the product. Examples include:

Industry Possible Cost Units

Brewing Litre, gallon, barrel
Beverages Litre, gallon
Food processing Can, case, Kilogram, tonne, litre, etc.
Soap Bar, tablet.

81
3.6.2 Process Losses

With varied forms of production, the quantity weight or volume of the product
emerging at the end of a process may be less than the expected output considering the
quantity weight or volume of the materials introduced. This may be due to various
reasons:
(a) The quality of materials introduced.
(b) Losses inherent in the materials or the method of processing.
(c) Withdrawal for testing and inspection.

It is important to keep records of input and output quantities and to check for losses
that occur due to expectation or formula application.

3.6.3 Normal Process Losses

These are expected losses arising from the nature of the production process. Provision
is always made for such issues and must be included as part of the cost of good
production. The accounting entries are:
(a) To credit the process account with any realised value of the scrap
items.
(b) To relate the net process cost to the achieved good output; that is, normal
process loss without scrap value with the cost of good production.

3.6.4 Abnormal Process Losses

Abnormal losses are losses which are in excess of normal losses and so not expected
from the production. Some of the causes of abnormal losses are as follows:
(a) insufficient working losses,
(b) regular plant breakdown, in any circumstance which could not
be foreseen.
(c) Unexpected defects in materials.
(d) Unforeseen events or circumstances.

Accounting entries
The abnormal losses are valued in like manner with the finished goods.
Entries include
(a) To locate an abnormal loss account from which will be debited
the value of the abnormal quantity(ies).
(b) To write off the abnormal loss account to costing profit and loss
account.
(a) Cr Process Account
Dr Abnormal loss Account (with the value of
abnormal loss quantity.)
(b) Cr Abnormal Loss account
Dr Profit and Loss account

82
(to write off the abnormal loss value.)

3.6.5 Valuation of Opening Work in Progress (W1P)

This relates to units that are partly completed at the end of a period or partly processed
in the current period. Opening work in progress can be subdivided into raw materials
or finished goods, labour and overheads.

There are two methods of calculating the cost per unit.

These are:
(a) Average Method
(b) First In First Out (FIFO) Method

(a) Average Method

Under this method, the unit cost is calculated by adding the total opening work-
in-progress with current period costs.

This method ignores the fact that the opening WIP units were partly completed
in the previous period. The effect is the loss of identify of WIP.

(b) FIFO Method

Under this method, the units are dealt with on the basis of first in first out to the
extent that the first work done in a period is the completion of the opening
work-in-progress. The FIFO method treats the opening work-in-progress as if it
were a separate batch. In order words, the opening work-in-progress keeps its
identity.

3.6.6 Valuation of Closing Work - In- Progress (WIP)

Where there is partly completed work in progress at the end of a period, it is necessary
to ascertain how much of the process costs relate to the work in progress. This is
achieved by expressing partly completed work in terms of equivalent completed units.
Thus 200 units which are considered to be three-quarters completed are equivalent to
150 completed units.

3.6.7 The Concept of Equivalent Units

At the end of any given period, there is likelihood that some units are partly
completed. From the completed units, it is possible to determine the costs of the period
attributable to the partly completed units. In order to equitably distribute costs over
partly completed and fully completed units, the concept of equivalent units is required.
To arrive at the number of equivalent units for costing purposes is the number of
equivalent fully complete units which the partly completed units represent. This is
denoted by the formula:

83
(a) TEP = CU + Eq. units in WIP
Where
TEP = Total Equivalent Production
CU = Completed Units
Eq. in WIP = Equivalent Units in Work in Progress

(b) Cost Per Unit = Total Costs

Total Equivalent Production Units

3.7 JOINT PRODUCT

A joint product is the term used to describe a process where two or more products
arise simultaneously in the course of production, each of which has a significant sales
value in relation to each other. Joint products occur in the following industries:
(a) Oil Refining
Diesel fuel, petrol, paraffin, lubricants, kerosene.

(b) Meat Processing The various grades of meat and hides.

(c) Mining The recovery of several metals from the same crushing.

3.7.1 Joint Product Costing

Joint products occur due to the inherent nature of the production process and therefore,
follows that none of the products can be produced separately The various products are
identical at a point known as the ‘split-off point’ to that stage, all costs are joint costs.
Subsequent to the split-off point, any costs incurred can be identified with specific
products and they are known as 'subsequent' or 'additional processing costs'.

It follows that subsequent costs after the split-off point do not pose any particular
costing problem because they are readily identifiable with a specific product and these
are coded, and charged accordingly For product costing purposes, the major problem
in joint-product costing is to apportion the joint costs, that is, those costs incurred prior
to the split-off point, on an equitable basis.

3.7.2 Apportioning Joint Costs

The methods that are universal in apportioning joint costs are:

(a) The physical unit basis:
The joint costs are apportioned over the joint products in proportion to the
physical weight or volume of the products.
(b) The sales value basis:
Here the joint costs are apportioned in proportion to the relative sales value of the products.

84
3.7.3 The Notional Sales Value Method

At times, the products which emerge from the split-off point are not saleable without
further processing. It assumes, therefore, that at the split-off point, sales values are not
known and joint costs cannot be apportioned until an estimate is made of a notional
sales value at the split-off point.

In order to calculate the notional sales value at split-off point subsequent processing
costs are deducted from the final sales value.
This is illustrated below:

3.7.4 Joint Products in Service Organisations

It is instructive to point out that joint products or joint services also arise in service
organisations. Wherever facilities such as buildings, staff and equipment — are used in
common to provide a variety of products or services, then joint products may occur as
in manufacturing.

Let us illustrate the above using the banking industry. Banks provide a range of
financial services using, largely, a common pool of facilities. The services include:
current and deposit accounts, foreign exchange, investments, insurance, trustees and
taxation and consultancy. Readers will observe that there are some identifiable costs
specific to particular services however, most of the costs are incurred in common for
all the services and that the cost accounting system in a bank has to deal with precisely
the same problems characterised in industries such as oil refining, near processing and
mining.

3.8 BY-PRODUCT COSTING

By-products are defined as "products recovered incidentally from the materials used
in the manufacture of recognised main products having either a net realisable value or
a usable value which is relatively unimportant in comparison with the saleable value
of the main products"(CIMA).

Examples of by-products are:

Iron and steel manufacture

 furnace slag is sold for use in cement and brick manufacture and for road
construction.

Meat trade
 bones, grease and certain offal are regarded as by-products.

85
Timber trade and Carpentry Workshop
 sawdust, small offcuts and bark are usually regarded as by-products.

After the point of separation, both joint and by-products may need further processing
before they are saleable.

For the purposes of clarity, we shall revisit waste and scrap as defined by CIMA:

Waste: ‘Discarded substances having no value’.

Scrap: 'Discarded material, having some recovery value, which is usually either
disposed of without further treatment (other than reclamation and handling), or re-
introduced into the production process in place of raw material.' (CIMA)

3.9 MISCELLANEOUS REVENUE

If the company considers that the value of the by-product is relatively insignificant, it
may decide that all of the previous methods are too detailed. In this situation, all of the
common costs will be borne by the main product and any revenue received from the
disposal of the by-product will be credited to the Profit and Loss Account and merely
shown as miscellaneous revenue.

3.9.1 Comparative Value

In some situations, the by-product may be usable elsewhere in the company or factory,
therein for example, wood shavings which can be used to heat the factory. A realistic
value to put on the by-product in this situation would be cost of the product replaced
by the by-product.

Let us assume that the by-product replaces a product for which we currently pay N4
per kg. and which is used in another process, Process I.

This process account would look like this:

Process I – Oil Account

Quantity N Quantity N
Materials 3,000 30,000 Main product 2,400 41,400
Labour 9,000 a/c
Overheads 6,000
By-product a/c 600 3,600
3,000 45,000 3,000 45,000

By-product Account
N N
Process Y A/c 2400 Process C A/c 2400
2400 2400

86
Process C Account
By-product a/c 2400

3.9.2 Standard Price

In order to save time, a company may decide to value any by-product output at a
standard price. This standard price is set after due consideration of historical records.
Any difference between the price actually obtained and the standard price would be
reflected as a difference in the By-product Account. This difference "variance" would
then be written off to Profit and Loss Account.

If the standard price were N4.50 per kg, the accounting entries would be as follows:

Process Oil Account

Quantity N Quantity N
Materials 3,000 30,000 Main product 2,400 41,400
Labour 9,000 a/c
Overheads 6,000
By-product a/c 600 3,600
3,000 45,000 3,000 45,000

By-product Account
N N
Process Oil A/c 2,700 Sales Income 4,200
Profit & Loss A/c 1,500
4,200 4,200

By applying the selling price of N7.00 per litre on the income, the profit and loss
account is N1,500.

3.9.3 Service / Function Costing

This is defined as:

'Cost accounting for specific services or functions, e.g. canteens, maintenance,

personnel These may be referred to as service centres, departments or functions.'
(CIMA)

The services provided may be for sale, such as. public transport, hotel accommodation,
restaurants, power generation etc, or they may be provided within the organisation, for
example, maintenance, library, stores.

A particular difficulty is to define a realistic cost unit that represents a suitable

measure of the service provided. Frequently a composite cost unit is deemed the more

87
relevant. For example, the hotel industry may use the 'occupied bed-night' as an
appropriate unit for cost ascertainment and cost control. Typical cost units used in
service costing are shown below:

Service Possible Cost Units

Transport Tonne-Mile, passenger-Mile, Miles traveled
Hospital Patient-days, number of operations
Electricity Kilowatt-hours
Hotels Occupied bed-nights
Restaurants Meals served
Colleges Full time equivalent student

Each organisation will have to determine what cost unit is most appropriate for its own
purposes. Frequently, if a common cost unit is agreed, valuable cost comparisons can
be made between similar establishments, such as Law Chamber, Audit firm, etc.

Whatever cost unit is decided upon, the calculation of the cost per unit is done in a
similar fashion to output costing, that is.

Cost per service unit = Total costs per period

Number of service units supplied in the period

Readers will notice the similarities in the cost per unit calculation of
cost drivers using ABC.

4.0 CONCLUSIONS

Process costing which entails the averaging of total cost over the total throughput costs
of the process, including any partly completed units was also treated. Process losses
may be normal, and/or abnormal while gain may also be involved. The valuation
methods in process costing which are FIFO and weighted average methods while joint
products or by — products costs are apportioned using either physical unit basis or the
sales value basis have also been well explained.

5.0 SUMMARY
The major costing methods which are job costing, batch costing, contract costing
process costing and service costing have been considered in this chapter.

6.0 TUTOR MARKED ASSIGNMENT

1. Polaru Construction Company has the following data concerning one of its
contracts
Contract Price N4,000,000
Value Certified N2,600,000
Cost incurred N2,100,000
Cash received N2,400,000

88
Cost of work certified N2,000,000

The profit (to the nearest N’000) to he attributed to the contract is

A N500,000
B N554,000
C N600,000
D N1,900,000
E N1,850,000.

2. Which of the following are characteristics of job costing?

(i) homogeneous products
(ii) customer-driven production
(iii) complete production possible within a single accounting
period.
A i only
B i and ii only
C ii and iii only
D i and iii only
E i, ii and iii.

3. A chemical process has a normal wastage of 10% of input. In a period, 2500

kgs of materials were input and there was an abnormal loss of 75kgs. What
quantity of good production was achieved?
A 2175 kg
B 2250 kg
C 2325 kg
D 2474 kg
E 2480 kg.

4. Which of the following are characteristics of service costing?

(i) high levels of indirect costs as a proportion of total costs
(ii) use of composite cost units
(iii) use of equivalent units

A i only
B i and ii only
C ii only
D ii and iii only
E i, ii and iii.

5. Process J had no opening stock, 13,500 units of raw material were transferred in
at N4.50 per unit. Additional material at N1.25 per unit was added in process.
Labour and overheads were N6.25 per completed unit and N2.50 per unit
incomplete. If, 11,750 completed units were transferred out. What was the
closing stock in process J?
A N77,625.00

89
B N14,437.50
C N141,000.00
D N21,000.00
E N131,000.00

6. What are the normal process losses and how are they dealt with in the costing
method?

7. What is an equivalent unit?

8. What is joint product?

9. What is split-off point?

10. “Discarded-substances having no value" is known as__________

7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

90
UNIT 5 PLANNING AND MANAGEMENT CONTROL SYSTEM

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Long-term Strategic Planning (Corporate Planning)
3.1.1 Importance of Corporate Planning (CP)
3.1.2 Stages in Corporate Planning (CP)
3.1.3 Advantages of Corporate Planning
3.1.4 Disadvantages of Corporate Planning
3.2 Control concepts
3.2.1 Types of Control Systems
3.2.2 The Process of Control
3.2.3 Open and Closed Loop Systems
3.3 The Decision Process
3.3.1 Stages in Decision Making Process
3.3.2 Types of Decisions
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignments
7.0 References/Further Readings

1.0 INTRODUCTION

Planning is one of the functions of management and is concerned with the future.
Planning relies upon information from many sources, both external and internal to the
company for it to be successful. Information for planning includes cost and financial
data and also information relating to personnel, markets, competitors, production
capacities and constraints, and material supplies.

Definition of planning
‘The establishment of objectives and the formulation, evaluation and selection of the
policies, strategies, tactics and actions required to achieve these objectives, Planning
comprises long term/strategic planning and short-term operational planning, The later
usually refers to a period of one year’ (CIMA). The overall planning process covers
both the long and short term. Planning is thinking before doing.

2.0 OBJECTIVES

In this unit, readers will be able to understand:

 Short-term and long-term planning;
 The differences between strategic, tactical and operational planning;

91
 Control systems and the basic knowledge of closed loop and open loop system
 The decision process.

3.0 MAIN CONTENT

3.1 LONG-TERM STRATEGIC PLANNING (CORPORATE PLANNING)

This is defined as' the formulation, evaluation and selection of strategies for the
purpose of preparing a long-term plan of action to attain objectives. Also known as
planning and long range planning' (CIMA).

Long-term strategic planning denotes planning with a long-term span in economic and
business affairs. It can further be explained as the total resources of a company for the
achievement of quantifiable objectives within a specified period of time. It signifies a
comprehensive and organised but flexible approach to planning. There is a need for a
routine monitoring of the organisation's internal and external environment to keep plan
relevant.

3.1.1 Importance of Corporate Planning (CP)

Corporate Planning is essential for the following reasons:

(a) It is a means by which a company gives itself the desire to construct its own
future;
(b) Wages and prices of materials are usually rising and the organisations are,
therefore, under pressure to make profit;
(c) Capital formation needs to be planned as a unit, because the implication of
investment decisions are more widespread nowadays;
(d) Business diversification is spreading presently with a resulting complexity of
operations; and
(e) The increased sophistication of products and production processes make
decision-making difficult for top executives.
Hence, long-term planning will assist in solving the problem.

3.1.2 Stages in Corporate Planning (CP)

Corporate planning involves six stages. These are:

Stage I: Determine the objective

This is the first stage in corporate planning process and it is the key stage. It seeks to
answer the question: what is the business attempting to achieve? A set of objectives
need to be established, which express in quantitative terms, what the organisation is
trying to accomplish. There are difficulties in establishing corporate objectives
because of the nature of the modern business which are now sophisticated. We have
the following areas in which objectives of performance and results have to be set,
namely:
92
(a) Productivity
(b) Innovation
(c) Market standing
(d) Physical and financial resources
(e) Manager performance and development
(f) Employee performance and attitude
(g) Public responsibility,

Stage 2: Establish the Current Position (Assessment Stage)

This is called a "position audit" which seeks to provide detailed answers to the
following questions:
How is the business at the present time and the environment in which
it operates? In what environment will the company operate in future?

The four aspects of the current position stage are:

(a) The external environment includes an assessment of economic, political, social

and technological factors, detailed analysis of competitive activity for
established product affecting the organisation.

The external investigation exposes the threats and opportunities that exist by
identifying changes within the environment.

(b) The organisation - This is a process of looking from the outside into the
company to assess its present strengths and weaknesses. It also involves the
appraisal of each part of the company's objective, identifying the key profit-
making factors. The following should be established: "How much can present
profits be increased from present resources?", "What serious weaknesses are
apparent?" etc.

(c) The future - The future is very difficult to predict. That not
withstanding, the following factors have to be considered to be able to predict
properly: economic forecast, inflation, taxation, political problems, and social
trend in taste and trend in government policy thrust.

(d) The expectation - The expectations of the stakeholders are to

influence the corporate objectives: stakeholders are employees, customers,
shareholders, government, the general public, etc.

Stage 3: Develop a strategy (also known as Appraisal Stage)

In this stage, SWOT Analysis (Strengths, Weaknesses, Opportunities, Threats) needs

to be carried out in order to be able to determine the next line of action. The question

93
to be asked is: "How can the gap between objectives and current position be closed?"
Primary considerations are:
(a) Product development expenditure;
(b) Improved cash flow:
(c) Greater share of the existing markets;
(d) New market expansion;
(e) Alternative producs lines;
(f) Production capacity;
(g) Manpower planning; and
(h) Control systems.

All the above represent the strengths, weaknesses, opportunity and threats which the
planning team must take into consideration when embarking on long-term planning.
A policy document showing the major decision to be taken, the time span for the
change and the supporting evidence necessary will be produced.

Stage 4: Preparation of the Plan.

The chosen strategy is being worked out. The critical problem that would have to be
resolved is getting a commitment from the whole of the management team and an
undertaking to make the strategy a success. Each aspect of the plan will be produced
by the department concerned while the whole exercise is being co-ordinated by the
corporate planning team.

Stage 5: Implementation of the Plan

The strategy is translated into action.
The preparation stage leads on to implementation stage. The plans will contain targets
and will be sufficient in details so that tactical level management know the task they
have to plan and execute. The strategic plan will be used by tactical management to
prepare operational plans, budgets etc. Each member of management must be
informed about all details of the plan together with the contribution each will make
towards its realisation.

Stage 6: Continuous Re-appraisal

This is monitoring and control stage. Reappraisal of the plan will occur in the
following ways: There will be an in going system by the corporate planning
department to improve the information in which the plan is based. This should be
helpful to the long-term forecast in closing the forecast gap. Specific re-appraisal or
monitoring will be required:

(a) At each end of the year, when current performance is measured against trends
and

(b) When any significant event occurs that would materially affect the plan, for
example, a merger of competitors.

3.1.3 Advantages of Corporate Planning

94
The benefits that can accrue from corporate planning include the following:
(a) It clarifies policies and strategies and provides the essential framework for
realistic operational budgeting and planning.
(b) It helps to avoid sub-optimality as the operational planning helps to co-ordinate
the different aspects of the organisation.
(c) It assists in greater job security.
(d) It is scientifically based on diversification and expansion policy.
(e) It improves management team because executives are forced
to think ahead of time.
(f) It exposes weaknesses in the company's information flow and
assists to improve the system.
(g) It improves the goal-congruence of the organisation and assists
in the motivational programme of the company.

3.1.4 Disadvantages of Corporate Planning

(a) The process may absorb a considerable amount of

management time and involve a lot of bureaucracy.
(b) It may lead to the formulation of unrealistic objectives, which
may act as a disincentive to the employees.
(c) It may make the organisation inflexible and less capable of
responding to changes.

3.2 CONTROL CONCEPTS

Control is the process of compelling events to conform to plan.

Control is concerned with the efficient use of resources to achieve determined
objective, or a set of objectives, contained within a plan. In an organisation, control is
exercised by the feedback of information on performance compared with plan. Control
regulates performance so that results conform to plans. Control is dependent upon
planning and cannot exist in isolation. In practice, planning and control overlap so
much that it is sometimes extremely difficult to separate them. Planning is a pre-
requisite for control. Control does not end when deviations from plans are produced
neither is it merely the correction of past mistakes. Control information is produced so
that decisions can be made in order to ensure that objectives are achieved.

3.2.1 Types of Control Systems

The quantitative control systems include budgetary control, standard costing,

production control and inventory control. We also have quantitative systems for
monitoring product quality and scheme of staff appraisal. In addition to the
quantitative systems. There are also control systems that are concerned with qualitative
factors.

3.2.2 The Process of Control

95
The control process or the elements of control cycle are:

(a) The setting of standard of performance - Targets and plans are established
and standards of performance are determined in
order to achieve those targets. The standards must be carefully
set in order to ensure that they are realistic and can be achieved.

(b) The operation of the system - The information of the standard of performance
and operation results are communicated to those operating the system. There is
need for good communication and motivation in order to ensure that output is
achieved in accordance with plans. It is important that managers must know
their objectives and the limits of their responsibility and authority.

(c) Feedback - Deviation is determined after the actual performance has been
compared with the standard expected. The decisions are reported to the
appropriate authority in a clear and useful way to ensure that corrective action
is taken. It may involve the adjustment of the original plans or current operation
to ensure the realisation of objectives.

3.2.3 Open and closed loop systems

(a) The closed loop system. In a closed loop system, the feedback remains within
the control system itself and passes to a control unit or correcting unit. This unit
will automatically correct the operating performance in response to any
deviation from standard. It is referred to as a closed loop system because it
operates without outside control, for example, problems are solved internally
and automatic machines such as numerically controlled machines, which are
capable of self adjustment are examples of closed loop systems.

(b) The open loop system. In an open loop system, feedback is directed to a higher
level for action. The system is capable of adjustment for external factors, and
control, usually human, is external to the system. It is usually recognised that
the original plans and standards of performance may have to be changed in the
light of actual results. Most business systems are open systems because control
is exercised by managers using skill and judgement to evaluate information and
initiate appropriate action.

3.3 THE DECISION PROCESS

3.3.1 Stages in decision making process.

Decision making is one of the major functions of management. A decision is a

commitment to action. Decision making is an important aspect of management
because the quality of decisions made can affect the long-term planning success of a
whole business as well as the day to day effectiveness of its operations. The following

96
stages form part of the decision making process.

(a) Identify that there is a problem.

(b) Collect all necessary information on all aspects of the problem.
(c) Evaluate the relevance of the information obtained.
(d) Define the objective.
(e) Find out the alternative courses of action.
(f) Evaluate these alternatives.
(g) Make decision with regard to the course of action to be adopted.
(h) Mobilise the resources required.
(i) Implement the objective.
(j) Find out if the problem has been solved.

However, it must be emphasised that many other factors may be of critical importance
in a decision situation. Examples include; markets, the environment, legal factors,
personal and psychological characteristics, production or service quality, reliability
and so on.

Therefore, decision making is not just a consideration of financial factors alone.

3.3.2 Types of Decisions

Decisions can be classified into programmed and non-programmed categories.

(a) Programmed decisions. These are decisions that can be clearly defined and
tailored through computer based management information system e.g.se-order
level decision and inventory control techniques incorporated into computer
based management information systems. A typical example is a reorder
decision based on usage and reorder levels in an inventory control system.

(b) Non-programmed decisions. These are decisions with decisions,

rules and procedures that cannot be defined. These decisions will therefore
involve many external and internal factors, frequently with high levels of risk
that require information from various sources.

4.0 CONCLUSIONS

Planning could be strategic — covering periods longer than one year but within 10
years. It is made up of several stages such as assessment, objective, approval and
evaluation.

The corporate plan gives birth to the detailed short term or operational planning
spanning a period of one year.

The advantages of corporate planning include: the classification of policies and

strategies, the avoidance of sub—optimality, taking a long-term view, the exposure of

97
weaknesses and motivational effects.

The shortcomings are: time costing, inflexibility and possible bureaucratic procedures.

Part of the planning process includes consideration of an appropriate control system,

which is concerned, with the efficient use of resources to achieve a plan.

The major quantitative control systems are budgetary control, standard costing,
inventory control, production control etc.

Control in organisations is carried out using information feedback loops. Control

action must be correctly phased otherwise the action may become the opposite of that
intended.

Open systems interact with the environment whereas close systems are self-contained.

5.0 SUMMARY
Planning is an important part of business activity and can be defined as the act of
setting objectives and deciding upon the manner that these will be achieved.

6.0 TUTOR MARKED ASSIGNMENT

1. Define planning

2. What are the stages in decision making process?

3. Mention two short-term tactical planning

4. Define short-term tactical planning

5. Distinguish between programmed decision and non-programmed decision

6. What is “SWOT ANALYSIS”?

7. A depiction of the interrelationship among recognized factors in real situation

called _________

8. What is the difference between an open and closed loop systems?

9. The formulation, evaluation, and selection of strategies for the purpose of

preparing a long term plan of action to attain objectives is known as_________

10. Mention two advantages of Corporate Planning?

98
7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

99
MODULE II: COST, BUDGET AND DECISION MAKING

Unit 6: Cost Estimation and Behaviour

Unit 7: Decision making under uncertainty
Unit 8: Budgeting and Budgeting Control
Unit 9: Standard Costing
Unit 10: Cost of Capital

UNIT 6: COST ESTIMATION AND BEHAVIOUR

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Importance of cost behaviour
3.1.1 The level of activity
3.1.2 Cost behaviour and range of activity level
3.2 Variable Cost
3.3 Fixed Cost
3.4 Semi-Variable Costs
3.5 Cost estimation
3.5.1 Techniques used in Prediction / Estimation
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION
In this unit, we shall look at the presentation of financial information for decision
making and cost control. We shall be considering how the management accountant can
be of assistance in providing answers to question about the consequences of following
a particular action.

2.0 OBJECTIVES
In this unit, readers would be able to understand:
 The importance of studying cost behavior.
 The definition of a variable cost in linear and non-linear forms.
 The techniques used in estimation and prediction
 How inflation affects costs.

100
3.0 MAIN CONTENT

3.1 IMPORTANCE OF COST BEHAVIOUR

The study of the behaviour of costs has to do with the classification of costs which
form the basis for the prediction of the future level of activity Costs can be categorised
into: Variable costs, fixed costs and semi-variable costs.

3.1.1 The Level of Activity.

The volume or level of activity constitutes the main basis for forecasting costs
especially where changes or future changes are to measured. The level of activity can
be viewed severally, for example, tonnage produced, standard or predetermined hours
required, bed space occupied, grammage of stock used, kilometres covered per hour,
passenger per bus, etc.

3.2 VARIABLE COST

A variable cost (VC) is defined as:

"A cost which varies with the measure of activity". (CIMA)

Variable Cost Behaviour

Variable cost can be analysed into two main groups: Linear and non-linear or
curvilinear.

(a) Linear Variable Cost

This is the easiest way of sharing the relationship between total
variable cost and output as a straight line graph thus:

Cost (N)

Output
Fig. 6.1 Linear variable cost

In order to ensure easy computation and analysis, the linearity is expressed

algebraically as:

cost = b(x)
where: x = volume of output in units/hours
b= a constant representing the variable cost per unit.

ILLUSTRATION 6 – 1

101
The materials contained in each Assembly Z110 are
6kgs of material A at N2.50 each
30kgs of material B at N4.00 each
16kgs of material C at N3.00 each
What is the expected variable cost of materials for producing 80 Assemblies?
SUGGESTED SOLUTION 6 – 1
N
6kgs of material A at N2.50 = 15.00
30kgs of material B at N4.00 = 120.00
16kgs of material C at N3.00 = 48.00
VC per Assembly = 183.00

Total VC = N183 x 80 = N14,640

(b) Non-Linear or Curvilinear Variable Costs

The non-linear cost curve establishes the relationship between output
and variable cost as that of a curved line on a graph. This can be shown in two ways,
thus:

convex - where each extra unit of output causes a less than proportionate increase in
cost

concave - where each extra unit of output causes a more than proportionate increase in
cost.

Convex Cost
Convex
Cost

Level of Activity (i)

Level of Activity (ii)
Fig. 6.2 Non-linear variable cost
A situation whereby there is an additional increase in the input of raw materials in the
production process, brings about a proportionate decrease in output will result in a
convex cost function.

Non-Linear Variable Costs - the Parabola

A curve is referred to as a parabola in a situation whereby changes in the level of

output brings about a uniform change in the gradient of the cost function. It can be
shown algebraically thus:
Cost = bx + cx2 + dx3 +…pxn

102
Where x = volume of output in units
b,c,d, ….p = constants representing the variable cost per unit.

ILLUSTRATION 6 – 2

Analysis of cost and activity records for a project show that the variable cost can be
accurately represented by the function:
Cost = N(bx + cx2 + dx3)
Where b = 10, c = 0.7 and d = 0.8.

Calculate:
(i) Variable cost when production is 20 units.
(ii) Variable cost when production is 25 units
Is the function convex or concave?

SUGGESTED SOLUTION 6 – 2

(i) Cost = N(10 x 20) + (0.7 x 202) + (0.08 x 203)

= N1,120
(ii) Cost = N(10 x 25) + (0.7 x 252) + (0.08 x 253)
= N1,937.35

It will be seen that a slight increase in activity from 20 to 25 units results in almost
doubling of variable cost. This shows that there is a more than proportionate increase
in the unit cost of extra production. Therefore, the function is concave.

3.3 FIXED COST

A fixed cost is defined as:

“A cost which is incurred for an accounting period, and which, within certain output or
turnover limits tends to be unaffected by fluctuations in the level of activity (output or
turnover)”(CIMA)'.

A fixed cost can also be referred to as a period cost.

Since fixed costs are a function of time, they do not respond to changes in activity
levels. Therefore, changes in cost is not related to changes in the volume of activity
within a given range of activity Fixed cost increased or stepped up only after a range
of activity and not at every level of activity.

Even though, fixed costs can be depicted on a graph, it can also be shown algebraically
as: = 'a'

103
Where 'a' is fixed.
(a) Fixed Cost (b) Stepped fixed Cost

Cost Cost
(N) FC (N)

Level of Activity
Relevant Level of
Range of activity
activity
Fig 6.4 Fixed cost and Stepped fixed cost

It means that at any level of activity, the fixed cost remained the same.

3.4 SEMI-VARIABLE COSTS

This type of cost can be defined as;

“A cost containing both fixed and variable components and which is thus partly
affected by a change in the level of activity", (CIMA).

Examples of semi-variable cost are: NEPA bill, NITEL telephone bills, Water rate,
and some GSM operators bills.
b le

Fixed
ri a
Va

le
ia b

Fixed
r
Va

Level of activity Level of activity

Fig 6.5 Semi-variable cost

Semi-variable costs can also be expressed algebraically by bringing together the

expressions for variable cost and fixed cost thus:

Linear Semi-variable cost = a + bx:

where 'a' represents fixed cost, b represent the unit variable cost and
x represents the level of activity.

104
Non-linear semi variable cost = a + bx + cx2 +dx3+… + pxn is expressed in
6.1.2 (b)

ILLUSTRATION 6 – 3

A breakdown of maintenance packaging department of Uzuh Limited costs shows that

there is a fixed element of N5,000 per month and a variable element related to hours
amounting to N6.00 per machine hour.

What is the expected cost for a month when the planned activity level is
(i) 2,500 machine hours,
(ii) 3,000 machine hours?

SUGGESTED SOLUTION 6 – 3

(i) Total cost = a + bx

= N5,000 + (N6.00 x 2500)
= N20,000

(ii) Total cost = N5,000 + (N6 x 3000)

= N23,000

(Alternatively, since the variable costs will change between 2,500 and 3,000 hours,
then the total cost can be computed as follows):

N20,000 + 500 (6) = N23,000

Note:
In another way, the semi-variable costs can be referred to as semi-fixed and mixed
costs.

3.5 COST ESTIMATION

Cost estimation is a term used to describe the measurement of historical cost with a
view to helping in the prediction of future costs for management decision making, i.e.
historic information is analysed to provide estimates on which to base future
expectations.

Mixed costs can be separated into their fixed and variable elements, using a variety of
techniques. Some techniques are more sophisticated than others, and, therefore, likely
to be more reliable, but in practice, the simpler techniques are more commonly found.

6.5.1 Techniques Used in Prediction / Estimation

(a) The account classification method / account analysis techniques

(b) The high - low method or the Range method.

105
(c) Scatter graph.
(d) Regression Analysis.

(a) Account Classification Method

This is the examination of each item of expenses which involves classifying
them into variable, and fixed cost using the subjective judgement of the
Accountant.

Advantages of Accounts Classification Method

(i) It is fast and inexpensive.
(ii) It is simple and easy to understand.
(iii) It can be revised regularly to account for changes in cost structure or cost
classification.
Disadvantages of Accounts Classification Method
(i) The initial classification has considerable subjective
element.
(ii) It relies on a single observation to determine the cost function.
(iii) It is based on past costs.
(iv) Separation of semi-variable cost into its fixed and variable component is
arbitrary.

(b) High-Low Method/Range Method

By this method, a check is made of historic costs in previous accounting
periods, and the costs in the two particular periods are selected for cost
estimation, namely:

(i) the period with the highest volume of output;

(ii) the period with the lowest volume of output (Note: the periods with
highest/lowest output may not be the periods of highest or lowest cost).

Where inflation makes the costs in each period uncomparable, costs should be
adjusted to the same level by means of a price level index.

The difference between the total cost of the high output and the total cost of the
low output will be the variable cost of the difference in output level.

ILLUSTRATION 6 – 4

The costs of operating the maintenance department of a computer manufacturer, for

the last five months have been as follows:
N Production volume
(standard hours)
Month: Jan 120,000 6,000
Feb 125,000 7,000
Mar 104,000 5,000

106
Apr 121,000 8,000
May 125,000 8,500

What cost should be expected in month 6 when output is expected to be 10,000

standard hours? Ignore inflation.

SUGGESTED SOLUTION 6 – 4

Output N
(i) High output 8,500 hours: total cost 125,000
Low output 5,000 hours: total cost 104,000
Total variable cost of 3,500 = 21,000

Variable cost per standard hour 21,000 = 6.00

3,500

(ii) Substituting in either the high or low volume cost:

High (8,500) Low (5,000)
N N
Total cost 125,000 104,000
Variable costs (8,500 x 6) 51,000 (5,000 x N6) 30,000
Fixed costs 74,000 74,000

(iii) Estimated total cost of 10,000 standard hours of output:

N
Fixed costs 74,000
Variable costs (10,000 x 6) 60,000
134,000

Advantages of High and Low Method

(i) It is relatively simple to operate.
(ii) It is a quick and an inexpensive method of determining the underlying
relationship of cost and level of activity.
(iii) It is not subjective.

Disadvantages of High and Low Method

(i) It ignores any information between the two extreme observations.
(ii) When the extreme points are not typical, the function calculated
will reflect an abnormal rather than normal cost function (i.e. a situation
whereby there is no relationship between the level of activity and the costs).
(iii) It is not fully represented, because it does not make use of the whole of the
available data.

The Effect of Inflation

When two or more years are compared to determine the variable cost and fixed cost

107
for estimation, it is likely that the price -index might have changed hence there is need
to adjust for the effect of inflation before arriving at the variable cost and fixed cost for
prediction purposes.

(c) Scatter Graph Technique

This is a visual technique which co-ordinates the cost and the level of activity of
historical records for a period of time and are plotted on a graph. At the point of
interception with the cost axis, the fixed cost emerges, the shape of the line represents
the rate of change of cost with activity level which is variable cost.

Cost N
1800
1600 Line of best fit
1400
Line joining high/low points
1200
1000
800
600
400
200

20 40 60 80 100 120 quantity in units

Thus: variable element = N8.50

Therefore, the estimated cost function using the line of best fit = 100 + 8.5x, where x =
units of output.

The scatter graph technique is simple and convenient but clearly no claims can be
made for its accuracy.

(d) Regression Analysis Technique

This is a statistical technique that is based on historical data. If it involves one

independent variable, it is called "Simple Regression; whereas when the use of more
than one independent variables is involved, it is referred to as "Multiple Regression".
However, the least square regression analysis is determined by the formulae as
follows;

b=

a=

108
x = independent variable
y = dependent variable
= Summation
n = is the number of pairs of data for x and y

Advantages of Regression Analysis

(i) Line of best fit can be easily recognized and could be extended through the use
of multiple regression analysis.
(ii) It uses the whole data, unlike the accounts classification and high and low
methods.
(iii) It assists in the use of computers and electronic calculation.

Disadvantages
(i) A reasonable number of observation is required.
(ii) The elimination of non-random variables can reduce the available data and
frustrate any attempt to fix the curve statistically to the observation.
(iii) A true relationship may not be linear, it may be curve-linear.

4.0 CONCLUSIONS

Costs frequently do not behave in regular manner and a cost function may be linear,
curve-linear or stepped at different activity levels .Therefore, the ability to forecast
costs is a vital part of supplying information for planning and decision making.

There are basically four ways to cost prediction or estimation. These are account
analysis, scatter-graph, high and low (range method) and linear regression analysis
method.

5.0 SUMMARY

The usage of any statistical technique requires a confirmation of its applicability and
usefulness.

Costs can generally be separated into either fixed or variable. However, cost
classification has its own drawbacks since variable costs are not always variable, fixed
costs can and do change and thus many costs are semi fixed or semi — variable.

When long term forecasting in required, extrapolation from historical data become less
relevant and judgement and qualitative factors become increasingly relevant.

6.0 TUTOR MARKED ASSIGNMENTS

1. Mokuolu Plc uses time series analysis and regression techniques to estimate
future sales demand. Using these techniques, it has derived the following trend
y = 10,000 + 4200x

109
where y is the total sales mix and x is the time period. It has also derived the
following seasonal variation index values for each of the quarters using
multiplicative (proportional) seasonal variation model:
Quarter Index Value
1 120
2 80
3 95
4 105

The total sales units that will be forecast for time period 33, which is the first
quarter of year 2004 is
A 138720
B 148720
C 176320
D 178320
E 180320

2. Eze Limited has found that its total overheads are dependent on labour hours,
machine hours and unit produced. Analysis has produced the following
multiple regression formula.
y = N25,000 + 7.3x1 + 4.8x2 + 3.1x3
where y = total overhead
x1 = Labour hours
x2 = Machine hours
x3 = Units produced

What is the predicted overheads in a period when there were 16500 labour
hours. 7300 machine hours and 13400 units were produced?
A 232,030
B 222,030
C 322,030
D 422,030
E 248,070.

3. Analysis of cost and activity data shows that the variable costs of part No 430
can be represented by the function:
Variable cost of Part No 430 = Nbx + cx2 + dx3
where b = material cost per unit = N3
c = labour cost per unit = N0.8
d = variable overheads per unit = N0.06

Calculate:
Variable cost when production is 15 units.
A N437.50
A N467.50

110
A N427.50
A N417.50
A N407.50.

4. Peter Limited has recorded the following distribution costs during the last three
months.
Month Volume Units Total Cost (N)
1 32,000 100,000
2 40,000 120,000
3 50,000 145,000

What will be the distribution costs in month 4 when the expected activity level
is 42500 units?
A N126,250
B N127,500
C N129,861
D N132,813
E N140,813.

5. Define variable cost

6. Explain what is meant by cost function.

7. What is the major limitation of the high and low method?

8. Identify and explain three requirements which should be observed when using
statistical regression analysis.

9. Describe the least square method.

7.0 REFERNCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

111
UNIT 7: DECISION MAKING UNDER CERTAINTY

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Definition of marginal costing
3.1.1 Marginal costing statement format
3.1.2 Merits of marginal costing
3.1.3 Demerits of marginal costing
3.2 Absorption costing
3.2.1 Absorption standard cost (where there is no opening and closing stock)
card-format
3.2.2 Advantages of absorption costing
3.2.3 Disadvantages of absorption costing
3.3 Marginal and absorption costing
3.3.1 Marginal costing
3.3.2 Absorption costing
3.3.3 Further distinctions between the two techniques
3.4 Marginal costing and decision making
3.4.1 The decision process
3.4.2 Types of decisions
3.4.3 Relevant cost
3.4.4 Differential costing
3.4.5 Differential and incremental costs
3.4.6 Historical cost information
3.4.7 Opportunity costs
3.4.8 Acceptance or rejection of a special order
3.4.9 Discontinuance of a product line
3.4.10 Key budget factor / limiting factor
3.4.11 Make or buy decisions
3.5 Cost-Volume-Profit (CVD) analysis
3.5.1 Applications of the P/V ratio
3.5.2 Basic assumptions of C-V-P analysis
3.5.3 Limitations of the basic assumptions
3.5.4 Applications of the C-V-P model
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignment

1.0 INTRODUCTION
The concept of marginal costing is based on the behavior of costs that vary with the
volume of output. Sometimes marginal costing and direct costing are treated as
interchangeable terms.

112
2.0 OBJECTIVES

In this unit, the readers will be able to understand:

 Marginal costing techniques and the preparation of operating statements using
marginal and absorption costing techniques;
 The principles of carrying out the cost-volume-profit (CVP) analysis for
decision making;
 Break-even charts and profit graphs;
 The limiting factor and its effect on decision process;
 The applications of the concepts of relevant cost, opportunity cost, incremental
cost, and differential cost to decision making.

3.0 MAIN CONTENT

3.1 DEFINITION OF MARGINAL COSTING

CIMA defines marginal costing "as a decision making technique used to determine the
effect of cost on changes in the volume of time and output in a multi — product firm
especially in the short run". Thus, it is a technique which emphasizes the variable cost
of a product, that is, the direct material, direct labour, direct expenses and other
variable overheads. It demands that fixed cost of the relevant period are written off in
full against the contribution. The contribution is the difference between the sales value
and the variable or marginal cost of a product in a given period of time.

3.1.1 Marginal Costing Statement Format

The format showing the components of a marginal costing statement is as shown

below:
N N
Sales (a) x
Direct material x
Direct labour x
Direct expenses x
Prime cost x
Production variable costs x
Production marginal cost (b) x
Contribution - (a-b) x

Fixed cost are excluded from the cost structure and therefore written off in the period.

3.1.2 Merits of marginal costing

Marginal costing is a technique which is of utmost importance to management

decision making efforts. The following reasons are pertinent to this assertion:
(a) Profit volume ratio helps management to decide which products

113
are most profitable.
(b) Contribution margin helps to decide whether:
(i) To accept or reject a special order;
(ii) To close down a line of product or business;
(iii) To determine product profitability;
(iv) To determine product mix using linear programming technique;
(v) To make or buy or lease decisions on an item of plant and equipment;
and
(vi) To decide further processing decision particularly in
relation to joint product cost.
(c) It assists in the pricing decision making process.
(d) Contribution approach can be used to forecast the units to be produced and sold.
(e) It facilitates the stock valuation for final accounts purposes.

3.1.3 Demerits of marginal costing

The difficulties associated with marginal costing are as follows:

(a) The analysis of costs into fixed and variable costs may be subjective for the
purpose of costs classification.
(b) It places emphasis on the short run effects of costs, whereas, fixed costs will
vary in the medium and long term.
(c) It is impossible to determine strategic or long term decision in that, giving a
product total cost data, it needs to be noted that in the final analysis (long run)
fixed costs must be recovered.
(d) It focuses attention on the contribution level and the tendency
to exclude fixed costs by the management may be disastrous.

3.2 ABSORPTION COSTING

Absorption costing is a method of costing stocks in which all production costs such as
variable and fixed are included as part of the cost of items'. (Statement of Accounting
Standard ES.A.SI No. 4 in stocks).

Absorption costing, therefore, is a technique in which all costs are absorbed into
production cost, hence operating statements, prepared using this approach, does not
distinguish between fixed and variable cost. It is an approach which allocates all
production costs into individual products. Fixed production overhead are absorbed into
products by establishing overhead absorption rate. This may result to over or under
absorbed overhead, which is less or more than recovery of fixed overheads at planned
or predetermined activity level.

114
3.2.1 (a) Absorption costing standard cost (where there is no opening and closing
stock) card-format
PER UNIT
N N
Sales x
Direct Materials x
Direct Labour x
Direct Expenses x
Prime Cost x
Production Variable Overhead x

(i) Marginal Cost x

Fixed Production overhead cost x
(ii) Total production cost of sales
(Absorption cost) (x)
Gross Profit xx

(b) Absorption Costing Operating Statement (with opening &

closing stocks).
N N
Sales x
Opening Stock (valued at Absorption cost) x
Cost of Production (“ “ “) x
x
Less: Closing Stock
(valued at absorption cost) x
Total Cost of sales x
Gross Profit x

3.2.2 Advantages of absorption costing

(a) It does not undermine the importance of fixed cost.

(b) It avoids fictitious losses being reported by representing product cost at full
factory cost to bring the product to a point that its ready for use.
(c) It assists in arriving at total cost of production which is a basis for selling price
decision process.
(d) It matches costs with revenues since fixed production cost are considered in the
product cost.
(e) It represents current market trends and, therefore, it is widely accepted
especially for tax purposes.

3.2.3 Disadvantages of absorption costing

(a) It does not help in decision-making.

(b) Production may be very difficult since there is element of fixed cost in the
product cost.

115
(c) Calculation of under or over absorbed overhead may be problematic.
(d) It overbears the product cost with management administrative inefficiency
which may partly be represented in fixed cost.
(e) It does not conform with the matching principle which stipulates that all costs
(fixed and variable) must be matched against revenue in the period concerned
for determination of profit.

3.3 MARGINAL AND ABSORPTION COSTING COMPARED

3.3.1 Marginal Costing

Marginal Costing is a useful technique for studying the effects of changes in volume
and type of output in a multi-product business. It is an accounting technique which
determines the marginal cost by distinguishing between fixed and variable costs. The
primary purpose of marginal costing is to provide information to management on the
effects on costs and revenues of changes in the volume and type of output in the short
run.

It can also be used in the system for recording and collecting costs. In this case, stocks
are valued at variable cost and fixed costs are treated as period costs in profit
statements.

3.3.2 Absorption costing

Absorption costing is the approach used in all published accounts, and all financial
accounting statements. It emphasizes a functional classification of costs, for example
manufacturing, selling and distribution and financial costs.

In contrast marginal costing, or the contribution approach, highlights the behaviour of

costs and classifies them accordingly, by identifying variable costs and fixed costs.

3.3.3 Further distinctions between the two techniques are presented in tabular form
below:

Marginal Costing and Absorption Costing Techniques:

Marginal Costing Absorption Costing
a. Fixed overheads are written off Fixed overhead are:
in a period. Treated as period a. Absorbed into production, such
costs that part of fixed cost is carried
to subsequent year by way of
its inclusion in closing stock.
(b) Only variable costs are (b) Fixed production overheads
regarded as product cost form part of the product
cost.
(c) Contribution is the main (c) Contribution are treated as
feature of the operating funds in which fixed cost are

116
statement (sales less marginal absorbed to arrive at profit.
cost = Contribution
(d) Distinction is made between (d) No distinction is made between
fixed and variable costs. fixed and variable costs.
(e) Stocks are valued at variable (e) Stocks are valued at total
costs which exclude fixed costs. production cost including fixed
production overhead costs.
(f) It is used for decision making (f) It is used for routine
purposes. purposes.

It is imperative to say that the marginal costing approach (also known as the
contribution approach) highlights the total contribution which forms a fund out of
which fixed costs must be paid. The contribution per unit will be the same irrespective
of the level of output. This approach does not attempt to imply a fixed overhead rate
per unit rather fixed overheads do not change with the level of output, and therefore,
should only be stated in total.

ILLUSTRATION 7-1

(1) Absorption Costing Statement N’000 N’000

Sales 75
Less: manufacturing cost of goods sold 45
Gross profit 30
Less: Selling costs 18.75
Net profit 11.25

(2) Marginal Costing Statement

Sales 75
Less: Variable costs 30
Contribution 45
Less: Fixed Cost – manufacturing 15
- Selling 18.75 33.75
Net Profit 11.25

The conventional absorption costing statement fails to differentiate between fixed and
variable costs and, therefore, cannot be used for cost-volume-profit analysis. In
addition, it is normal procedure to calculate the cost and profit per unit, based on
absorption costing as illustrated below using the level of activity of 7,500 units:
N N
Selling price 10.00
Manufacturing cost 6.00
Selling cost 2.50 8.50
Profit per unit 1.50

Assuming the level of activity increased to 9,000 units, the following results would be
expected.

117
Total Per Unit
N’000 N’000
Sales
Less: Manufacturing cost of goods sold 90 10,00
Gross profit 54 6,00
Less: Selling costs 36 4,00
Net profit 22.5 2,50
13.5 1,50

ILLUSTRATION 7 – 2

Kike Nigeria Limited produces “Pomade” in 2004, and made the following data
available. As Management Accountant, you are required to present to the management
of Kike Nigeria Limited the profit based on marginal costing and absorption costing.

Selling price N20.00 per unit

Variable manufacturing cost N8.00 per unit
Fixed manufacturing cost N20,000.00
Selling and administrative cost Fixed N10,000
Variable N4.00 per unit
Units produced 20,000 units
Units sold 19,000 units

SUGGESTED SOLUTION 7 – 2

(a) Absorption Costing Statement

N N N
Sales 380,000
Less: Cost of goods sold Per Unit
N
Variable manufacturing costs 20,000 units 8 160,000
Fixed manufacturing cost 1 20,000
9 180,000
Less: closing stock (500 units) 9 4,500 175,500
Gross profit 204,500

Less: Selling and administrative costs 86,000

Net profit 118,500

(b) Marginal Costing Statement

N N
Sales 380,000
Variable manufacturing costs of production-
(20,000 units at N8) 160,000
Less: closing stock (500 units N8) 4,000

118
Variable manufacturing cost of goods sold 156,000
Add: Variable selling and administrative costs 76,000

Variable cost of goods sold 232,000

Contribution 148,000
Less: fixed costs:
Manufacturing cost 20,000
Selling and administrative cost 10,000 30,000
Profit 118,000

The difference in the operating statement of both techniques of N500, relates to the
valuation of the closing stock (N4,500 – 4,000).

3.4 MARGINAL COSTING AND DECISION MAKING

Decision making is defined as making choices between future, uncertain alternatives.

It must be emphasized that all decision making relate to the future and that a decision
is a choice between alternatives in pursuit of an objective. Where no alternatives exist,
no decision can be made and nothing can be done now that will alter the past. These
fundamentals of decision making are of critical importance in determining what
information the management accountant should supply to the decision maker.

3.4.1 The decision process

The overall decision process can be subdivided into stages:

(a) definition of objective(s);
(b) consideration of alternatives;
(c) evaluation of alternatives in the light of the objective(s); and
(d) selection of the course of action.

3.4.2 Types of decisions

Decision making is concerned with 'cost and revenues' or costs/benefits analysis. The
assumption that level of activity will remain constant within the relevant range of
output will not be maintained. However, variation in unit variable costs or fixed costs
might occur. Various types of decisions are:
(a) Routine planning decisions - These relate to budgeting decisions whereby fixed
and variable costs are analysed together with revenues over a period.
(b) Short-run problem decisions - These refer to unforeseen decisions of a non-
recurring nature, so that revenue and costs are obtained within a relatively short
time.
(c) Investment or disinvestments decisions - These refer to decision of long-term
consequences. It allows for the concept of time value of money and the
appreciation of discounted cash flow techniques.
(d) long-range decisions - These relate to an infrequently reviewed decisions. They
are decisions made once, meant to provide a continuing solution to a recurring

119
problem, for example, deciding, or reviewing the channel of distribution of the
company's products.
(e) Control decisions - That is, these are cautious decisions with a view to evaluate
the benefits expected such that they exceed the costs of investigation. It is more
like "think before you act" circumstances.

3.4.3 Relevant cost

Any cost that is useful for decision making is often referred to as a relevant cost. A
cost is said to be relevant provided there is a future cash flow arising from a direct
consequence of a decision.

(a) Relevant cost are future costs:

(i) A decision is about the future; it cannot alter what has been done already
In a famous passage, the economist Jevons( 1871) wrote 'the fact that
labour once spent has no influence on the future of any article; It is gone
and lost forever In commerce, bygones are forever bygones, and we are
always starting clear at each moment judging the values of things with a
view to future utility
(ii) The concept that bygones are bygones refers not only to labour, but also
to all historic costs of materials, machinery and other items.
(iii) Costs that have been incurred include:
 cost that have already been paid; and
 costs that are the subject of legally binding contracts, even if
payments due under the contract have not yet been made.
It is necessary to advise the readers that past costs are only useful as long
as they provide information for forecasting.

(b) Relevant costs are cash flows:

(i) Decisions are most often taken which will maximize the 'satisfaction' of
a company's shareholders. Readers will realise that the time value of
money affects the worth of cash flows from project over a longer period,
and all short - run decisions are assumed to improve the shareholders'
satisfaction if they increase net cash inflows. 'The decision rule will be to
accept opportunities that increase the value of future cash resources and
to reject those that decrease it.’ (Arnold 1963)
(ii) Only cash flow information is required. In essence, any cost or charge
that fails to reflect additional cash spending should be excluded. These
include:
 Depreciation as a fixed overhead incurred.
 Notional rent or interest, as fixed overhead incurred.
 All overheads absorbed. Fixed overhead absorption is always
irrelevant, since it is overheads to be incurred which affect
decisions. (Confusingly variable overhead cost are usually
relevant, because they should be incurred at the same rate that
they are absorbed).
120
(c) A relevant cost is one which arises as a direct consequence of a decision.
Thus, only costs which will differ under some or all of the available
opportunities should be considered; relevant costs are, therefore,
sometimes referred to as incremental costs or differential costs.

Thus, if an employee is expected to have no other work to do during the next

week, but will be paid a basic wage (of N100 per week) for attending work and
doing nothing, his manager might decide to give him a job which earns only
N40. The net gain is N40, and the N100 is irrelevant to the decision, because
although it is a future cash flow, it will be incurred anyway whether the
employee is given work or not. Relevant costs were slow to be accepted by the
accounting profession, and did not properly feature in accounting textbooks
until the early 1960's. Economists have been aware of them for a much longer
time; and they are simply the application of common sense and economic
wisdom. Parker(1963), (Topics in Management Accounting ) wrote that
intelligent business men at an early date were aware intuitively of the notions of
a voidable cost and opportunity cost, and of irrelevance of cost which are the
same under all alternatives,

3.4.3 Differential costing

This is a term used in the preparation of adhoc information when all the cost and
income differences between the various options being considered are highlighted so
that clear comparisons can be made of all the financial consequences. In one sense,
differential costing is a wider concept than marginal costing because all cost changes
are considered, both fixed and variable, whereas the presumption when marginal cost
is used is that only variable cost changes.

3.4.4 Differential and incremental costs

A differential cost is the difference in the cost of alternative choices. If option A will
cost an extra N300 and option B will cost an extra N360, the differential cost is N60,
with option B being more expensive.
A differential cost is the difference between the incremental cost of each option.

3.4.6 Historical cost information

Although historical costs (also called past cost, sunk costs, irrevocable
cost and including committed costs) are irrelevant for decision making,
historical cost data can be useful for decision making. ["Historical costs are
themselves irrelevant to the decision, although they may be the best available basis for
predicting future costs." (Horngren, 2004).]

121
3.4.7 Opportunity Costs

Relevant cost may also be expressed as opportunity costs.

An opportunity cost is the benefit of the next best alternative that is forgone:

(a) If the choice is between choosing option A or doing nothing, the opportunity
cost of A is the extra cash expenditure incurred, for choosing option A,
Arnold(1963), calls this an external opportunity cost but it is, quite simply,
incremental cost.
(b) If the choice is between choosing option B or C, the opportunity cost of A
would be described as the benefit forgone from the more profitable of the two
other choices, B or C. Arnold calls this an internal opportunity cost, which
arises whenever there are mutually exclusive options, or limiting factors/scare
resources for production. It is this type of opportunity cost which is more
widely known by the general term; opportunity cost, for example. see quotation
in the above paragraph incremental or differential costs.

3.4.8 Acceptance or rejection of a special order

By this is meant the acceptance or rejection of an order which utilizes spare capacity
but which is only available if a lower than normal price is quoted. The procedure is
illustrated by the following example.

ILLUSTRATION 7 – 3

Babariga Company which manufactures rubber soles for use in its production cycle,
has the following unit cost for production of 40,000 units.

N
Director labour 30
Direct material 8
Manufacturing overheads 36
74
75% of the manufacturing overhead is fixed. Buba Ltd has offered to sell 40,000 units
of the rubber soles to Babariga Ltd for N55 per unit. If Babatiga accepts the offer, part
of the facilities presently used to manufacture the rubber shoes could be rented to
Kaftan Ltd at a rent of N72,000. Also, per unit of the fixed overhead costs applied to
the rubber shoes would be avoided.

The Managing Director, Mallam Danbaba has called you to advise him on whether or
not to accept the offer. You are also required to state other matters that should be noted
before taking the decision.

SUGGESTED SOLUTION 7-3

122
EVALUATION OF BUBA LTD’S OFFER
N N
Buba Ltd’s Quotation (N55 x 40,000) 2,200,000
Less incremental outlay
Direct Materials (N8 x 40,000) 320,000
Direct Labour (N30 x 40,000) 1,200,000
Valuable manufacturing overhead
(25% of N36 x 40,000) 360,000
1,880,000

Applicable fixed overhead

(N10 x 40,000) 400,000
2,280,000
Opportunity cost -
rent to Kaftan Ltd. 72,000 2,352,000
(152,000)

Decision: Since Buba Ltd's quotation of N2,200,000.is fess the cost of

producing within (N2,352,000), it is hereby recommended that the offer should be
accepted from Buba Ltd. Subject to other qualitative factors.

However, there are several other factors which would need to be considered before a
final decision is taken. These include:
(a) Will the acceptance of one order at a lowered price lead other customers to
demand lower prices as well?
(b) Is this special order the most profitable way of using the spare capacity?
(c) Will the special order lock up capacity which could be used for future full price
business?
(d) Is it absolutely certain that fixed costs will not alter?

3.4.9 Discontinuance of a product line

If a company has a range of products, one of which is deemed to be unprofitable, it

may consider discontinuing with the item from its range.

ILLUSTRATION 7 – 4

Aseye Ltd. Igbogbo produces three products for which the following operating
statement has been produced:

Product A Product B Product C Total

N N N N
Sales 128,000 200,000 180,000 508,000
Total Costs 144,000 152,000 136,000 432,000
Profit/(Loss) (16,000) 48,000 44,000 76,000

123
The total cost comprises 2/3 variable and 1/3 fixed.
The directors consider that as product A shows a loss it should be discontinued.
Based on the above cost data, should Product A be dropped? What other factors should
be considered?

SUGGESTED SOLUTION 7 – 4

ASEYE LTD, IGBOGBO

Product A
N
Sales 128,000
Less Total Variable Cost
(2/3 x N144,000) 96,000
Total Contribution 32,000

Decision:
Product A is showing a positive total contribution of N32,000, hence it should not be
dropped. If product A is mistakenly dropped, the total profit of the business (N76,000)
will go down by the positive contribution of A (N32,000) to N44,000.

Other factors that should be considered are:

(i) Is product A jointly demanded with any of the other products? If so, then sales
of other products will be affected. This will also lead to loss of profit.
(ii) Loss of goodwill will result if customers of product A cannot see the product in
the market.
(iii) What will be the fate of workers that manufacture product A? Are they going to
be re-trained or retrenched?
(iv) What would happen to the plant and equipment used in manufacturing Product
A, particularly if it is of a specialized nature and not readily marketable.

3.4.10 Key Budget Factor / Limiting Factor

Key budget factors sometimes known as a limiting factor or principal

budget factor. This is a factor which is a binding constraint upon the
organization, that is, the factor which restricts indefinite expansion or unlimited
profits. It may be sales, availability of finance, skilled labour, supplies of material or
lack of space. Where a single binding constraint can be identified, then the general
objective of maximizing contribution can be achieved by selecting the alternative
which maximizes the contribution per unit of key factor. It will be apparent that from
time to time, the key factor in an organization will change. For example, a firm may
have a shortage of orders. It overcomes this by appointing salesmen and then finds that
there is a shortage of machinery capacity. The expansion of the productive capacity
may introduce a problem of lack of space and so on.

The 'maximizing contribution per unit of the limiting factor' rule can be of value, but

124
can only be used where there is a single binding constraint and where the constraint is
continuously divisible, that is, it can be altered one unit at a time. Where several
constraints apply simultaneously, the simple maximizing rule given above cannot be
applied because of the interaction between constraints.

In such circumstances mathematical techniques can be used to establish the optimal

position. One of the more important mathematical techniques that can be used for such
problems is known as Linear programming (LP). This is explained in chapter eleven
(11) of this study pack.

Rules governing the limiting factor(s):

(a) When there is no key limiting factor, use contribution margin
(b) If there's only one key limiting factor, use contribution per key limiting factor.
(c) If there is more than one limiting factor, use linear programming.

3.4.11 Make or buy decisions

Frequently, management is faced with the decision on whether to make a component

part within or to buy from outside supplier. A decision is relevant particularly in a
situation whereby the company has the capacity to produce/make such component.

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

3.5 COST-VOLUME-PROFIT (CVP) ANALYSIS

Cost-Volume-Profit Analysis otherwise known as Break-Even Analysis refers to a

technique that assists in decision making by employing the marginal costing concept
and is used to measure the effect on profit as a result of changes in volume of
activities, cost and prices. It also facilitates planning in the sense that CVP analysis
could assist to predict future cost levels and sales as related to a range of level of
activity. It demonstrates how the profit will be affected as a result of changes in any of
the variables that make up the profit function. Its use requires the separation of the
total cost function into their, variable and fixed portion, as required in the application
of marginal costing principles.

The profit-volume ratio is a very useful figure which indicates the relationship of
contribution to turnover. The formula used to calculate it is:
Contribution 100
Sales x 1

It is common practice to express this measurement in percentage form, so the usual

version is:

125
S – V x 100
S

The profit-volume ratio may be used to measure the relative contribution of a product
or a company for various periods. It is popularly called P/V Ratio.

3.5.1 Application of the P/V ratio

Management may request information towards solving a variety of problems which

require calculations and involving profit-volume ratios, for example:
(a) What is the company’s is break-even point?
(b) What would be the profit on sales volume NX?
(c) What volume of sales would be required to achieve a planned level of profit?
(d) What volume of sales would be required to maintain the present level of output
if selling price were reduced, lets say, by 10%

The use of P/V ratio and graphs can provide answers to such problems although it is
again assumed that these answers are guides only and may not be accurate. However,
they do at least provide a measuring tool which can form the basis of decision making.

3.5.2 Basic assumptions of C-V-P-Analysis

The basic assumptions associated with C - V - P technique are:

(a) All costs could be categorized as either variable cost or fixed cost.
(b) Semi-Variable cost can be segregated into both the variable
and its fixed component.
(c) Selling price per unit is constant.
(d) Variable cost per unit is constant.
(e) Total fixed cost remains unchanged regardless of output.
(f) Parity of production and sales. That is, there is no closing stock
of goods since production equals sales.
(g) Only one product is involved and in case of a multi-product
organization, there is a constant sales mix.
(h) Level of technology and efficiency remains the same.
(i) Volume is the only independent variable that affects cost.
(j) Risk and uncertainty are non-existent.
(k) There is a relevant range.

3.5.3 Limitations of the basic assumptions

In a true life situation, the basic assumptions of C-V-P analysis as discussed above
tend only to be valid over a limited range of activity. As a result of this reason, care
must be exercised when using break even analysis as a basis for decision making or
the presentation of information.

126
The basic assumptions of C-V-P have the following deficiencies:
(a) It might be difficult to separate some costs into their fixed and variable cost
portions.
(b) The selling price per unit is assumed to be constant. This is not realistic because
of possibility of discounts.
(c) The variable cost per unit is assumed to be constant. This is not realistic
because quantity discount could result in decrease in material cost and labour
cost per unit could fall whenever the learning curve theory becomes applicable.
(d) Fixed cost is assumed to remain unchanged. This is not true because in reality,
fixed cost moves in a step-like manner. Also in the long run all costs are
variable.
(e) It is assumed that production is equal to sale, hence no closing stock. This
assumption looks unrealistic because a business is a going concern and
invariably stocks are carried from one period to the other.
(f) The assumption of one product or constant mix of product is not realistic
because most organizations produce variety of products and invariably actual
mix turn out to be radically different from the expected level of activity. This
may be due to a host of factors such as the tastes of the customers and the
economic realities of the day,
(g) The assumption that there is no change in level of technology and efficiency is
untenable since innovations are taking place every day in all spheres of business
endeavours.

3.5.4 Applications of the C-V-P model

(a) To determine the breakeven point in units

= Total fixed cost

Contribution per unit or contribution margin

= TFC
CM
(b) Break even point in sales value (N)

= Total fixed cost

Contribution margin ratio

(c) Number of units to sell to make a targeted profit (N)

= TFC + Targeted profit

CM

(d) The sales value in N required to achieve a targeted profit

127
= TFC +Targeted profit
CMR
Note: Targeted profit is assumed to be profit before tax (PBT). However, if the
targeted profit is profit after tax, there is need to gross-up the profit after tax to profit
before tax, using the formula below:

Profit before tax = Profit after tax

1 - tax rate

That is, if tax rate is 30%, PBT = Profit tax = PAT

1 – 0.30 0.7

ILLUSTRATION 7 – 5

Yinka Limited is considering a reduction in the price of its product by 10% because it
is felt that such a step may lead to a greater volume of sales. It is thought that there is
no prospect of a change in fixed costs or variable cost per unit. The director wishes to
maintain profit at the present level, so the loss which will be incurred by reducing the
selling price must be offset by a gain due to increased volume of sales. You are given
the following information:

Sales (10,000 units) N200,000

Variable costs N15 per unit
Fixed costs N40,000
State the volume of sales required to maintain the existing profit.

SUGGESTED SOLUTION 7 – 5

The present level of profit = N200,000 – (150,000 + 40,000)

= N10,000
and the P/V Ratio is = S – V = 50,000 = 25%
S 200,000
If the selling price were reduced with no corresponding increase in sales volume, the
profit-volume ratio would be:

Sales = 180,000
VC = 150,000
Total Contribution = 30,000
CMR = S – V = 30,000 x 100
S 180,000 x 1 = 16.67%

It is not expected that fixed costs will change. The Director wishes profit to remain at
its present level. So, the volume of sale required is

= TFC + Profit = N40,000 + 10,000

128
P/V or CM Ratio 162/3%

= N300,000

The P/V Graph

The profit volume graph - This graph is a development of the break - even chart and
portrays the relationship of profit to volume. It requires the same basic data as the
Break - Even Chart (BEC) and suffers from the same limitations with BEP chart. But
if these limitations are borne in mind, they provide a valuable aid to management in
making decisions concerning volumes of output. Construction of profit - volume chart
will involve the following processes:
(a) Draw a vertical line and select a point in between it to represent point 0, that is,
the point at which neither profit nor loss is made.
(b) From point 0, draw the horizontal line to the right and scale appropriately for
sales.
(c) Also scale the upper vertical line for profit and the lower line for losses.
(d) On the vertical axis, the area below the sales line represents fixed cost and that
above it represents profit.
(e) Profits are plotted for the required fixed costs and for profit and a line is drawn
to connect the two points.

The P/V graph, or profit/volume graph is similar to the break - even chart, and records
the profit or loss at each level of sales. It is a straight line graph, drawn most simply by
recording:
(i) The loss at zero sales, which is full amount of fixed cost and
(ii) The profit (loss) at the budgeted level of sales; and joining up the two points.

4.0 CONCLUSIONS

Marginal costing is a decision making technique used to determine the effect on profit
due to cost changes and volume changes from time to time in a multi-product firm
especially in the short run. Emphasis is on the variable cost of a product and the fixed
cost is written off in full against the contribution and treated as period cost.

The various areas where the marginal costing technique is applicable are in: make or
buy, accept or reject situations, deleting a segment, special pricing decisions etc.

Cost-Volume-Profit analysis, also known as Break-even analysis, is used to measure

the effect on profit as a result of changes in both revenue and cost parameters,

129
5.0 SUMMARY

This unit treated in a greater depth the concept of marginal costing and its contribution
towards the provision of information for managerial decision making.

6.0 TUTOR MARKED ASSIGNMENT

1. Ade Limited has fixed costs of N60,000 per annum. It manufactures a single
product which it sells for N20 per unit. Its Contribution margin ratio is 40%.
Ade Limited’s break-even point is:
A 1,200
B 1,800
C 3,000
D 5,000
E 7,500.

2. Zaria Plc. makes a single Product which it sells for N16 per unit. Fixed costs
are N76,800 per month and the product has a contribution to sales of 40%. In a
period when sales were N224,000, Zaria Plc’s margin of safety in units was:
A 2,000
B 6,000
C 8,000
D 12,000
E 14,000.
3. Ariara Plc produces a single service to its customers. An analysis of its budget
for the year ending 31, December 2002 shows that in period 4, when the
budgeted activity was 5,220 service units with a sales value of N42 each, the
margin of safety was 19.575%. The budgeted fixed contribution to sales ratio of
the service is 40%. Budgeted fixed costs in period 4 were nearest to
A N1,700
B N71,000
C N70,500
D N176,000
E N96,000.

4. The following extract is taken from the production cost budget of Sunday
Ebang Limited:
Production Units 2,000 3,000
Production Cost N11,100 N12,900
The budget cost allowance for an activity level of 4,000 units is

5. The make-up of a company’s cost structure changes so that the contribution per
unit increases, but the total cost remains exactly the same. The operational
gearing (also referred to as operational leverage) would:
A Increase
B Decrease

130
C Stay the same
D Probably decrease
E Probably increase.

6. What is differential cost?

7. What are the formulae for: break-even point (units); break-even point (sales
value)?

8. Define relevant cost.

9. A company fixed cost is N100,000 and has two products. The sales and
contribution sales Ratio are”
Product Sales P/V Ratio Variable
A N300,000 20% _______
B N 80,000 50% _______

Determine the variable cost for products A and B.

10. Explain the term “Opportunity Cost”

7.0 REFERNCES/FUTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

131
UNIT 8 BUDGETING AND BUDGETARY CONTROL

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Definition of budget
3.2 Types of budget
3.3 Budget preparation and approval procedures
3.3.1 Budgets preparation procedures
3.3.2 Approval of the master budget
3.4 Preparation of budget
3.4.1 Cash budget
3.5 Techniques used in budgeting
3.5.1 Flexible budget
3.5.2 Zero-based budget (ZBB) or "priority based budgeting"
3.3.3 Activity based budgeting (ABB)
3.5.4 Planning, programming, budgeting system (PPBS)
3.3.5 Continuous budget / rolling budget
3.6 Behavioural aspects of budgeting
3.7 Solving behavioural problems in budgeting
3.8 Forecast
3.8.1 Distinction between forecast and budgets
3.8.2 Forcasting procedures
3.9 Budgetary control
3.9.1 The objectives of budgetary control
3.9.2 Organization for budgetary control
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignments
7.0 References/Further Readings

1.0 INTRODUCTION

Every organization makes plans, Some plans are more formal than others and some
organization’s plan more formally than others but all makes same attempt to consider
the risk and opportunities, which lie ahead, and how to confront them. In most
businesses, this process is formalized at least in short-term, with considerable effort
put into preparing annual budgets and monitoring performance against those budgets.
Traditionally, budgets have been employed as devices to limit expenditure, but a much
more useful and constructive view is to treat the budgeting process as a means for
obtaining the most effective and profitable use of the company’s resources via
planning and control.

132
2.0 OBJECTIVES

At the end of this unit, readers would be able to understand:

 The objectives of budgeting.

 The stages in developing budgets and their inter-relationships.
 Cash budget and its importance in an organisation.
 Functional budgets and master budget
 Control limits, activity and efficiency ratios.
 The major techniques used in budgeting such as Flexible budgets, Zero based
budgeting, Activity-based budgeting, Continuous budgeting, and Programme
Plannng dud Budgeting systems.
 The need for budgetary control.
 The Vital importance of the human aspects of budgeting.

3.1 DEFINITION OF BUDGET

A budget is defined as "a quantitative statement for a defined time which may include,
planned revenues, expenses, assets, liabilities and cash flow. A budget provides a
focus for the organisation, aids the coordination of activities and facilitates control.
Planning is achieved by means of a fixed master budget whereas control is generally
exercised through the comparison of actual costs with a flexible budget" (CIMA).

Budget is a financial and/or quantitative plan of operations for a forthcoming

accounting period.

Many functional budgets [a budget of income or expenditure for individual functions

of a business such as the sales budget, production budget, direct labour budgets, etc]
are incorporated into a master budget.

"Budgets are designed to carry out various functions such as planning, evaluating
performance, co-ordinating activities, implementing plans, communicating, motivating
and authorizing actions. The last-named role seems to predominate in government
budgeting and not-for-profit budgeting, where budget appropriations serve as an
authorisation and ceiling for management actions" [Horngren (2004).]

The purpose of a budget is to:

(i) Communicate ideas and plans to everyone affected by them. A formal system is
necessary to ensure that each person is aware of what he or she is supposed to
be doing. Communication might be one-way, that is, with managers giving
order to subordinates; or there might be a two-way dialogue and exchange of
ideas, this is between managers and subordinates.
(ii) Coordinate the activities of different departments or sub-units of the

133
organization. This concept of coordination implies, for example, that the
purchasing department should base its budget on production requirements, and
that the production budget [that is, direct labour budget and machinery
utilization budgets etc] should in turn be based on sales expectations. Although
straight forward in concept, coordination, in practice, is remarkably difficult to
achieve, and this often leads to 'sub-optimality' and conflict among
departmental managers.

(iii) Establish a system of control by having a plan against which actual results can
be progressively compared and variance analysed for prompt attention and
action.

(iv) Motivate employees to improve their performances. The level of attainment

usually incorporated in the budget is a realistic figure for the budget period.
[Thornton: [1978].
Thornton, (1978) suggests that two levels of attainment could be fixed:
(i) a 'minimum expectations' budget, and
(ii) a 'desired standards' budget.

A budget is a means to an end, and not an end in itself. It is a short term plan that
depicts the focus of a long term objective of the organisation. It covers area of
responsibility of one specified person, so that his performance can be measured at the
end of a budget period. It follows that the budget should be prepared in conjunction
with those who are to be responsible for achieving the budgeted performance. In this
way, a head of department translates his goal in the budgets. This approach offers
motivation to the managers. This technique, with its stress on personality, differs from
standard costing, for the latter is concerned with standards for products or services.

3.2 TYPES OF BUDGET

(a) Functional budgets

Functional budgets are prepared by the departmental heads. The order of
importance in preparation of the budget depends on the budget limiting factor
of the organisation. Where sales are considered critical to the success of the
objectives, the sales budget is prepared first. Similarly, where source of raw
material is restricted and in limited supply the raw material budget is prepared
first.

The order of presentation suggests that the sales are critical and so sales budget
is prepared before other budgets:
(i) Sales budget. This will incorporate decisions about selling
prices and expected sales volume for each item of product (or service)
for all segments of the company's product or service;

(ii) The departmental budgets for marketing, sales and distribution would
also be made at an early stage, because estimates of spending on sales

134
promotion, advertising and salesmen, etc will be necessary to gauge the
expected volume of sales;
(iii) Having prepared the sales budget, it should be possible to estimate
production requirements in terms of quantity of raw materials, labour
hours, machine hours etc. However, decision must first be taken about
stocks of finished goods. A decision to increase stocks would mean that
production for the period must exceed sales volume. On the other hand, a
decision to reduce stock levels (so as to improve the organisation's cash
position) would mean that production volume would be less than sates
volume by the amount of the run-down in stocks. The level of stock to
hold would depend on the variability in demand, leadtime for raw
materials, etc.;

(iv) The production budget is then prepared, specifying the expected

quantities of each product to be made, in each factory or manufacturing
department, followed by the budgets of resources for production, that is,
 Materials usage budget for all types of materials, direct and
indirect;
 Machine utilization budget for the operating hours
required on each machine or group of machines;
 Labour budget ( all grades of labour, direct and indirect in hours
and cost);
 Overhead cost centres budgets for production, administration, and
research and development cost centres.
(v) A materials purchasing budget is also required, specifying the expected
quantities and price of each stores item for raw materials bought-in
components, stationery, etc. In order to prepare the purchases budget a
decision must first be taken about stock level. Purchase requirements (in
quantity) are the usage requirements, plus any increase in raw material
stocks, or less any decrease in stocks;
(v) A capital expenditure budget, updated each year, covering a period of the
next three to five years.

(vi) A working capital budget, specifying the changes in debtors and

creditors during the year. Turnover periods would be estimated and the
effect of any proposed decision on discounts or credit period allowances
considered.

(vii) The cash budget cannot be prepared until the functional budgets in (i) to
(vi) have been decided, prepared and agreed.

(b) Master budget

The master budget consolidates the position of all the functional budgets in the
form of a budgeted trading and profit and loss account and a budgeted balance
sheet. Budgetary control relates expenditure to the person responsible for each
function, thus affording an effective method of control. It is an important

135
principle of the system that an executive is held responsible only for
expenditure within his control.

3.3 BUDGET PREPARATION AND APPROVAL PROCEDURES

3.3.1 Budgets Preparation Procedures

The business of any organisation must be conducted in an organised and orderly

manner to achieve the desired results.

Budget preparation is a serious activity of management and some time should be

expended on it. In practice, top management may constitute a budget committee which
could comprise:
(a) The Managing Director/ Chief Executive Officer as the Chairman
(b) Chief Accountant (or Director of finance) as the budget officer. He coordinates
the preparation and readiness of other budgets and prepares the cash budget as
well as the master budget. His knowledge of the interrelationship of these other
functional budgets puts him in an advantageous position to be the budget
officer.
(c) The head of department or the line and service managers who prepares the
functional budgets of the department.

It is good management policy to have a pre-budgeting meeting where the guidelines

for the new budget period are drafted, discussed and approved. This would include the
requirements that the new budgets must meet the standard parameters.

3.3.2 Approval of the master budget

The budget committee will submit the master budget to the top management (usually
the board of directors) for approval. If it is approved, the master budget will then
become the blueprint for the activities of the budgeted period. If approval is not
received, sections of the budget will have to be amended to incorporate any change or
review in emphasis so as to meet the requirements of top management. However, these
requirements should be realistic. There are limits to the success which can be
achieved. Some improvements may be possible for the following reasons:
 managers may have been too pessimistic in their estimates.
 padding or slack variables may have been built into the budget - that is
estimates of costs may be overstated and activity understated so that the budget
can be easily achieved.
 improvements in efficiency may be possible.
 additional sales promotion may yield positive results.
 it may be possible to increase productive capacity — although
in many industries this could take considerable time.

3.4 PREPARATION OF BUDGETS

136
3.4.1 Cash Budget

A cash budget is a summary of the company's expected cash inflows and outflows
over a given period of time.

Cash is required in order to facilitate the achievement of a company's plans and

intentions. Inadequate flow of liquidity will hamper efficiency and level of
profitability of the firm. A company may be profitable but, still faces liquidity
problems. Cash is a resource which should be effectively utilised in order to generate
benefits for the company Cash budget shows the timing of expected cash flows. The
benefits to be derived from the preparation of detailed cash budget are as follows:
(i) It provides early signals of potential deficit or surplus in order to take
appropriate action,
(ii) It enables financial feasibility of plans to be ascertained.
(iii) It indicates the financial effects of policies within a firm.
(iv) It provides a base for monitoring actual activity. The frequent comparison of
actual cash flow with budgeted cash flow will enable up to date information to
be incorporated into budget revisions.

ILLUSTRATION 8.1

From the following data, prepare a cash budget for the first six months of 2005 for
Super Industries Ltd:

(i) Budgeted Profit and Loss Accounts for the period ended 30 June, 2005.

Jan Feb Mar April May June

N’000 N’000 N’000 N’000 N’000 N’000
Sales 90 92 88 95 90 94
Less Purchases 54 56 50 60 52 55
Gross Profit 36 36 38 35 38 39
Less operating
expenses: (10) (12) (13) (13) (16) (15)
Selling expenses (6) (4) (5) (7) (4) (5)
Distribution expenses (3) (4) (4) (2) (5) (3)
Admin. expenses 17 16 16 13 13 16
Net profit

(ii) Sales for November and December 2004 were N85,000 and N90,000
respectively.
(iii) 40% of sales would be in cash, 30% each would be paid in 30 days and 60 days.
(iv) Purchases for November and December 2004 were N48,000 and N50,000
respectively
(v) 75% of purchases would be paid for immediately and the balance in two
months time.

137
(vi) Selling expenses are to be settled in two equal installments in 30 and 60 days.
December 2004 expenses are N15,000.
(vii) Distribution, expenses are payable one month in arrears while administration
expenses are payable immediately.
(viii) Distribution expenses for December 2004 would be N5,000 while selling
expenses would be N8,000 for November 2004 and N9,000 in December 2004.
(ix) Balance in the bank on 31 December, 2004 is expected to be N28,000
overdrawn.
(x) The company intends to pay for the following:
 Company tax of N12,000 in February 2005
 A new generator costing N6,500 in March 2005
 Dividends of N20,000 in April 2005.
(xi) Some unserviceable vehicles would be sold in January 2005 for N8,000. Show
all workings.

SUGGESTED SOLUTION 8 – 1

SUPER INDUSTRIES LIMITED

Jan Feb March April May June Total

RECEIPT
(N’000) 88.5 90.8 89.8 92 90.9 93.1 545.1
Sales 8.0 8
Asset disposal 96.5 90.8 89.8 92 90.9 93.1 553.1
TOTAL

PAYMENT 52.5 54.5 51.0 59.0 51.5 56.25 324.75

(N’000) 7.5 12.5 11.0 12.5 13.0 14.5 71.0
Purchases 5.0 6.0 4.0 5.0 7.0 4.0 31.0
Selling 3.0 4.0 4.0 2.0 5.0 3.0 21.0
expenses 12.0 12.0
Distribution 6.5 6.5
exp. 2.0 2.0
Admin. 68.0 89.0 76.5 98.5 76.5 77.75 486.25
expenses 28.5 1.8 13.3 (6.5) 14.4 15.35 66.85
Corporation (28.0) 5.0 2.3 15.6 9.1 23.5 (28.0)
tax 5.0 2.3 15.6 9.1 23.5 38.85 38.85
Generator
Dividends
TOTAL
Net Cashflow
Opening
balance
Closing
balance

138
WORKINGS
Nov. Dec. Jan. Feb. Mar. Apr. May June
2004 2004 2005 2005 2005 2005 2005 2005
Sales
Actual 85.0 90.0 90.0 92.0 88.0 95.0 90.0 94.0
40% 34.0 36.0 36.0 36.8 35.2 38.0 36.0 37.6
30% 25.5 27.0 27.0 27.6 26.4 28.5 27.0
30% 25.5 27.0 27.0 27.6 26.4 28.5
Total 34.0 61.5 88.5 90.8 89.8 92.0 90.0 93.1

Nov. Dec. Jan. Feb. Mar. Apr. May June

2004 2004 2005 2005 2005 2005 2005 2005
Purchase
Actual 48.0 50.0 54.0 56.0 50.0 60.0 32.0 55.0
75% 36.0 37.5 40.5 42.0 37.5 45.0 39.0 41.25
25% 12.0 12.5 13.5 14.0 12.5 15.0
Total 36.0 37.5 52.5 54.5 51.0 59.0 51.5 56.25

Selling Nov. Dec. Jan. Feb. Mar. Apr. May June

Expenses 2004 2004 2005 2005 2005 2005 2005 2005
Actual - 15.0 10.0 12.0 13.0 13.0 16.0 15.0
50% - - 7.5 5.0 6.0 6.5 6.5 8.0
50% - - - 7.5 5.0 6.0 6.5 6.5
7.5 12.5 11.0 12.5 13.0 14.5

ILLUSTRATION 8 – 2

GSMA Limited expects sales of its airtime to amount to N800 million in January,
N850 million in February and N950 million in March, 2004.
Prepare an estimate of cash budget from these information for the three (3) months
ended 31 March 2004 assuming the following:
(i) 10% of sales are cash sales with 5% discount
(ii) 3% discount is also given for credit sales when payment is received within 10
days, 25% of credit sales are paid within 10days.
(iii) Half of the remaining debtors paid in the month following sales.
(iv) The remainder paid two months following sale with the exception of bad
debtors, who amount to 1% of total sales.
(v) The following expenses were incurred during the period:

JAN FEB MARCH

N’000 N’000 N’000
Salaries and wages 14,500 15,200 16,000

139
Printing of cards 2,300 4,200 4,500
Loan (Principal due) 80,000 185,000 220,000
Interest on loan 8,500 9,000 10,000

The following notes relate to these expenses:

 10% of salaries are paid one month in arrears, 10% salaries and wages due as at
the end of December 2003 not yet paid amounted to N1,200,000.
 Loan is paid as at when due while interest on loan is paid one month in arrears.
Loan interest for the month of December 2003 is N7,900,000.
 Royalties are also paid one month in arrears. Royalties are 5% of total cash
receipts and total receipts for December 2003 is N210,500,000.
 Administrative expenses are 5% of total sales and are paid in the month of
sales.

SUGGESTED SOLUTION 8 – 2
GSMA LIMITED
WORKINGS JAN FEB MARCH
N’000 N’000 N’000
Total sales 800,000 850,000 950,000
10% cash sales (80,000) (85,000) (95,000)
Credit sales 720,000 765,000 855,000

Payment within 10 days (25%) (180,000) (191,250) (213,750)

540,000 573,750 641,250
50% month following 10days 270,000 286,875 320,625
270,000 286,875 320,625
Bad debt – 1% of sales 8,000 8,500 9,500
Payment 2 month after sales 262,000 278,375 311,125
10% cash sales without discount 80,000 85,000 95,000
Less 5% discount 4,000 4,250 4,750
76,000 80,750 90,250
Credit sales within 10 days 180,000 191,250 213,750
Less 3% discount 5,400 5,738 6,413
174,600 185,512 207,337
Admin expenses – 5% of sales 40,000 42,500 47,400
Salaries & wages 90% 13,050 13,680 14,400
10% arrears 1,200 1,450 1,520
Salaries & wages paid 14,250 15,130 15,920

GSMA LTD.
CASH BUDGET FOR THE PERIOD ENDED 31 MARCH 2004
JAN FEB MARCH
RECEIPTS N’000 N’000 N’000
140
Cash sales less discount 76,000 80,750 90,250
Credit sales less discount 174,600 185,512 207,337
Payment in the following month - 270,000 286,875

Payments – 2 months after sale - - 262,000

Total cash receipts 250,600 536,262 846,462
PAYMENTS
Salaries and wages 14,250 15,130 15,920
Printing of cards 2,300 4,200 4,500
Loan repayment 80,000 185,000 220,000
Interest repayment 7,900 8,500 9,000
Admin. expenses 40,000 42,500 47,500
Royalties 10,525 12,530 26,813
Total payment 154,975 267,860 323,733
Net Cash Flow 95,625 268,402 522,729
Opening Balance - 95,625 364,027
Closing Balance 95,625 364,027 886,756

3.5 TECHNIQUES USED IN BUDGETING

3.5.1 Flexible budget

The C1MA defines a flexible budget as "a budget which is designed to change in
accordance with the level of activity attained".

A flexible budget recognises the existence of fixed, variable and semi-variable costs,
and it is designed to change in relation to the actual volume of output or level of
activity in a period. The principles underlying the flexible budget are:
(i) to prepare 'contingency plans' in advance. Flexible budgets are prepared for a
range of activity rather than for a single level of activity (although the most
probable activity level becomes unavoidable/desirable during the course of the
year, management automatically adapts itself to the change by switching to a
more appropriate flexible budget as the new budget master plan;
(ii) budgetary control. Flexible budgeting is fundamental to budgetary control.
Control is not achieveable with a fixed budget. In fixed budgets control, the
budgets prepared are based on one level of output, a level which has been
carefully planned to equate sales and production at the most profitable rate. If
the level of output actually achieved differs considerably from that budgeted,
large variances will arise. Basically the idea of a flexible budget is that there
shall be some standard of expenditure from varying levels of output.

The concept of flexible budget was to focus on how control could be achieved over the
operations. In a flexible budget, overheads are analysed into three, namely:
(a) fixed;
(b) variable; and

141
(c) semi variable.

ILLUSTRATION 8-3

Sales director of Tayo Box Fabricators has become aware of the disadvantages of
static budget. The director asks you as the Management Accountant to prepare a
flexible budget for October 2005 for its main brand of boxes.

The following data are available for the actual operation in September 2005:
Boxes produced and sold 4,500 units
Direct Materials costs N180,000
Direct Manufacturing Labour Costs N135,000
Depreciation and other fixed

Manufacturing costs N101,400

Average selling price per box N 140
Fixed marketing costs N 62,700

Assume no stock of boxes at the beginning or end of the period. A 10% increase in the
selling price is expected in October. The only variable marketing cost is a commission
of N0.50k per unit paid to the manufacturer’s representatives, who bear all their own
costs of traveling, entertaining customers, etc. A patent royalty of N2 per box
manufactured is paid to an independent design firm. Salary increases that will become
effective in October are N12,000 per year for the production supervisor and N15,000
per year for Sales Manager. A 10% increase in direct materials prices is expected to
become effective in October. No changes are expected in direct manufacturing labour
wage rates or in the productivity of the direct manufacturing labour personnel standard
costs for any of its inputs.

You are required to:

Prepare a flexible budget for October 2005 showing budgeted amounts at each of these
output levels of boxes, 4,000 units, 5,000 units and 6,000 units.

SUGGESTED SOLUTION 8 –3

TAYO BOX FABRICATIONS LIMITED

FLEXIBLE BUDGET FOR THE MONTH OF OCTOBER, 2006

Activity Level 4,000 units 5,000 units 6,000 units

N N N
Sales 616,000 770,000 924,000
Less
Direct material (176,000) (220,000) (264,000)
cost (120,000) (150,000) (180,000)
Direct labour (2,000) (2,500) (3,000)

142
cost (8,000) (10,000) (12,000)
Marketing (306,000) (382,500) (459,000)
variable
Royalties 310,000 387,500 465,000
Variable costs (266,350) (266,350) (266,350)
43,650 121,150 198,650
Contribution
Less: Fixed
Costs
NET PROFIT

WORKINGS
STATEMENT OF COST

SEPTEMBER OCTOBER
N N
Direct material cost 40.00 44.00
Direct labour cost 30.00 30.00
Marketing variable cost 0.50 0.50
Royalties 2.00 2.00
Total variable cost 72.50 76.50
Fixed Cost-Depreciation 101,400 101,400
Marketing 162,700 162,700
Increase in salary – production - 1,000
Increase in salary – marketing - 1,250
264,100 266,350
Selling Price 140 154

3.5.2 Zero-based budget (ZBB) or "priority based budgeting"

ZBB is a budgeting technique which seeks to eliminate the draw backs of traditional
incremental budgeting by taking the budgets for service or overhead centres back to a
minimal operating level and then requiring increments above this level to be quantified
and justified.

'A method of budgeting which requires each cost element to be specifically justified,
as though, the budget related were being undertaken for the first time, without
approval, the budget allowance is zero" CIMA

ZBB was introduced in the early 1970s in the United States by 0. Phyrr. It gained
prominence because of the fact that it is based on common sense. President Carter, the
President of the United States, directed all US government departments to adopt this
technique.

ZBB is concerned with the evaluation of the costs and benefits of alternatives and,
implicit in the technique, is the concept of opportunity cost.

143
ZBB is applied in three stages
(i) The decision unit: This means subdividing the organisation to
discrete sub-units where operations can be meaningfully and individually
identified and evaluated.

(ii) The decision packages: Each decision unit manager submits

no less than three budget packages namely (a) the lowest level of expenditure,
(b) the expenditure required to maintain levels of activity. (c) the expenditure
required to provide an additional level of service or activity.

(iii) Agreed packages will form the budget.

Advantages of ZBB
(i) Results in a more efficient allocation of resources to activities
and departments.
(ii) It focuses attention on value for money
(iii) ZBB develops a questioning attitude which enables management to determine
inefficiency.
(iv) It may lead to cost reduction.
(v) Managers performance can be monitored.

Disadvantages of ZBB
(i) ZBB is a time consuming process and generates volume of paperwork
especially for the decision packages.
(ii) It requires management skill in both drawing decision packages and for the
ranking process.
(iii) It encourages the wrong impression that all decisions have to be made in the
budget.
(iv) Trade Union always go against ZBB, who prefer status quo to remain.
(v) Co-ordination of all activities may be difficult.

3.5.3 Activity based budgeting (ABB)

Activity based budgeting (ABB) which is also known as Activity Cost Management is
defined as ` method of budgeting based on an activity framework and utilizing cost
driver data in the budget-setting and variance feedback processes" (ICMA).

It is a part of planning and control system which tends to support the objectives of
continuous improvement. ABB is a form of development of conventional budgeting
system. It is also based on activity analysis techniques.

ABB FEATURES
(a) It recognises activities that drive costs with the aim of controlling the causes of
cost directly rather than the costs themselves. It enables costs to be managed

144
and understood in the long run.
(b) ABB differentiates and examines activities for their value adding potentials.
(c) The department activities are driven by demands and decisions which are
beyond the control of the budget holder.
(d) It encourages immediate and relevant performance measures
required than are found in conventional budgeting systems.

Advantages of ABB
(i) It provides stronger links between an organisations strategic objectives.
(ii) It has ability to tackle cross organisational issues through a participating
approach.
(iii) It also uses activity analysis techniques which promotes continuous
improvement.

3.5.4 Planning, Programming, Budgeting System (PPBS)

PPBS analyses the output of a given programme and also seeks for the alternatives to
find the most effective means of reaching basic programme activities.

PPBS involves the preparation of a long-term corporate plan that clearly establishes
the objectives that the organization have to achieve.

PPBS is the counter part of the long-term process for profit-oriented organisations.

Aims and Objectives of PPBS

(i) The aim of PPBS is to enable the management of a non-profit making
organisation to make more informed decision about the al location, of resources
to meet the overall objectives of the organisation.
(ii) It enables the management to identify the activities, functions or programmes to
be provided thereby establishing a basis for evaluation of their worthiness,
(iii) PPBS provides information that will enable management to assess the
effectivenesses of its plans.

Stages In PPBS
(i) Calls for a careful specification and overall objectives are
determined.
(ii) identify programmes that will achieve these objectives and
those programmes which are normally related to the major activities undertaken
by government establishments.
(iii) The costs and benefits of each programme are determined, so that budget
allocations can be made on the basis of the cost-benefit of the programme.
(iii) Analyses the alternatives to find the most effective means of
reaching basic programme objectives.
(iv) This analytical procedures will be established as to systematically form part of
budgetary control.

145
3.5.5 Continuous Budget/Rolling Budget

Continuous budget which is known as rolling budget is a system of budgeting that

involves continuously updating budgets by reviewing the actual results of a specific
period in the budget and determining a budget for the corresponding time period. It has
been described as an attempt to prepare targets and plans which are more realistic and
certain by shortening the period of budget preparations. Under this method, instead of
preparing a budget annually, there would be budget every three or six months so that
as the current period ends, the budget is extended by an extra period; for example, if a
continuous budget is prepared every three months, the first three months would be
planned in great details and the nine months in lesser details, because of the greater
uncertainty above the longer term future. This means that, if a first continuous budget
is prepared for April to June, in details to March, in less detail a new budget will be
prepared towards the end of June to cover June to September in details and October of
the following year in lesser details.

Advantages
i. Management is made to be continuously aware of the budgetary process since
the figures for the next 12 months are made always available.
ii. It allows for more frequent assessment and revision of the budgets in the light
of current trends particularly during the period of inflation, thus, the budget
does not become quickly obsolete or outdated.

Disadvantages
i. Higher costs and efforts are required for continuous budgeting.
ii. It is time consuming in that, in each period, the whole procedures of preparing
budgets have to be undertaken.

3.6 BEHAVIOURAL ASPECTS OF BUDGETING

Despite all the benefits/objectives already narrated on the budgetary control system
and inspite of the management accounting control techniques, the operations of
budgetary control techniques have met with little success. Many scholars have done
research on these, in order to detect what should have been responsible for the failure.
Such researchers are Hopwood (1974), Argris (1952), Horgren (1960) and a host of
others.

The main causes of the level of low success in practice have been attributed to lack of
co-operation and negative attitude of the operating managers to the control techniques.
Managers' personal objectives also override the goal congruence of the organisation.
This negative and dyfunctional attitude of managers manifest at both the planning
stage and implementation stage.

(a) Planning Stage: Assuming the operating managers are involved in preparing a
budget; they may:

146
(i) Intentionally build in slack in the budget.
(ii) Express the opinion that budget is time wasting and that they are always
busy to prepare the budget.
(iii) Argue that formalising a budget on paper is too restrictive and that they
should be granted some flexibility in making their operational decisions.
(iv) Always prefer incremental system of budgeting to considering
alternative options and new ideas.
(v) Have in mind that the budget is unattainable, that is, having negative
idea about the achievement of the budget.

(b) Implementation Stage

i. Lack of co-operation and co-ordination with other budget centres.
ii. Putting in less effort to achieve budget targets without putting all efforts
to achieve more than budgeted.
iii. Managers may disregard control reports which show negative variances.
iv. Lack of controlling cost to achieve their own selfish end.
v. Having much interest in short-term factors to the detriment of more
important longer term consequences.
vi. Blaming budgeting systems for any problems which may occur.

8.7 SOLVING BEHAVIOURAL PROBLEMS IN BUDGETING

(a) Motivation
Horngren (1996) defined motivation as the "need, some selected goal and the
resulting drive that influence action towards the goal", He suggested that
motivation has two aspects:
(i) Direction or goal congruence exists when managers working in their
own best interest also are in harmony with the goals of top management
(that is, the organisation as a whole). It is very difficult to obtain the goal
congruence in an organisation. This is one of the essentially behavioural
problems in budgeting.

(ii) Strength with getting subordinates to run rather than work towards the
desired goal. Incentive improves the performance of employee and helps
to reduce personal or departmental objective.

Motivation helps to improve business results and eliminate misdirected

or dysfunctional operation. Horngren argues that accounting system
must be designed in such a way as to achieve a motivational response
from its use, provided that the costs of providing such a system do not
outweigh the expected results. He also acknowledges that human
behavior is inclined to damage the usefulness of format accounting
system.

(b) Participation
Participation by employees in budget setting and the encouragement of a human

147
approach, and man-management would remove the drawbacks to effective
budgeting. All the operators of the budget should be fully involved in the
preparation of the budget.
Participation leads to more positive attitude and higher performance.
Kenis (1979) reported a positive correlation of attitude and performance with
participation, while other scholars such as Bryan and Locke, Stedry and others showed
a negative relationship between participation and performance.

Argyris (1952) on the other hand cautioned against the level of participation, as
different organisations use the word participation to describe quite different activities.
He suggested that the involvement of managers should be total, otherwise pseudo-
participation could lead to counter-productive results.

(c) Goal Congruence

Goal congruence means the overall objective of an organisation. This overall
objective should not conflict with the individual or group objectives entirely but
recognition must be given to the fact that organisational objectives cannot be set
and implemented through budgeting without consideration of the interaction of
individual group and departmental objectives.

Hopwood's (1976) emphasised that there are many problems in achieving goal
congruence because:
(i) There may be numerous objectives in one organisation, some of which
may conflict.
(ii) Different managers may perceive their objectives differently.
(iii) Departmental rivalries.
(iv) Different and conflicting reward structures. Other practical realities
make perfect goal congruence extremely unlikely.
Efforts should be made to educate both top management and middle
management on the importance of goal congruence.

(d) Management Support

Top management should be interested in the budgetary system in order to
ensure that operating managers give the necessary co-operation.

(e) Reporting System

Efforts should be made to isolate uncontrollable cost from controllable ones in
order to have meaningful-variances reporting system.

(f) Communicating
Communication should be adequate with the operating managers at all stages of
the budgetary system.

3.8 FORECAST

"The technique of business forecasting has been developed to give a logical and

148
comprehensive means of providing management with information to determine the
most advantageous plans which can be made within the anticipated resources of the
business." (MA).

Despite the uncertainty that exists about the future, business plans are prepared to
resolve some of this uncertainty.

3.8.1 Distinction between forecast and budgets

A forecast states the events which are likely to occur in the future. A budget states the
plans which the managers will endeavour to turn into actual events. It is a statutory
executive order.

3.8.2 Forecasting procedures

There is more than one way of arriving at the sales forecasts. Probably the most
satisfactory approach is to use all available methods; each result then provides a check
on the others.

Three possible approaches are:

(a) Assessments by staff of sales department: Estimates should be made by the
individual salesmen and passed upwards to the sales manager. The advantage of
this method is that individual salesmen can give consideration to the particular
factors which are relevant in their areas.
(b) Mathematical analysis of past sales: Such analyses should indicate trends and
seasonal variations. This information can be adjusted for known factors, such as
increase advertising, to give a forecast of future sales.
(c) Senior management judgement: The senior management team, including
production manager, administrative manager etc., will meet to discuss sales
prospects. The approach brings a variety of skills and experience to the
forecasting exercise.

The sales budget will be determined by reference to the sales forecast. However, the
budget should be prepared in the light of any constraints on the amount that can be
produced.

3.9 BUDGETARY CONTROL

There is a difference between a budget and budgetary control/budgeting. A budget is

just an integral part of budgetary control/budgeting.

Budgetary control is defined thus: "a system of controlling costs which includes the
preparation of budgets, coordinating the departments and establishing responsibilities,
comparing actual performance with that budgeted and acting upon results, to achieve
maximum profitability" (CIMA).

149
Budgetary control is also defined as 'the establishment of budgets relating the
responsibilities of executive to the requirements of a policy, and the continuous
comparison of actual with budgeted results either to secure by individual action the
objective of that policy or to provide a basis for its revision.

Certain fundamental principles can be outlined from the above definitions of

budgetary control:

(a) Establish a plan or target of performance which co-ordinates all the activities of
the business;
(b) Record the actual performance;
(c) Compare the actual performance with that planned;
(d) Calculate the differences or variances, and analyse the reasons for them; and
(e) Act immediately, if necessary, to remedy the situation.

3.9.1 The objectives of budgetary control

These are:
(a) To combine the ideas of all levels of management in the preparation of the
budget;
(b) To co-ordinate all activities of the business;
(c) To centralize control;
(d) To decentralize responsibility of each of the manager involved;
(e) To act as a guide for management decisions, when unforeseeable conditions
affect the budget;
(f) To plan and control income and expenditure so that maximum profitability is
achieved;
(g) To direct capital expenditure in the most profitable direction;
(h) To ensure that sufficient working capital is available for the efficient operation
of the business;
(i) To provide a yardstick against which actual results can be compared;
(h) To show management which action is needed to remedy a situation.

3.9.2 Organisation for budgetary control

These include:
(a) The Preparation of an Organization Chart: This defines the functional
responsibilities of each member of management and ensures that he knows his
position in the company and his relationship to other members.

(b) The Budget Period is the time to which the plan of action relates. Period
budgets cover a fixed period of time, most commonly one year. They will be
divided into shorter time periods, known as: control periods, for purposes of
reporting control. With a one-year period budget, control periods may be 4
weeks [13 periods each year] or one month [12 periods each year]. Long-term
budgets [for example, capital expenditure budgets] may be for periods of up to

150
five or ten years, or even longer.

(c) Budget manual-The organization for budgeting [and budgetary control] should
be documented in a budget manual, which has been described as a "procedure
or rule book which 'sets out standing instructions governing the responsibilities
of persons, and the procedures, forms and records relating to the preparation
and use of budgets". (CIMA)

Even though organisations are different, the content of a manual are:

(a) Description of budgetary planning and control;
(b) Goals of each level of the budgetary process;
(c) Association with long term planning;
(d) Nature of organogram depicting duties and level of budget officers;
(e) Analysis of relevant budgets and association with
accounting activities;
(f) Description of principal budgets;
(g) Composition of budget committee and mode of operation;
(h) Modalities for the preparation and publication of budget;
(i) Designation and responsibility of the budget manager;
(j) Chart for codes;
(k) Design and nature of form; and
(l) Mode of operation especially where they concern procedures for
accounting, preparation of reports and dead line for the submission of
such reports/budgets.

(d) Budget Committee: The overall responsibility for budget preparation and
administration should be given to a Budget Committee, normally chaired by the
chief executive of the organization, with departmental heads or senior managers
as members. The purpose of the committee is to:
(i) ensure the active co-operation of departmental
managers, and to act as a forum in which differences of opinion can be
argued out and reconciled;
(ii) ensure that managers in the organization understand
what other departments are trying to do;
(iii) establish long-term plans around which the budgets should be built, and
then to identify budget objectives;
(iv) review departmental budgets;
(v) during the year, examine reports showing actual
performance compared with budget and expectations.

(e) The Budget Officer: He controls the budget administration on a day to day
basis. He will be responsible to the budget committee and should ensure that its
decisions are transmitted to the appropriate people and relevant data and
opinions are presented for its consideration. He will normally also have the vital
job of educating and selling the budget idea. Since the master budget is
summarized in cost statements and financial reports the budget officer is

151
usually an accountant.

(f) The Introduction of Adequate Accounting & Records: It is imperative that the
accounting system should be able to record and analyse the information
required. A chart of accounts should be maintained which corresponds with the
budget centres.

(g) The General Instruction on Techniques to all concerned in Operating the

System: Each person must feel that he is capable of carrying out the budgeted
programme.

(h) Budget Centres: An organisation's planned activities are divided into separate
areas known as budget centres or cost centres. Each area selected as a budget
centre must be clearly definable, and should be the natural responsibility of one
particular manager [or supervisor]. A separate budget is prepared for each
budget [or cost] centre. The 'budget centre budgets are known as departmental
budgets. Departmental budgets are often used to build up budgets for overhead
costs, that is:

(i) the production overhead budget will be compiled from separate budgets
for the production departments, maintenance, production planning,
quality control, etc
(ii) the administration budget will be compiled from separate budgets for
personnel, finance, management services, data processing etc;
(iii) the selling and distribution budget will be the amalgamation of budgets
prepared by sales office managers, marketing managers, warehouse and
transport managers.
(iv) the research and development budget.

(i) Principal Budget Factor: This is also known as the key budgeting factor or
limiting budget factor. The first task in budgeting is to identify the factors
which impose limitation or ceilings on the level of activity. It is usually sales
demand; but it may also be limitations on any resource-materials, labour,
machine time, working capital, etc. Once this factor is defined, the rest of the
budget can be prepared. It determines priorities functional budgets, for
example, it may be material, labour or plant.

Management may not know in advance which is the principal budget factor.
One method to identity this factor is to prepare a draft sales budget, and then
consider whether any resource shortage prevents this level of sales from being
met.

(j) Level of Activity: it will be necessary to establish the normal level of activity,
that is, the level the company can reasonably be expected to achieve: quantity to
produce, quantity to be sold, etc.

152
4.0 CONCLUSIONS

Budgeting or short term planning is the process by which the long term corporate plan
is converted into action or activities.

A budgetary system ensures co-ordination, assignment of responsibilities,

communication, control, motivation, direction and goal congruency. This will help to
avoid sub - optimality.

A budgetary system must fulfill the following conditions for it to be successful:

support of the top management, clear definition, full involvement of everyone at all
levels, appropriate accounting system put in place and administration in a flexible
manner.

Of importance to any budgeting activity is the availability of budget manual, budget

committee and budget officer. All the various budgets are related and composite to
form the master budget.

The various methods adopted in budgeting are zero based budgeting (ZBB),
programme planning and budgeting systems (PPBS), Incremental budgeting method,
rolling budget etc.

5.0 SUMMARY

Every organization needs to plan and consider how to confront future potential risks
and opportunities. In most organisations, this process is formalized by preparing
annual budgets and monitoring performance against the budgets. Budgets are mainly a
collection of plans and forecasts. They reflect the financial implications of business
plans, identifying, the amount, quality and timing of resources needed.

6.0 TUTOR MARKED ASSIGNMENT

1. When preparing a production budget, the quantity to be produced equals

A sales quantity + opening stock + closing stock
B sales quantity - opening stock + closing stock
C sales quantity - opening stock - closing Stock
D sales quantity + opening stock - closing stock
F sales quantity.

2. ABIBATU Limited is currently preparing its production budget for product Z

for the forth coming year. The sales director has confirmed that he requires
60,000 units of product Z. Opening stock is estimated to be 6,500 units and the
company wishes to reduce stock at the end of the year by 50%. How many units
of product Z will need to be produced?
A 56,750 units
B 60,000 units

153
C 63.250 units
D 66.500 units
E 67.250 units

3. The budgeting process is

A Purely a marketing function
B Purely a production function to forestall products deficiency
C Purely a purchasing function
D An overall company function moderated by the Accountant
E Purely an accounting function.

4. A zero-based budget
A is prepared up without regard to historical records
B figures are rounded up to the nearest thousand
C uniform incremental percentage of past performances
D is also known as flexible budget
E is the budget for not profit organizations.

5. In the context of budget preparation the term “goal congruence” is

A the alignment of budget with objectives using feed-forward control
B the setting of a budget which does not include budget bias
C the alignment of corporate objectives with the personnel objectives of a
manager
D the use of aspiration levels to set efficiency
E fixed in nature.

6. What is a master budget?

7. Describe three stages in the budgeting process in chronological order.

8. Mention three function/purpose of budgets.

9. Explain what is meant by the term “planning, programming, budgeting

systems”.

10. What is a Discretionary cost?

7.0 REFERNCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

154
UNIT 9 STANDARD COSTING

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 A Standard cost
3.2 Standard costing
3.3 Setting of standards
3.3.1 Types of standards
3.3.2 Capacity levels
3.3.3 Need for revising standards
3.3.4 Shortcomings of setting standard costs
3.4 Variance Analysis
3.4.1 Basic variances
3.4.2 Why cost variances?
3.4.3 Interdependence between variances
3.4.4 Cost accounting entries
3.5 Advanced variances
3.5.1 Material variances - mix and yield
3.5.2 Individual price method
3.5.3 Weighted Average Price Method (Alternative method)
3.5.4 Sales margin variances
3.6 Standard marginal cost
3.7 Opportunity cost approach to variances
3.7.1 Opportunity cost approach
3.7.2 Marginal costing and opportunity costs
3.7.3 The opportunity cost of capacity costs
3.7.4 The opportunity cost of efficiency variances
3.8 Planning and operational variances
3.8.1 Calculation of planning and operational variances
3.8.2 Importance and shortcomings of planning and operational variances
3.9 Control Ratios
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignments
7.0 References/Further Readings

1.0 INTRODUCTION

In this unit, we shall look at a financial control system that enables the deviations from
budget to be analyzed in detail, thus enabling costs to be controlled more effectively.
This system of control is called standard costing. We shall consider how a standard
costing operates and how the variances are calculated.

155
2.0 OBJECTIVES

At the end of this chapter, readers will be able to understand:

 The difference between standard cost and standard costing;
 The different types of standards and capacity levels;
 The standard costing techniques and the associated objectives;
 How to apply the various principles required for the computation of variances;
 The concept of standard hour and computation of the capacity, efficiency and
activity ratios.
 How to apply the principles of marginal costing in standard costing.

3.0 MAIN CONTENT

3.1 A STANDARD COST

This is defined as "the planned unit cost of the products, components or services
produced in a period. The standard cost may be determined on a number of bases. The
main uses of standard costs are in performance measurement control, stock valuation
and in the establishment of selling prices". (CIMA)

A standard cost, apart from being related to production costs, may also be looked at
from the view point of selling and distribution costs, administration costs, etc.
A standard cost can be meaningful if based on good production systems, work
methods and measurement, labour and material rate forecasts as well as peculiarities of
materials required.
Standard costs can be applied to both absorption and marginal costing techniques, in
that:
(a) Fixed costs, under absorption costing, are determined on total basis and the
machine hour or direct labour hour basis can be adopted to absorb them into the
standard unit costs;
(b) The basis for determining the variable cost content of the direct materials and
labour is the unit basis;
(c) Even though the variable overhead costs can be budgeted in total, they can be
identified on a unit basis, thus ensuring the determination of hourly cost and
unit cost.

3.2 STANDARD COSTING

This is a useful control technique based on the feedback control concept which ensures
the determination of standard costs of products or services and compares them with the
actual results and costs with the difference being referred to as a variance. This
difference can be further explained by a process called variance analysis.

The standard costing technique can be of use in a number of circumstances such as:
where there is repetition of jobs and large production activities (process); service
industries (hospital, merchandising) etc.

156
Reasons for adopting a standard costing techniques
Some of the basic reasons for adopting a standard costing technique are:
(a) To encourage management and employees, since it ensures that they have to
plan ahead;
(b) To serve as the basis for quoting for jobs or fixing prices;
(c) To ensure that performance improvement measures are adequately guided;
(d) To provide the basis for setting budgets;
(e) To ensure that standards are put in place and variances properly analysed in
order to control costs;
(f) To provide the basis for allocating duties in order to check inefficiencies or take
advantage of opportunities;
(g) To serve as basis for determining unprofitable ventures; and
(h) To ensure that stocks and work-in-progress are Properly valued.

Drawbacks/Disadvantages of the technique:

The following are the disadvantages of standard costing;
(a) Lack of understanding of its application could bring about resistance from the
employees.
(b) Confidence of the users may be eroded, especially where they become outdated.
(c) The technique may be very expensive to operate especially where technicalities
are involved and set-up time is elongated.
(d) It may not be appropriate for business use, if standard costs are not properly
determined.

3.3 SETTING OF STANDARDS

3.3.1 Types of Standards

Performance standards setting are a function of four basic standards:

(a) Ideal Standards: These are based on perfect operating conditions whereby
there are no wastages, inefficiencies, idle-time, breakdown of machines etc.
Variances relating to ideal standards are beneficial in showing aspects requiring
verification, thus, bringing about some savings. Ideal standards are not
necessarily of encouraging status in that staff may be of the opinion that the
objectives are not achievable, therefore, resulting in less efforts being put into
the work by the labour force.

(b) Basic Standards: These are standards which remained unaltered over a long
span of time and they may become outdated as a result of changes in
technology, laws, norms etc. They can only be used to express changes in the
level of efficiency or performance over a period of time and as well as the trend
of prices from period to period.
Nonetheless, the drawbacks are:
(i) The standard may become useless as a result of the changes in price and

157
efficiency levels;
(ii) After the first year, the fixed overhead aspect of basic standard cost
computed on annual basis from the budget, may have little or no impact.

(c) Current Standards: They are based on current conditions of service or

production, for example, current losses, inadequacies etc. However, they do not
seem to bring about a higher current level of performance.

(d) Attainable/Expected Standards: They are a function of normal operating

circumstances, thus ensuring that some allowances are available for losses,
wastages, inadequacies, etc. They make for a challenging situation for
employees in as much as psychological awareness is created.

3.3.2 Capacity Levels

Since standards cannot be set on their own, it is therefore necessary for capacity levels
that give meaning to standards set to be discussed 'here. The capacity levels include:

(a) Full Capacity: It is the "production volume expressed in standard hours that
could be achieved if sales order, supplier and work force were available for all
installed work places" (CIMA).

Under this circumstance, full capacity can be related to ideal standards with the
assumption that labour shortages, shortfall in supplies, equipment breakdown
will not affect the smooth running of the production processes.

(b) Practical Capacity: This is "full capacity less an allowance for known
unavoidable volume losses" (CIMA). Some examples of unavoidable losses
are: repair time for equipment and plants, job resetting times, machine
breakdown etc.
Therefore, since full capacity is more than the practical capacity, the latter can
be related to attainable standards.

(c) Budgeted Capacity: It is the "standard hours planned for the period, taking
into account budgeted sales, suppliers and work force availability " (CIMA).

In effect, it is the labour hours and machine hours required to have the budgeted
units and can be a function of current standards that are not peculiar to normal
practical capacity over an extended period of time.

(d) Idle Capacity: This is the difference between the practical capacity and the
budgeted capacity based on standard hours of output. This is the unutilized
capacity that is not required, in that, the budgeted volume is less than the
practical volume that could be achieved.

158
3.3.3 Need for Revising Standards

The unexpected change(s) in the economy as a result of change(s) in economic and

socio-political situations could make for the unreasonableness of standard costs. It
should be noted that the said change(s) could bring about inconsistency in the
application of the standard costs which may eventually lead to a high cost of operation
especially when inflation constitutes a determining factor. Therefore, in practice, the
revision of standard cost should be done on a yearly basis, with the action being taken
at the beginning of every accounting year.

3.3.4 Shortcomings of Setting Standard Costs

The shortcomings that can be associated with the setting of standard costs may
include:
(a) The significant influence of quantity discounts and cyclical price changes that
may make it difficult to determine the prices of materials.
(b) If is desired to have a mix of the constituents parts of materials, it may be
difficult to determine the proportion of the mix of the constituent parts of the
materials.
(c) It may not be easy to come up with the appropriate wage efficiency standard.
(d) The manner of introducing the issue of inflation into predetermined unit costs is
also a matter of concern.
(e) Even though good materials may be expensive to obtain, the issue is how to
determine the quality to be utilized per time may not be easy especially when
there is the need to reduce material losses and spoilage

159
160
3.4 VARIANCE ANALYSIS
The process of further explaining the difference(s) between the actual costs or results
and the predetermined costs or results is referred to as variance analysis. The various
variances can be depicted in the form of a diagram in order to have an effective picture
of what they look like. See figure 9.1 below

Operating Profit Variance

Sales variances Sales variances

Sales volume Sales price

Admin selling Variable Fixed production
distribution production cost cost variances
Sales mix Sales quantity cost variance variances
variance variance

Expenditure Volume
Variance (or Variance
Budget variance)

Efficiency Capacity
Variance Variance

Direct materials Direct labour cost Variable overheads

cost variance variance cost variance Capacity Fixed
usage overhead
variance idle time
variance

Usage Price Efficiency Rate

Idle time Efficiency Expenditure
Variance Variance Variance Variance
Variance Variance Variance

Mix Yield
Variance variance

Figure 9.1: Summary of Variances

3.4.1 Basic Variances

The basic variances can be categorised under four main headings:

(a) Sales volume variance.
(b) Sales price variance.
(c) Variable cost variances, that is, direct materials; direct labour and variable
overheads (which can also be sub-divided into spending and efficiency
variances).
(d) Fixed overhead cost variances, that is, expenditure and volume variances
(which can be further categorised into efficiency and capacity variances (which

161
can also be sub-divided into capacity usage and fixed overhead idle-time
variance).

I Sales Margin Variance - is the difference between the predetermined margin

from turnover and the actual margin derived when the cost of goods sold is
based on the standard cost of manufacturing goods or products.

This can be further analysed into sales margin price variance and sales margin
quantity variance with the objective of being able to control the profit from
sales whereby all the products are expressed at standard production costs in
order to carry out the sales margin variance analysis.

II Variable Cost Variances

Variable cost variances, in case of materials, labour or overheads, are all
determined in the same manner. The total cost variance for each type of
variable costs is classified as:
(a) Price, rate or expenditure variance, whereby:
(i) The actual price of a unit of raw material is different from the
predetermined or standard price.
(ii) The actual rate per direct labour hour is different from the
standard labour rate.
(iii) The actual rate per hour of expenditure on variable production
overhead is not the same with the standard rate of spending.

(b) Efficiency or usage variance; that is,

Material usage variance:
(i) The quantity of materials put in to have the output is different
from the standard or required usage.

(ii) Labour efficiency variance/variable overhead efficiency variance:

The actual time of spending the output is different from the
standard time allowed, with effects on both direct labour and
variable production overhead costs.

Direct labour efficiency variance and variable production

overhead variance require the same number of hours.

(iii) Labour idle time variance; This involves the

actual hours for which no productive efforts were made. Thus, the
direct labour costs are affected without any effect on variable
overhead expenditure, since they are not incurred when idle time
are being accounted for in term of the variance element.

It is important to note that price or expenditure variances are

measured in money terms, for example, Naira, Cedis, etc. while

162
efficiency variances are measured in quantities (hours, kilograms,
litres etc) after which they are expressed in monetary terms at the
standard cost per unit of labour, material or variable overheads.

III Fixed Cost Variance

The fixed cost variance is a function of the magnitude of fixed overhead over-
absorbed in the production process. Thus:
(a) The manufacturing fixed cost volume variance, is the difference between
predetermined and actual production volumes multiplied by the
absorption rate in order to have the monetary values of the volume so
involved.
(b) The difference between the actual and predetermined production
volumes can be expressed in two ways:
(i) Since the efforts put in by the labour force will determine the
degree of output, then, the fixed production overhead efficiency
variance is the same as the direct labour efficiency variance.
(ii) If the actual hours involved is greater or less than the
predetermined hours, thus resulting in more or less output and the
predetermined hours put in represent normal capacity, then the
capacity variance will be measured in standard hours and
expressed in monetary terms at the standard absorption rate per
hour.

3.4.2 Why Cost Variances?

Expected standards of performance are set for a firm's operations taking into account
wastage and lost time. The standards try to be realistic by setting levels of attainable
performance which do not necessarily correspond with current levels of performance,
if management considers that any particular operation for which standards are set is
not meeting its capability.

Variances show those situations where actual results are not as budgeted. They depict
the difference between standard and actual for each element of cost and sometimes for
sales. If actual operations outweighed the planned, a favourable variance is arrived at,
(F) and where the reverse is the case, an adverse variance arises (A).

Computation of Variances

Variances may be computed as follows:

(a) Material cost variances

The material cost variance shows the difference between the actual costs
incurred and the standard costs. It is calculated as Standard cost less actual cost,
that is, (SC - AC).

163
These variances can be sub-analysed into price and usage variances so that the
variance is attributed to the manager who has the responsibility for controlling
it. Usage Variance can further be analysed into mix and yield. The standard cost
is determined by multiplying the standard specified actual quantity of output by
the standard cost per unit of output.

(i) Material price variance

This is derived by multiplying the difference between the standard price
and actual price by the actual quantity of materials purchased. It is
calculated as: AQ (SP - AP). This variance may occur because of:
 Material price changes.
 Reduction in supply of materials.
 Ineffective purchasing policy.
 Non-availability of storage space.
 Insufficient funds.
 Purchasing mistakes.
 Reversal of specification standards.

(ii) Material usage variance

This is determined by multiplying the difference between the standard
quantity and the actual quantity by the standard price of quantity used.
The standard quantity is expressed as a function of the actual quantity
produced at the standard specifications. It is calculated as SP (SQ - AQ).

The material usage variance can be sub-divided into mix and yield
variances:

 Material Mix Variance — This can be computed by multiplying

the difference between the standard specification of the material
input and the actual mix used by the standard price. That is, SP
(SM — AM).
 Material Yield Variance — This can be expressed as the
difference between the standard yield and the actual yield from
the materials used in production. That is, SC (AQSM - SQSM).

(b) Wages cost variance

Wage cost variance is the difference between the standard wage cost of actual
output and the labour cost paid for. It is commonly separated into wage rate
variance, an idle time variance and efficiency variance.

Standard cost is the actual quantities produced at standard hours specified

multiplied by standard rate per hour. It is calculated as the difference between
standard cost and actual cost, that is, SC — AC.

 Wage Rate Variance —

This is the difference between the standard wage rate and the wage rate
164
actually paid, multiplied by the actual hours worked, that is, AH (SR -
AR).

The foreman is to ensure that the machines are operated by the

employees with the requisite skills as the wage negotiation is a national
policy and not that of an individual.

 Wage Usage Variance

This is as a result of the difference between standard labour hours of
actual output and the labour hours actually paid for multiplied by the
standard rate per hour, that is, SR (SH - AH). The wage usage variance
can be sub-divided into an idle time and efficiency variance.
Standard hour (51-1) is the actual quantity of output based on specific
standard hour.
 Idle Time Variance — This is the difference resulting from
hours lost through unexpected situations, such as machine
breakdown, lack of materials or tools, etc. (unexpected idle time
multiplied by standard hour).
 Efficiency Variance – This is the variance resulting from the
difference between the standard labour hours of actual output and
the useful labour hours actually worked. This is represented by
Standard Labour Cost of Actual output and standard cost of useful
hours worked multiplied by the standard rate of pay; that is, SR
(SH – AUH). Therefore, hours paid for less idle time equals
Actual Useful Hours (AUH).

(c) Variable Overhead Variance

Variable overhead can be absorbed into production on the basis of units of
output produced or standard hours used in production. Where standard hours
are adopted as the strength for determining the level of activity, the variable
overhead absorption rate can be computed as:

OAR = Predetermined Variable Overhead

Predetermined Standard Hours
Where the OAR = Overhead Absorption Rate

Therefore, the difference between the variable overhead absorbed for actual
production and the actual variable overhead expenditure is termed the total
variable overhead variance.

The variable overhead variance can be sub-divided into expenditure variance

and efficiency variance.
 Expenditure Variance: This is as a result of the difference between
actual cost and standard cost for the actual level of activity. It is to be
taken that where the determination of level of activity is a function of the
actual activity labour hours, the actual activity is the number of labour

165
hours for which the work was performed. It is calculated as the
difference between standard rate and actual rate multiplied by the actual
hour.
 Efficiency Variance: This is as a result of the difference in the labour
hours worked and the standard hours equivalent of actual production,
multiplied by the standard cost or rate. It is expected that the activity
level will be measured in labour hours for the purpose of determining the
variable overhead absorption rate. Its formula is SR (SH - AH).

(d) Fixed Overhead Variance

Fixed Overhead cost is a cost that will not change within a giver level of
activity, but overhead absorption rate per unit will be charged to products,
Nonetheless, it is normal to compute a budgeted fixed overhead absorption rate
whenever product cost and valuation of stock are required.
Fixed Overhead Absorption Rate (FOAR)

= Predetermined Fixed Overhead

Predetermined Standard Hours

Therefore, the difference between the fixed overhead absorbed

by the actual production and the actual fixed overhead for the
period is referred to as total fired overhead variance. Its formula is given as
(SC - AC).

(i) Fixed Overhead Expenditure Variance - This is the difference between the
actual and predetermined cost of overhead. The degree of spending on the fixed
overhead is not affected by the volume of activity. Therefore, the difference
between the standard overhead stated in the budget and the actual overhead
incurred is referred to as expenditure variance. Budgeted Fixed Overhead
(BFO) is the budgeted quantities at standard hours specified multiplied by
standard rate per hour. Its formula is BFO - AFO.

(ii) Fixed Overhead Volume Variance — This is the difference between the
standard fixed overhead elements of actual output and the standard fixed
overhead in the budget. Its formulae is given as SR (BR - SH).

The fixed overhead volume variance can be further analysed into efficiency and
capacity variances.

 Efficiency Variance - This is the difference in the standard efficiency

and the efficiency actually attained. Its formulae is SR (SH - AUH)
(Standard hours - Useful hours) x Standard Absorption Rate (SH -
Actual Hours worked (AH)).
 Capacity Variance - This is the difference in the budgeted activity and
the level of activity actually attained. That is, Standard Rate (Budgeted
Hours - Actual Useful Hours).

166
(e) Sales Variance
A sales variance is used to give effect to the difference between budgeted sales
and actual sales and can be further sub-divided into a sales price variance and
sales volume variance.

These variances may be related to sales profit or sales contribution, with the
assertion that those related to profit or contribution ensure the provision of
effective information.

(i) Sales Price Variance - This variance is used to determine the effect of
selling output above or below the predetermined selling price. Its
formulae is: AQ (SSP - ASP).
(ii) Sales Volume Variances - This variance is used to determine the effect
on profit or contribution on selling more or less than the predetermined
quantity. Its formulae is SP (BQ - A QS), where, BQ = budgeted
quantity and AQS = actual quantity sold.

Where the valuation of the variance is based on the standard profit per unit, it shows
the difference between budgeted standard profit and the standard profit earned on
actual sales. On the other hand, if it is at standard selling price, it shows the difference
between budgeted sales revenue and actual sales at a standard price.

Where the standard marginal costing is used, all final products are valued at a standard
marginal cost, therefore, ensuring that all fixed overheads are treated as period costs
against the contribution made in the budgeted period, thus making it impossible to
absorb them into product costs.

The variances under the standard marginal costing approach are the same as those of
the budgetary control where the standard costs are not existence:
(a) Since fixed overheads are not absorbed into product cost, then, there exists
fixed overhead expenditure variance and no fixed volume variance.
(b) Sales volume variance can be computed, thus: volume variance in units
multiplied by standard contribution per unit.

ILLUSTRATION 9-1

Dapo Ltd produces thatched roofs for houses. The budget for 2006 was as follows:
N
Number of houses to be thatched 140 roofs
N
Revenue 6,000
Standard cost per roof:
Direct materials:
Thatch: 2 tons @ N400 per ton 1,800
Other materials 1,300

167
Direct labour 300 hours @N5 1,500
Variable production overhead
300 hours @N1.0 1,300
Fixed production overhead:
300 hours @N7.0 2,100
Standard cost 5,000
Standard profit. 1,000

Note:
(a) The budgeted fixed production overhead was N147,000, from which the
standard absorption rate of
294,000
(140 x 300 hours) = N7.00 per standard hour was derived
(b) Since one thatched roof equals 300 standard hours = N2,100.
(c) There is additional budgeted overhead for selling and administration of
N30,000. This expenditure is regarded as a fixed cost.

Actual results in 2006 were as follows

Number of roofs thatched 150 roofs
Revenue (Selling price per roof 5,760) N864,000
Thatch:
Purchase 360 tons, cost N133,200
Used 340 tons
Other direct material, cost 1N48,000
Direct labour: N152,000 hours
Hours worked (active time) N144,000 hours
Hours of idle time N118,000 hours
Cost of hours paid for N288,000
Variable production overhead 1N46,000
Fixed production overhead N304,000
Sales and administration overhead 1N32,000

Required:
(a) Prepare an operating statement reconciling the budgeted profit with the actual
profit. All closing stock are valued at standard cost.
(b) An explanation of the possible interdependence between variances.

SUGGESTED SOLUTION 9-1

DAPO LTD

(a) The budgeted profit, before deducting sales and administration costs was (140 x
N1,000) = N140,000.

168
(b) The calculation of actual profit begins with:

N
Actual Sales 864,000
Less: Actual standard production
Cost of sales (150 x N5,000) 750,000
Unadjusted profit 114,000

(c) From this unadjusted profit, adjustments are made for cost variances. All cost
variances reported are written as an adjustment to the profit and loss account at
the end of the accounting period.

Direct Materials
(i) Direct material price variance
This variance measures the actual purchase price for materials against the
expected price:
N
360 tons of Thatch purchased should cost (360 x N400) 114,000
but did cost 133,200
Material price variance 110,800(F)

(ii) Direct material usage variance

This variance measures the efficiency in the usage or consumption of a
material. Because it is a measure of efficiency (i.e. quantity) it must be
measured in quantities –i.e. tons-and then valued in money terms by applying
the standard cost per unit (ton) of material.

150 roots were made and should be use (x2) N300 tons of thatch
they did use N340 tons
material usage variance – (Thatch) 1N40 tons (A)
Valued at standard price N400 per ton
That is, N16,000(A)

Other Direct Materials Variance

Since we are not given the quantity of other materials per roof, nor the purchase price
per unit of these other materials, the only variance we can calculate is the materials
cost variance.
N
Actual cost of 150 roofs (other materials) 48,000
Standard (expected) cost of 150 roofs (x N300) 45,000
Other direct materials cost variance 43,000(A)

Direct Labour Variances

(a) The total cost variance for direct labour is:

169
N
Actual labour cost of 150 roofs 288,000
Standard labour cost of 150 roofs (x N1,500) 225,000
Direct labour cost variance 163,000(A)

This variance need not be calculated, because we can analyse it in greater depth as the
sum of the rate, idle time and efficiency variances.
(b) Direct labour rate variance – This is the same type of variance as the materials
price variance. It measures the actual price or rate paid per hour for labour
against the actual rate per hour.

N
52,000 hours were paid for and cost 288,000
They should cost (x N5 per hour x 52,000) 260,000
Direct labour rate variance 128,000(A)

(c) Idle time variance – This is an inefficiency variance which is recorded in hours.
It is valued in naira by applying the standard per hour; i.e.
8,000 hours (A) x N5 per hour = N40,000(A)

(d) Direct Labour efficiency variance – This variance measures the efficiency (or
inefficiency) of labour. Since idle time is measured separately, we are
concerned with efficiency in active hours worked. It is calculated in the same
way as the materials which is costed in N by applying the standard rate per
hour.

150 roofs were made and should take (x 300) 45,000 hours
They did take (active hours) 44,000 hours
Direct labour efficiency variances 11,000 hours(F)
Valued at standard rate N5 per hour
i.e. N5,000 (F)

(e) Summary N
Rate variance (b) 28,000(A)
Idle time variance (c) 40,000(A)
Efficiency variance (d) 15,000(F)
Total labour cost variance (a) 63,000(A)

Variable Production overhead

(a) The total cost variance for variable production overhead is:
N
Actual cost of 150 roofs 46,000
Standard (expected) cost of 150 roofs (x N300) 45,000
Variable production overhead cost variance 11,000(A)

170
(b) It is usually assumed that variable overheads are incurred during Active
Working Hours, but are not incurred during idle time. This means that the
company, in our example, has had to pay for 44,000 hours of variable overhead
expenditure, and not 52,000 hours.

(c) Variable production Overhead Expenditure variance – following on from (b)

the expenditure variance may now be calculated in the same way as the
materials price and labour rate variances.
44,000 hours of variable overhead expenditure N
should cost (N1.00) 44,000
they cost 46,000
Variable overhead expenditure variance 42,000(A)

In other words, during 44,000 active hours of work, the expected spending at
the standard hourly rate would be N44,000. The actual hourly rate was in
excess of this and the total excess amounted to N2,000.

(d) Variable Production Overhead Efficiency Variance – This is exactly the same,
in hours, as the direct efficiency variance. This is 1,000 hours (F) and is valued
in N1 at the standard rate per hour for variable overhead (N1.00).
1,000 hours (F) x N1.00 per hour
Variable production overhead efficiency variance = N250(F)

(e) Summary N
Expenditure variance (c) 2,000(A)
Efficiency variance (d) 1,000(F)
Total variable production overhead cost variance (a) 1,000(A)

Fixed Production overheads

(a) In standard absorption costing, fixed overheads are absorbed into production
costs at a standard cost per unit. For each roof that is thatched, a standard cost
of N2,100 (300 standard hours of production) is applied to the cost of
production.

(b) The standard cost of 150 roofs is therefore is 150 x N2,100 = N315,000. The
actual cost of fixed production overhead was N304,000
N
Absorbed (Standard) fixed overhead 315,000
Actual fixed overhead 304,000
11,000(F)
This over-absorbed overhead is the fixed production overhead total cost
variance.

(c) Fixed production overhead expenditure variance:

N
Budgeted expenditure 294,000

171
Actual expenditure 304,000
Fixed production overhead volume variance 10,000(A)

(d) Fixed production overhead volume variance;

Budgeted production volume 140 roofs
Actual production volume 150 roofs
Volume variance 110 roofs(F)
X Absorption rate (=standard rate) N2,100 per roof
N21,000 (F)
(e) Fixed production overhead efficiency variance – This is exactly the same as the
labour efficiency variance (in hours) but is valued at the standard fixed
overhead absorption rate per hour
Efficiency variance 1,000 hours(F)
Absorption rate per hour N7.00per hour
Fixed production overhead efficiency variance N7,000(F)

(f) Fixed production overhead capacity variance

Hours
Budgeted hours of work (140 roofs x 300 hours) 42,000
Actual hours of work (active hour only) 44,000
Capacity variance 22,000hours(F)

2,000 hours more work was done than budgeted. The expected over-absorption
of overhead as a result of this capacity variance = 2,000hours (F) x N7.00 per
hour = N14,000 (F)

(g) Summary N
Capacity variance (g) 14,000(F)
Efficiency variance (f) 17,000(F)
Volume variance (d) 21,000(F)
Expenditure variance (c) 10,000(A)
Total fixed production overhead variance (b) 11,000(F)

Sales variance
(a) Sales Price Variance N
150 thatched roofs should sell for x N6,000 900,000
They did sell for 864,000
Sales price variance 36,000(A)

(b) Sales Volume Variance

(i) In standard absorption costing, fixed overhead costs increase with
output, and the standard cost of sales increases by the full standard cost
for each extra unit sold. The sales volume (margin) variance is calculated
by applying the Standard Profit per unit and not the contribution per unit.

172
(ii) Standard profit used because a fixed production overhead volume
variance is calculated. This is a further difference, therefore, from the
calculation of variances in other types of budgetary control.

 if a fixed production overhead volume variance is calculated, the

sales volume variance is based on standard profit.
 where a fixed production overhead volume variance is calculated,
the sales volume variance is based on standard contribution.

(iii) In our example:

Budgeted sales volume 140 roofs
Actual sales volume 150 roofs
Sales volume variances 110 roofs(F)
X Standard profit per unit Nx 1,000
Sales volume (margin) variance N10,000(F)
Sales and administration overheads are not absorbed into standard units costs.
They are fixed costs, and the only variance is an expenditure variances.
N
Budgeted expenditure 30,000
Actual expenditure 32,000
Expenditure variance 12,000 (A)

Reconciliation of Operating Statement for 2006

N N
Budgeted profit, before sales and admin. O/H(140 roofs x N1,000)
140,000
Overhead
Sales variance
Sales price 36,000 (A)
Sales volume 10,000 (F)
126,000(A)
Actual sales minus standard production
Costs of sales 114,000
Cost variance (F) (A)
Direct materials:
Thatch price 10,800
Thatch usage 16,000
Other materials cost 13,000
Direct labour:
Rate 28,000
Idle time 40,000
Efficiency 5,000
Variable Production overheads:
Expenditure 12,000
Efficiency 1,000
Fixed production overheads: 10,000

173
Expenditure 7,000
Efficiency 14,000 99,999
Capacity 37,800 99,0001 61,200(A)
52,800
Less: increase in closing stock (20 x N400) 8,000
Actual profit before sales and admin overhead 44,800
Costs:
Budgeted sales & admin costs 30,000
Expenditure variance (30,000 – 32,000) 12,000
(32,000)
Actual profit (12,800

Confirmation of Actual Result: N N

Revenue 864,000
Less Costs:
Thatch 133,200
Other materials 148,000
Labour 288,000
Variable production overhead 146,000
Fixed production overhead 304,000 (819,200
(144,800
Sales and admin. Overhead 1(32,000)
(112,800

3.4.3 Interdependence between variances

Interdependence between variances is a term adopted to describe the way in which the
reason for one variance may be wholly or partly stated by the reason for another
variance. In the example above:

(a) the material price variance for thatch was N10,800(F) and the usage variance
N16,000(A). It is possible that by buying a cheaper type of thatch (and earning
a favourable purchasing variance) the purchasing manager has obtained lower
quality materials, which explains the adverse usage in production;

(b) the sales volume variance is favourable (by roofs), but in order to obtain the
extra business, the selling price per roof may have been reduced. The
favourable sales volume variance and the adverse sales price variance may,
therefore be, to a certain extent, interdependent;

(c) the favourable efficiency variances (labour, variable and fixed production costs)
may be the result of using more highly skilled labour which is paid higher rate
per hour. The favourable efficiency variances and the adverse labour rate
variance may be interdependent.

174
3.4.4 Cost Accounting Entries

Variances are written to a variance account. There may be separate variance accounts
for materials price, materials usage, labour rate etc. or there may be one single account
for all the variances.

You should check the following T accounts, carefully, but the basic principles are:
(a) material price variance is usually recorded in the stores account;
(b) labour rate variance is usually recorded in the wages account;
(c) material usage, labour efficiency and the idle time variances are recorded in the
work in progress (WIP) account;
(d) the cost ledger control account, in a system where cost accounts and financial
accounts are not integrated, represents all those items which appear in the
financial accounts but which are excluded from the cost accounts (e.g. debtors,
creditors, cash, reserves etc.)

SUGGESTED SOLUTION 9-2

(a) Cost Ledger Control Account (CLC)

N N
Sales 95,600 Stores account 9,800
account
Direct wages 16,800
account
Variable
production
Overhead account 2,600
Fixed production 42,300
o’hd a/c
Sales admin. costs 18,000
a/c
0,0000 P & L a/c (profit) 6,100
95,600 95,600

175
(b) Stores Ledger Control Account
N N
Purchases 9,800 WIP (2,300kg x 9,200
(CLC) N4)
Material Price
variance
0000, (Variance a/c) 9,600
9,800 9,800

(c) Direct Wages Control Account

N N
CLC 16,800 WIP 17,000
(8,500hrs x N2)
Ratevariance
(variance a/c) 09,200 09,600
17,000 17,000

(d) Variable Production Overhead Control A/C

N N
CLC 2,600 WIP (8,000 hrs @ N0.3) 2,400
0000, Expenditure 9,200
2,600 2,600

(e) Fixed Production Overhead Control Account

N N
CLC 42,300 WIP(8,000hrs at 29,600
N3.70)
Expenditure variance 4,560
02000, Capacity variance 88,140
42,300 42,300

(f) Sales And Administration Costs Account

N N
CLC 18,300 Cost of sales a/c 18,000

(g) Work in Progress Control Account

N N
Stores account 9,200 Finishedgoods 67,900
account (4,850 x
N14)

Direct wages account 17,000 Idletime variance 1,000

176
Variable production 2,400
overhead a/c
Fixed production 29,600
overhead a/c
Labour efficiency 3,400
variance
Material usage variance 500

Variable o’hd efficiency 510

variance
Fixed o’hd efficiency 16,290 95,60
variance
68,900 68,900

(h) Finished Goods Control Account

N N
WIP a/c 67,900 Cost of sales a/c 67,900

(i) Cost of Sales Control Account

N N
Finished 67,900 P & L a/c 85,900
goods a/c
Sales and 18,000 18,000
admin
85,900 85,900

(j) Sales Account

N N
P & L 95,600 CLC 95,600
Account

(k) Variances Account

N N
Stores a/c (Material Direct6wages (rate) 2
price) 0 0
0 0
Variable overhead Variable
2 overhead 5
expenditure efficiency
0 (WIP) 1
0 0
Fixed overhead Fixed 4 overhead efficiency 6
expenditure (WIP), ,
5 2
6 9
0 0
Fixed overhead capacity Labour8 efficiency (WIP) 3

177
, ,
1 4
4 0
0 0
Idle time (WIP a/c) Material
1 usage (WIP) 5
, 0
0 0
0
0
P & L0a/c 1
0 3
0 ,
0 6
, 0
0 0
1 1
4 4
, ,
5 5
0 0
0 0

(l) Profit and Loss Account

N N
Cost of sales 85,900 Sales account 95,600
account
Variance 3,600
account
Profit (CLC) 96,100 09,600
95,600 95,600

Note: That sales are recorded at the actual amount invoiced and that there are no sales
variances at all in the accounts.

3.5 ADVANCED VARIANCES

3.5.1 Material Variances – Mix and Yield

In Section 3.4.1 of this unit, the basic material variances were explained. In some
situations, it may be necessary to further analyse the materials usage variances into
direct material mix variance and direct material yield variance. This may be possible
in situations where the manufacturing process require a mix of various material inputs
in order to achieve the expected output such as: production of paints, textiles, roofing
sheets etc. As in a normal process, losses could be caused by pilferage, machine break
downs, power failure, evaporation etc.

178
There are basically two approaches to analysing material usage variance into mix and
yield variances. The first is the individual price method under which individual
standard prices are adopted for the components and the second is that which involves
the usage of weighted average price for all components.

3.5.2 Individual Price Method – (Direct materials mix variance)

“A subset of the direct usage variance, applicable when materials are applied in a
standard proportion showing the effect on cost of variations from the standard
proportions.” (CIMA)

Direct Material yield variance

“A subset of the direct materials usage variance applicable when materials are
combined in standard proportion.” (CIMA)

Mix and yield formulae (individual price method)

Budgeted Cost Budgeted Cost

Direct Materials = of the actual quantity minus of the actual quantity of
Mixture Variance of the actual mixture the Budgeted mixture

Budgeted Cost Budgeted Cost

Direct Materials = of the actual quantity minus of the Budgeted
of the Budgeted Quantity of the
Mixture Budgeted Mixture

Notes:
(a) The mix and yield variances use only budgeted prices.
(b) The change of expressions from actual to budgeted values
(c) The yield variance measures abnormal process losses or gains
3.5.3 Weighted Average Price Method (Alternative Method)

Direct materials mix variance is “the difference between standard quantity of inputs
for the output achieved and the actual quantity used priced at the difference between
individual standard prices and weighted average standard price.” (CIMA)

Direct materials yield variance is the difference between the standard quantity of
inputs for the output achieved and the actual quantity used priced at the weighted
average standard price.

3.5.4 Sales Margin Variances

Apart from the cost variance analysis carried out from control reasons, other factors
required for the realisation of planned profit is the effect of the sales margin whether

179
as profit margin in the case of absorption costing or the contribution margin where the
marginal costing technique is applied. Under this circumstance, all products are valued
at the standard factory cost in order to give effect to sales margin variance analysis.
Therefore, the standard sales margin is actually the difference the budgeted selling
price of a product and the related standard cost which could also be referred to as the
budgeted profit for a product.

Total Sales margin variance

This is the difference between the standard margin from sales and the actual margin
when the cost of sales is treated at the standard cost of production. This can be sub-
analysed into the sales margin price and quantity variances.

Sales margin price variance

This is the difference between the standard margin per unity and the actual margin per
unit for the quantity of units on sales in the period (CIMA).

Sales margin quantity variance

“The difference between the actual total number of units at the actual mix and the
actual total number of units at standard mix valued at the standard margin per unit.”
(CIMA)

Sales margin volume variance

“That portion of the sales margin quantity variance which is the difference between the
actual total quantity of units sold and the budgeted total number of units at the
standard mix valued at the standard margin per unit.” (CIMA)

ILLUSTRATION 9-3

Ijaodola Ltd. produces and sells three product brands of lime. In a period, the budgeted
and actual results were as follows:
Budget
Products Volume Unit Margin Total Total
Units price sales margin
(N) (N) (N) (N)
Small Jar 500 20 1 8 10,000 4,000
Medium Jar 250 30 12 1 7,500 3,000
Large Jar 150 50 20 1 2,500 1,000
800 20,000 8,000

Actual
Products Volume Unit Margin Total Total
Units price sales margin
(N) (N) (N) (N)
Small Jar 430 18 16 17,740 2,580
Medium Jar 230 34 15 17,820 3,450

180
Large Jar 140 48 18 11,9201, 720
700 17,480 6,750
Required:
Determine the following variances:
(a) Sales price
(b) Sales margin mix
(c) Sales margin volume
(d) Sales margin quantity variance

SUGGESTED SOLUTION 9-3

(a) Actual units @

Actual mix N6,750 sales margin
price variance
Actual margin N250 A

(b) Actual usage

Actual mix N7,000 Total
Standard margin sales Sales
margin Margin
mix Variance
(c) Actual usage variance Sales
margin N,250 A s
Standard mix N6,992 N8 F
Quantity a
Standard margin s
sales Variance
l
margin N1,000A a
(d) Standard units e
volume l
Standard mix N8,000 variance s
e
Standard margin N1,008A
Note: s
m
(a) This is as given in the question N6.750. a
(b) m
It is the actual units in the actual proportions but at the standard margin, that
r is,
N(430 x 8) + (230 x 12) + (40 x 20) = N7,000. a
g
(c) It is the actual number of units sold (700) but as the rstandard proportions i
(62.5%, 31.25%, 0.0625%). g
n
(d) This is as given in the question N8,000. i
n
q
The sales margin variance is derived by comparing the standard state with the actual
state, that is, N6,750 – N8,000 = N1,250A u
v
a
o
3.6 STANDARD MARGINAL COST n
l
t
u
It is noteworthy to state that the total absorption casting principles i
m form the basis on
which standard costing systems operate. However, the marginal costing principles t can
e
y
also be introduced into standard costing operations, hence being referred to as standard
v
marginal costing. It can also be recalled that marginal costing operates on the
contribution approach, whereby costs are separated into variablea and fixed costs v and
r
the latter are not part of product costs but are treated as period costs. a
i
r
a
i
181 n
a
c
n
e
c
N
e
The standard marginal costing technique adopts the following principles and
characteristics:

 Standards are evolved in the usual manner on standard cost card, without the
inclusion of the fixed costs. The direct materials, direct labour, direct expenses
and variable overheads are recorded on it.

 The standard selling price is determined by adding the budgeted contribution

for every product to the budgeted marginal cost. Therefore, the budgeted sales
margin is the budgeted contribution.

 The budgeted sales levels and fixed overhead cost can be used to come up with
the budgeted profit statement for the subsequent operating period. The format
would appear as below.

Budgeted Profit Statement for the Period ended

N
Budgeted sales (XXX
(Budgeted no of units x budgeted selling price)
Less: Budgeted cost of goods sold (XXX)
(Budgeted no. of units x budgeted marginal cost per unit)
= Budgeted Contribution (XXX
Less Budgeted fixed costs (XXX
Budgeted profit (XXX
With the non-inclusion of the fixed overhead volume variance and the sub-analysed
variances (the capacity and efficiency variances), the analysis of variances becomes
easier
3.7 OPPORTUNITY COST APPROACH TO VARIANCES

These variances conform to the terminology of the Chartered Institute of Management

Accountants. It is not uncommon in practice for additional ‘special’ variances to be
included within a reporting system, to reflect the unique characteristics of a company’s
operations, that is, a flour or sugar manufacturer might include an item in his standard
costs for losses due to damaged or broken packs.

Nevertheless, most variance reporting systems conform on the whole to the

conventional type.

A school of theorists, however, has suggested a different approach to the calculation of

variances. The leading exponent of this school is Professor Joel Demski.

Demski (1977) argues that Existing internal accounting techniques of flexible

budgeting and variance analysis are thought to be general purpose in nature, because
of their emphasis on comparison between actual and planned results’.

182
Analysis of differences between actual and planned results, leads to the taking of
remedial action as well as learning. Unfortunately, the price of this generality is an
accounting model that merely monitors performance relative to the original plan,
except as signalled by implication or use of an adjusted budget. Put another way,
because of its emphasis on comparison between actual and planned results, and
consequent disregard of changes in these planned results, the traditional accounting
model does not act as an opportunity cost system.

3.7.1 Opportunity Cost Approach

An opportunity cost approach ‘compares what a firm actually accomplished during

some planning period with what it deems on the basis of hindsight, it should have
accomplished. It is an opportunity cost approach in the sense that what a firm actually
accomplished during some planning period is what it should have accomplished in the
ex-post optimum programme’. Demski therefore argues that in order to provide control
information which guides managers towards better control decisions, it is necessary to
show what realistically could have been achieved during a period, rather than what the
possibly-out of-date budget plan intended to be achieved. ‘Instead of comparing actual
results with ex ante standard results, this system compares actual results with revised
optimum results.

‘This implies that the proper standard to be used in supplying variance information is a
standard based on actual conditions; that is ‘those that would have been incorporated
in the original plan if the actual conditions had been known in advance.’ We shall call
this an ex-post (currently attainable) standard.’

The opportunity cost approach considers:

(a) actual results;
(b) budgeted results; and
(c) ‘ex-post’ optimum results. Traditional variance analysis does not to do this.

9.7.2 Marginal Costing and Opportunity Costs

You may have noticed that in the previous examples, marginal costing variances were
calculated, that is, sales volume variances were valued at contributed foregone and
there are no fixed cost volume variances. This because contribution foregone, in terms
of lost revenue or extra expenditure incurred, is the nearest equivalent to opportunity
cost which is readily available to management accountants (who assume linearity of
costs and revenues within a relevant range of activity).

3.7.3 The Opportunity Cost of Capacity Variances

Horngren (1990) suggested that a ‘contribution foregone’ approach to reporting

capacity variances would be preferable to the traditional absorption costing capacity
variance.

183
ILLUSTRATION 9-4

The Master budget of Jones Ltd for 1988 is to make and sell 100 units of its product
each month, at a contribution of N50 per unit. However, at the beginning of May, the
scheduled production for the month was reduced to 95 units because of difficulties in
making sales to customers. Each unit takes 4 hours to make, and actual production and
sales in May amounted to 90 units in 360 hours of work. Calculate the opportunity cost
of the capacity variances.

SUGGESTED SOLUTION 9-4

(a) Scheduled production for May in the Master Budget 400 hours
Schedule production at the beginning of the month 380 hours
Marketing capacity variance 20hours(A)

At N50 per unit (N12.5 per hour), the contribution foregone is N250 by the
failure of the sales department to achieve the expected sales.

(b) Similarly;
Scheduled production at the beginning of the month 380 hours
Actual hours worked 360 hours
Production capacity 20 hours (A)

The contribution foregone is N250 by the failure of the production department

to meet its output targets.

(c) N N
Budgeted Contribution 5,000
Opportunity cost of
Marketing Capacity variance 250 (A)
Production Capacity variance 250 (A) 1,500
Actual Contribution (90 units x N50) 4,500

3.7.4 The Opportunity Cost of Efficiency Variances

The same argument might be applied to efficiency variances. If inefficiency, by

restricting output below what it should have been, also results in lost sales, the cost of
inefficiency will include the contribution foregone by losing the sales.

ILLUSTRATION 9-5

Ayo Wale Ltd budgets to make and sell 200 units of its product during a period.
Unit costs are as follows:
N N
Sales 18
Direct materials 16

184
Direct labour (5 hours per unit) 10 16
Contribution 12
During the period, the production department works for 1,000 hours and produced 175
units. The actual contribution was
N N
Sales (175 units at N18) 3,150
Direct Materials 1,000
Direct Labour 2,000 3,000
Actual Contribution 1,150
Analyse the variance from an opportunity cost approach

SUGGESTED SOLUTION 9-5

175 units should take (x 5 hours) 1,875 hours

but did take 1,000
Efficiency variance 1,125 hours (A)
x N2 per hour N250 (A)

Inefficiency of 125 hours (A) has also cost the company lost production and sales of
25 units, and the contribution foregone from these sales at N2 per unit is N50 (A).
N N
Budgeted Contribution 400
Efficiency Variance
Labour costs 250 (A)
Lost sales volume 150 (A)
300 (A)
Material cost variance 150 (F) 250 (A)
Actual contribution 150

3.8 PLANNING AND OPERATIONAL VARIANCES

Traditional variances imply that actual performance is always at fault, as a result of the
method of analysing variances between operational and planning factors, that cause
failure to achieve budgeted profit in that faulty standards could be identified
separately.

Planning and operational variances provide additional relevant information as they

separate the variances into components which are the result of good planning and
operation.

When planning, variances may not be separated, some elements which are
uncontrollable may work against the planning system. It must however be remembered
that the Planning and Operational approach does not make the traditional approach
absolute, but rather make the information of things more relevant especially in
controlling the operation of the organization.

185
The main difficulty in this approach is the ability of the management to separate the
total variances into their planning as well as operational sources, hence most
organisations are slow in modifying their system in this direction.

3.8.1 Calculation of Planning and Operational Variances

In calculating planning and operational variances, we have to understand the following

terms:

(a) Ex-Ante: this is the first target set.

(b) Ex-Post: this is the later situation during the year or immediately which were
not foreseen during the first target (Budget);
(c) Actual Result: this is actual result at the end of the period.

Planning Variances = Ex-Ante – Ex-Post

Operational Variances = Ex-Post – Actual Result

Planning variances are those variances which are not within the control of
management (Uncontrollable).

Operational variances are variances which are controllable by the management.

Planning variances may be due to the following:

(a) New government policy on importation
(b) New government policy on taxation
(c) Inflation

ILLUSTRATION 9-6

In January 2004, Jaye Limited set a standard marginal cost for its major product at
N50 per unit. The standard cost is re-calculated once each year.

Actual production costs during August 2004 were N608,000 when 8,500 units were
made.

With the benefit of hindsight, the management of Jaye Limited realized that a more
realistic standard cost for current conditions would be N80 per unit. The planned
standard cost of N50 is unrealistically low:

SUGGESTED SOLUTION 9-6

With the benefits of hindsight, the realistic standard should have been N80. The
variances caused by favourable or adverse operating performance, that is, the material
price and usage, labour rate and efficiency variances etc – should be calculated by
comparing actual results against this realistic standard. Since the variance should then

186
be a true reflection of operating performance, they will be called operational variances,
that is, (Ex-post less Actual Result).

N
8,500 units should (realistically have cost (x N80) 680,000
But did cost 608,000
Total operating variances 172,000 F
The planning variance reveals the extent to which the original standard would be at
fault (Ex-Ante less Ex-Post).

N
The original (ex-ante) standard cost 8,500units x N50 per unit 425,000
The realistic retrospective (ex-post) standard cost
8,500 units x N80 per unit 680,000
Planning Variance 255,000
(Note: it is an adverse variance because the original standard was too optimistic, that is
over-estimating the expecting profits by understating the standard cost).
N
Planning 255,000
Operating variances (72,000)
Total 183,000

If traditional variance analysis had been used, the total cost variance would have been
the same, but the ‘blame’ would all appear to lie on actual results and operating
inefficiencies.
N
Standard cost (ex-ante) of 8,500 units (x N50) 425,000
Actual cost of 8,500 units 608,000
Total Cost Variance 183,000

Bromwich (1990) would argue that:

(a) the total cost variance reported by the traditional method would not be helpful
for management control purposes;
(b) planning and operating variances give a better idea of why actual results failed
to reach the original budget expectations. Operating variances may or may not
be controllable, whereas planning variances tend to be uncontrollable. If the
standard is wrong, no amount of control-action to adjust operating resources
will reconcile actual results to the faulty budget. Nevertheless, planning
variance reveals a severe weakness in a business organization in that failure to
budget correctly may lead a company into severe financial difficulties or at best
poor financial results for the accounting period. They need to be identified,
albeit in hindsight, and eliminated as much as possible in future planning.

187
ILLUSTRATION 9 – 7

Ayo limited budgeted to sell 10,000 units of a new product during 2005. The budget
sales price was N20 per unit, and the variable cost N6 per unit. Although actual sales
in 2005 were 10,000 units and variable costs of sales were N60,000. Sales revenue
was only N10 per unit.

With the benefit of hindsight, it is realized that the budgeted sales price of N20 was
hopelessly optimistic, and a price of N9 per unit would have been much more realistic.

Required: Analyse the variances into operating and planning variances.

SUGGESTED SOLUTION 9 – 7

AYO LIMITED
Budgeted Contribution 140,000 (N14 per unit)
Actual contribution 40,000 (N4 per unit)
Total Variances 50,000 (A)

The only variances are sales price variances.

Operating (Sales price) variance N
10,000 units sold for N10 each 100,000
but should (realistically) have been sold for N9 each 90,000
10,000(F)
Planning (Sales price) variance:
Volume Sales Variable Total
Price Cost Contribution
______ N N N
Ex-ante (original) budget 10,000 units 20 6 140,000
Ex-post (realistic) budget 10,000 units 9 6 30,000
Planning Variance 11 A per unit 110,000 A

The total difference between budgeted and actual profit of N50,000 (A) can be
analysed as:
N
Operating variance (sales price) 5,000 (F)
Planning Variance 55,000 (A)
50,000 (A)

3.8.2 Importance and shortcomings of planning and Operational Variances

Even though, the conventional variances may not be analysed into the planning and
operational elements, the importance cannot be underestimated and they include:

(a) Ensures an orderly manner of reviewing standards as well as the associated

basis for setting them up.

188
(b) Prompts the realistic nature of standard costing and variance analysis,
especially where circumstances change and are drastic.

(c) Ensures the usage of updated information, especially in the operational

variances adopted for determining present levels of efficiency.
(d) Since standard costing as a technique is realistic and informative, its
acceptability will be on the high side and encourage motivation.

(e) Since the planning efforts are enhanced, problem areas can be easily identified
and actions takes as at when due.

Nonetheless, the shortcomings of the variances are:

(a) The responsibility centres may experience some form of pressure especially
where interpretation are involved in terms of controllable and uncontrollable
activities or internal or external factors affecting planning and operating duties.
(b) The determination and updating of additional variances entail many clerical and
managerial efforts on a continuous basis.
(c) The determination of the ex-post element may be subjective, hence resulting in
the allotment of the planning and operational causal factors being political in
nature.

3.9 CONTROL RATIOS

The units of output can be shown in different variety of forms and for the purpose of
standard costing. They are identified as a peculiar element/unit, that is the standard
hour which is referred to as the quantity of production that should be produced in an
hour.

A standard hour is a measure of the work content in an hour and not that of time
involved or taken to produce. For example, if 500 units of a product should be
produced in one hour, then output of 2000 units is equivalent to 4 standard hours.

Therefore, the relationship between standard hours and actual production can be
expressed as control rations. These are used to show the degree of efficient or
inefficient utilization of resources at the disposal of management.

The following ratios can be computed:

(a) Activity Ratio

This ratio compares the actual level of production with the planned level of
production.

It can be expressed as:

Standard hours equivalent of actual production x 100
Budgeted hours

189
It is not a measure of efficiency, but indicates the level of activity which has,
infact, been achieved.

(b) The Efficiency Ratio

The ratio measures the efficiency with which production has been achieved.
Actual time taken to achieve the actual production is compared with the time
such production should have taken.

The efficiency ratio can be expressed as:

Standard hours equivalent of actual production x 100

Actual hours worked

(c) The Capacity Ratio

This ratio assesses the utilization of the available capacity by comparing actual
hours worked with budgeted hours.

Actual hours worked

Budgeted hours x 100

It should be noted that:

Activity ratio = capacity ratio x efficiency ratio.

ILLUSTRATION 9-8

One of the departments of Lawal Company Limited produces two products “Gas oil”
and “kerosene”. The standard times for the production of the products are 30 minutes
for Gas oil and 24 minutes for kerosene. The budget for July is 24,000 units of Gas oil
and 10,000 units of kerosene. During the month, 12,000 labour hours were worked and
20,000 units of Gas oil and 8,000 units of kerosene were produced. You are required to
compute:

1. The activity ratio;

2. The efficiency ratio;
3. The capacity ratio and interpret your results.

SUGGESTED SOLUTION 9-8

LAWAL LIMITED

The Standard hours equivalent to actual production for July is:

Standard Hours
Gas oil 20,000 x 30 = 10,000
60
Kerosene 18,000 x 30

190
60 = 13,200
13,200
The budget in terms of standard hours is:
Budgeted Hours
Gas oil 24,000 x 30 = 12,000
60
Kerosene 10,000 x 30
60 = 15,000
17,000

The control ratios are:

1. Activity Ratio = Standard hours
Budgeted hours
= 13,200 x 100
17,000 1 = 77.6%

This means that the actual level of production is less than the budgeted level by 22.6%

2. Efficiency Ratio = Standard hours

Actual hours
= 13,200 x 100
12,000 1 = 110%

This means that the actual level of production was achieved in less time than standard
by working at a rate which was nearly 10% above the normal level of efficiency

3. Capacity Ratio = Actual hours worked x 100

Budgeted hours 1
= 12,000 x 100
17,000 1 = 70.5%
This means that the actual hour worked were less than the budgeted hours by 30%.

4.0 CONCLUSIONS

Standard costing involves comparing actual costs with predetermined costs.

The various types of standard are: basic standard, ideal standard, attainable standard
and current standard.
Standards are expected to be reviewed on a periodic basis, for example, half yearly, or
yearly.
Variance analysis is the process of analysing the total difference planned and actual
performance into its components parts. They should not be considered in isolation.
The basic variances are those of material, labour and overhead.
The basic material variances measure the differences between actual and standard
wage rates and actual and standard labour efficiency.
A standard hour is a unit measure of production not of time.

191
If total absorption principles of fixed and variable costs are absorbed into production,
variances relating to both fixed and variable overheads will arise while in marginal
costing only variable overheads are absorbed into production overheads.
Material usage variance can be sub-divided into mix and yield variances.

Sales marginal variances can be sub-divided into price and quantity variances.
Traditional variances can be separated into planning and operational variances with the
attendant benefits whereby planning variances seek to measure that part of the total
variance which is due to planning deficiencies whilst the operating variances seek to
measure operating as compared to a realistic current standard.

5.0 SUMMARY

In this unit, we have discussed the standard setting process. We then looked at the
relationship between budgetary control and standard costing. Finally, we calculated
material, labour, overhead and sales margin variance.

6.0 TUTOR MARKED ASSIGNMENT

1. During a period, 17,500 hours were worked at a standard cost of N6.50 per
hour. The labour efficiency variance was N7,800 favourable.
How many standard hours were produced?
A. 1,200
B. 16,300
C. 17,500
D. 18,700
E. 18,400

2. Femi Limited has the following budget and actual data:

Budgeted fixed overhead cost N100,000
Budget production (units) N120,000
Actual fixed overhead cost N110,000
Actual production (units) N119,500
The fixed overhead volume variance is
A. N500 Adverse
B. N2,500 Adverse
C. N10,000 Adverse
D. N17,500 Adverse
E. N17,600 Favourable.

3. Lawani Limited uses standard costing system. It purchases a small component

for which the following data are available.
Actual purchase quantity 6,800 units
Standard allowance for actual 5,400 units
Standard price N0.85

192
Material price variance (N544) Adverse
What was the actual price per unit?
A. N0.75K
B. N0.77K
C. N0.93K
D. N0.95K
E. N1.00K

4. In a period, 11,280 kgs of materials were used at a total standard cost of

N46.248. The material usage variance was N492 adverse. What was the
standard allowed weight of material for the period?
A. 11.520kgs
B. 11,280kgs
C. 11.394kgs
D. 11,160kgs
E. 11,180kgs

5. Under what circumstances will a (i) material mix (ii) material yield variance
arise?

6. What is the formula for calculating sales mix variance?

7. Explain “Ex-Ante” and “Ex-Post” as planning variances concepts.

Use the below data to answer question 9 and 10.

8. Tayo purchased 19,000kgs raw materials at N11 per unit. The standard price is
N10 per unit. What is the material price variance?

7.0 REFERNCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

193
UNIT 10 COST OF CAPITAL

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 What is cost of capital?
3.1.1 Cost of Equity
3.1.2 Growth in Dividend Rate: Gordon's Growth Model
3.2 Capital Asset Pricing Model (CAPM) and Cost of Equity
3.2.1 Cost of Retained Earnings
3.2.2 Cost of Preference Shares
3.2.3 Cost of Debentures
3.2.4 Cost of Short-term Funds
3.2.5 Concept of Weighted Average Cost of Capital (WACC)
3.3 Computation of WACC
3.4 Concept of Marginal Cost of Capital (MCC)
3.5 Cost of Capital and Gearing
3.5.1 Traditional Theory
3.5.2 MM Theory
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignments
7.0 References/Further Readings

1.0 INTRODUCTION

For any business venture to operate effectively it must have capital funds, that is,
source(s) of financing its operations for example, profits ploughed back, funds brought
in by the entrepreneur, shareholders’ funds (ordinary and preference), debentures, long
term loans and short term loans, overdraft, etc. However, these funds do not come free
of charge because their usage in the business has made unavailable for other
investments. Therefore, some costs are involved which are referred to as opportunity
cost that is, alternative returns forgone in order to achieve a particular objective.

2.0 OBJECTIVES

 In this unit, readers will able to understand:

 The term ‘Cost of Capital.’
 The sources of capital funds to an enterprise
 The different costs of funds and their computations.
 The variance cost models.
 The various cost concepts as they related to cost of capital – WACC and MCC
 The relationship between cost of capital and gearing.

194
 The various model of capital structure and the contributions for the
determination of cost of capital as well as the acceptability of projects.

3.0 MAIN CONTENT

3.1 WHAT IS COST OF CAPITAL?

Cost of capital can be defined as the minimum return required by providers of finance,
over-time, in order to compensate them for not investing their funds in some other
alternative businesses available to them. It is calculated on the basis of opportunity
cost of different sources of finance, therefore, the most recent market values of such
sources will always represent the investment outlay. The concept of cost of capital is a
return or yield concept and can be represented in most cases as:

Yield or Return = Interest s

Investment

The calculation of specific cost of the different sources of finance, that is, cost of
capital which is synonymous with the cost of finance can therefore be determined from
the under-mentioned variables as follows:

(a) Cost of Equity

(b) Cost of Retained Earnings or Profit
(c) Cost of Preference Shares
(d) Cost of Debentures
(e) Cost of Short-term funds
(f) Weighted average cost of capital

3.1.1 Cost of Equity

This refers to the returns on the investment due to the ordinary shareholders as a result
of the capital they have provided for the company’s use over a given financial period,
that is, what the company has to give up in order to have a use of the shareholders
funds. This can be determined based on the following situations namely;

 When there is a constant dividend rate.

issue cost of transaction or cost of reduction in market
per share is involved.
 When there is a growth in the rate of dividend.
 Constant dividend rate.

(a) When the element of constant dividend is involved, the cost of obtaining or
using equity funds is determined thus:

195
Ke = d
MV ex – div
Where: Ke = Cost of Equity
d = Dividend
MVex–div = Market value excluding dividend

ILLUSTRATION 10-1

Osimagba Plc has 200,000 25k ordinary shares currently valued at 40k. Cumulative
dividend and the dividend which about to be paid is 4k. What is the company’s cost of
equity?

SUGGESTED SOLUTION 10-1

Going by the above formulae, the cost of equity can be determined thus:

Ke = d = 0.40 = 11.11%
MV ex–div 0.36

(b) When issue cost of transaction is involved

If transaction costs or issue costs of flotation costs are involved, the cost of
equity and in fact, the cost of any other source of finance will be redefined as
follows:

Ke = d
MVex – div – c

Where: c = issue/transaction costs or reduction in market value per share

ILLUSTRATION 10-2

From illustration 10-1 above, let us assume that in addition to the condition therein, the
company intends to issue new shares which involves incurring issuing cost of 5k per
share and reduction below market value of 10k per share would also be required to be
made. Determine the company’s cost of equity?

SUGGESTED SOLUTION 10-2

Cost of equity is determined thus:

Ke = d 0.04
MVex – div – c = 0.40 – (0.04 + 0.05 + 0.1)

= 0.4 = 0.04 = 19.05%

(0.40 – 0.19) 0.21

196
3.1.2 Growth in Dividend Rate: Gordon’s Growth Model

This is a model that has to do with share price movements which is a function of the
fact that the present value of the anticipated future of dividends determines the price of
shares.

This model is based on various assumptions, the basic elements of which are:

(a) Investors act rationally with regard to future returns.

(b) Investors have the same time preference which can be evaluated by discounting
at the investors personal discount rate.
(c) There is no inflation or taxation and that the future is known with certainty by
all investors.

As deficient as the theory may be is practice, the application may be a good takeoff
point in the prediction of cost of equity. Nonetheless, two further assumptions made
for examination purposes are that: either constant dividend are paid each year to
perpetuity or that there is a constant compound growth rate of dividends to perpetuity,
that is, the dividend each year increases by the same percentage.
The formulae for the dividend valuation model are as follows:

(i) Constant dividend to perpetuity

Ke = d
Mv
(ii) Constant compound growth rate of dividends to perpetuity
Ke = d (1+g) + g
Mv – c
Where mv = current market value per share
d = dividend per share
Ke = discount rate or personal discount rate
g = growth rate of dividends
c = issued transactions cost or reduction in market value per
share.

ILLUSTRATION 10 – 3

Otiribe Plc has just paid a dividend of 70k on its ordinary shares which are currently
priced at N4 is the investors personal discount rate if:
(a) There is no growth rate in dividend?
(b) There is a growth rate of 20% in dividend?

SUGGESTED SOLUTION 10 – 3

(a) Ke = d = 0.70 = 0.175 or 17.5%

197
mv 4.00

(b) Ke = d (1+g) + g
mv – c
= 0.70 (1+0.20) + 0.20
4.00
= 41%

3.2 CAPITAL ASSET PRICING MODEL (CAPM) AND COST OF EQUITY

The CAPM is an alternative approach to the problem of measuring the cost of capital,
particularly cost of equity. The plan is to determine the linear relationship between
risk and return in the capital market. The investor’s return is categorized into two:
(i) a risk free rate of interest; to which is added
(ii) a premium to cater for the particular level of risk in a given security. The
premium is determined by adopting what is required in the (Beta) coefficient
which is the measure of the volatility of the return in a share relative to the
market. If a share price were to rise or fall at triple the market rate, it would
have beta factor of 3.0. Conversely, if the share price moved at half of the
market rate, the beta factor would be 1.5.

The procedures involved in adopting CAPM to estimate the cost of equity capital are
as below:
(i) Estimate the market parameters. This involves the determination of the risk free
rate of return, the expected return on the market and the variance of the market
return.
(ii) Estimate the firm’s beta co-efficient. This is based on the historical analysis of
the share performance, that is, the prices, price changes, dividend yield,
variances of return and co-variances with market return over as long a period as
possible. Riskless securities have beta co-efficients equal to nil; an average
security has a beta value of 1.0; securities have beta value greater than 1.
(iii) Estimate the cost of equity using the market parameters and the firm’s beta co-
efficient.

The appropriate equation for establishing the expected returns is as follows:

Ra = Rf + (Rm – Rf) 

Where: Ra = the expected return on the security

Rf = the risk free interest rate
Rm = the expected return on a market portfolio
 = the beta co-efficient which measures the volatility of the security’s returns relative
to market return.

ILLUSTRATION 10.4

198
If the risk free interest rate is 8%, the market return 12% and the beta co-efficient is
1.2 then:

Ra = Rf + (Rm – Rf) 
8 + (12.8) 1.2
= 12.8%

This is the cost of capital estimated according to the Capital Asset Pricing Model.

Note:
The  co-efficient is found by dividing the covariance of the return on the new
investment and the return on the market folio by the variance of the market return, that
is,

 = Cov (Ra . Rm)

Variance (Rm).

The cost of equity can be determined as follows, if there is an increase or growth in the
rate of dividend involved;
Ke = d0 (1 + g)
MV – c
Where d0 = Dividend in Year ‘0’
g = Growth rate in dividends annually
MV = Market value ex-dividend
c = issue/transaction cost or reduction in market value
per share.

ILLUSTRATION 10 – 5

Sepele Nig. Plc has in issue 12 million ordinary shares with a market value of N7 per
share. N6 million in dividend were paid this year which represented 75% of earnings.
The earnings are expected to grow at an annual rate of 5%. The issue of new ordinary
shares now will make the company to incur cost which would represent 25k per share
and a reduction below market value of 50k per share would also be made. Determine
the company’s cost of equity?

SUGGESTED SOLUTION 10 – 5

Ke = do (1 + g) + g
MV – C

Ke = 50k (105) + 0.05 = 13.4%

7 - (0.05 + 0.25)

199
The element or rate of dividend was derived by dividing dividend paid by the number
of ordinary shares issued and fully paid i.e.

6,000,000 = N0.50
12,000,000

It is important to note that growth rate in dividend is not given, but there is sufficient
information to estimate the growth rate. There is a need to use the growth rate formula
as the growth rate exhibited in previous dividend payments, will be expected to
continue in the future.

3.2.1 Cost of Retained Earnings

The represented revenue and other reserves accumulated in a company over time.
They statutorily and legally belong to the ordinary shareholders. Earlier theories in
this area erroneously assumed that retained earnings could be regarded as free source
of funds because there were no payments or cash flow to shareholders that will be
based on reserves or retained earnings. However, it is now agreed that ordinary
shareholders will demand the same rate of return that they are getting from new funds
supplied by them to the company in respect of retained earnings. Therefore, the cost
of retained earnings will be equal to cost of equity calculated in illustration 10 – 3
above.

Nevertheless, where market values have been used to attach weights for weighted
average cost of capital (WACC), the retained earnings in the company cannot be
attached with any costs. The reason is that the shareholders would have adjusted for
the retained earnings in arriving at the market value of the company’s share.
Therefore, where book values are used in the calculation of weighted average cost of
capital (WACC), the costs to be attached to retained earnings will be equivalent to the
prevailing cost of equity.

3.2.2 Cost of Preference Shares

From our knowledge of financial accounting, we know that the preference

shareholders are not part of the company, they are only shareholders, therefore a need
to pay them fixed dividend as return on their investment. These shares can also be
grouped into irredeemable and redeemable preference shares. Irredeemable means
that the share remain perpetually in the company unless there is a liquidation whereas
the redeemable suggests refund of capital to the shareholders on the expiration of the
agreed period of investment in the company. Therefore, the discussion here will be
based on the cost or irredeemable and redeemable preference shares as follows:

(a) Cost of Irredeemable Preference shares

This can be determined by using the formula below:

200
Kp(i) = dividend (d)
MV – C
where, d = rate of dividend
MV = market value ex-dividend
C = transaction cost or reduction in market value.

(b) Cost of Redeemable Preference Shares

The cost of redeemable preference shares is that rate of return that equates
current market value of the preference shares to all future receipts or payment
of preference dividend and the market value of preference share at redemption.
This can be calculated in the same way as cost of convertible debenture and
redeemable debentures which are discussed below.

3.2.3 Cost of Debentures

Debentures issued by a company is a means of acquiring long term source of financing

projects which is not provided by the owners of the company. The debenture holders
are always paid a fixed return on their investment which is called interest. However,
debentures can be grouped as follows irredeemable; redeemable and convertible.
These groupings will form the basis for the determining the associated cost of securing
the capital.

(a) Cost of Irredeemable Debentures

This can be calculated by using the formula as follows:

Kd = Interest
Mvex-interest – C

However, where the element of taxation is to be incorporated, the cost of irredeemable

debentures will then be:

Kd = Interest (1 – t)
Mvex-Interest – C

where t = tax rate

This is illustrated in the example below:

(b) Cost of Redeemable Debentures

This can also be referred to as the market rate of interest or the implicit cost of
debentures. It is that rate of return that equates the current market value of the
debentures to all future receipts or payments or interest including market value
at redemption. Therefore, to calculate this cost, it is necessary to assume that
the redeemable debenture is a project and that the internal rate of return on the
project is the cost of redeemable debentures. In this case, the current market
value can be regarded as initial outflow while interest received or receipts will

201
be regarded as cash inflows and market value at redemption will be treated as
scrap value.
The cost of redeemable debentures is, therefore, derived through an
interpolation method. The example below can be used to illustrate the
principles stated above.

(c) Cost of Convertible Debentures

The principles and concepts here are the same as in redeemable debentures.
The only difference is that we usually substitute the market value of equity into
which the debts have been converted for market value at redemption. Hence,
the cost of convertible debenture is that rate of return that will equate current
market value of the convertible debentures to all future receipts or payment of
interest and market value of equity into which the debentures have been
converted at the date of conversion.

The following are to be given consideration when the calculation is being made:

(a) for convertible and redeemable debentures, adjustments for taxation

should only be made in the interest element and not the market value.
(b) where there is no sufficient information to calculate the IRR for the
convertible or redeemable debentures, it is better assumed that such
debentures are not convertible or redeemable, even if they have been
described as such.

3.2.4 Cost of Short-Term Funds

This refers to the interest payment in respect of such fund, for example, interest on
bank overdraft or short term loan. However, where the element of taxation is to be
incorporated, the cost will then be determined thus:

Interest payment (1 – t)

Where “t” is tax rate

It should be realized that market values are not relevant in this area because short-term
funds are not traded in the capital market.

3.2.5 Concept of Weighted Average Cost of Capital (WACC)

There have been considerable arguments as to what constitute the cost of capital of a
company that obtains funds from different sources. It has also been argued that the
cost of capital for each source of finance, if taken in isolation is irrelevant. However,
the theoretically correct view is that the cost of capital relevant to a company is the
weighted average of the costs of the various components of the company’s capital
structure. The weights attached are based on the proportion that the different
components contribute to the total capital structure of the company.

202
The argument for the relevance of WACC is that in financing a project, it may not be
easy to identify the particular sources of finance used to fund the project, since in most
cases, projects are financed from a pool of the company’s financial resources.
Although, a particular source of finance may be used on a specific occasion, that
source cannot be used indefinitely. It will be necessary in the future to raise finance
from some other sources. Secondly, the costs and the risks associated with the
difference sources of finance do change from time to time, thereby necessitating an
averaging system to recognize differences in the composition of the company’s capital
structure should be regarded as having a target optimum capital structure. This view is
supported by Gordon, a financial management expert thus, “if projects are evaluated
using the WACC, the wealth of the shareholders in the long run will be maximized”.

This same view is supported by Van Horne (1976) and some other finance authors.
Van Horne (1976) said “the rationale behind using the WACC is that by financing
projects in the proportion specified and accepting projects yielding more than WACC,
the company will be able to, in the long run, increase its market value.

3.3 COMPUTATION OF WACC

Theoretically, in calculating the WACC, the market value of equity and debt should be
sued as the relevant weight to be attached. This is because the returns or costs
themselves can be calculated by reference to market value, hence market values are
more appropriate. Also in financial management for futuristic models, market values
are more relevant than book values. However, if market values are not given, book
values may be used on the assumption that the book values are equal to the market
values. In particular, with reference to overdraft and other short-term funds that are
not quoted, book values should be applied as weight. When book values are used as
weight, cost of retained earnings equivalent to cost of equity should be included in the
WACC. Nevertheless, where market values are used as weights, no cost and value
should be attached to retained earnings.

In effect, the following steps are involved in WACC calculation thus:

(a) Calculate the specific cost of each source of finance as previously explained in
the former part of the chapter.
(b) Multiply the cost of each source by the market value of that source to arrive at
the expected return from that source.
(c) Add up the total returns from all sources and the total market value of all
sources.

(a) WACC = Total Return = d

Total Market Value MV

The above principles and concept can be illustrated by the example below:

ILLUSTRATION 10 – 6

203
Oribamise Plc has a capital structure consisting of 100,000 N1 ordinary shares and
50,000 12% loan stock. The ordinary shares are currently valued at 75k each and the
loan stock at 80. Annual dividends have been constantly running at 10k per share and
a dividend has just been paid. The loan stock interest has just been paid too.
Calculate.

(a) Cost of equity

(b) Cost of Loan stock
(c) Weighted average cost of capital.

SUGGESTED SOLUTION 10 – 11

(a) Ke = d = 0.10 = 13.33%

MV 0.75

(b) Kd = Interest = 0.12 = 15%

MV 0.8

(c) Source Market Value Cost Returns

N N
Equity 75,000 13.33% 10,000
Debt (Loan) 40,000 15% 6,000
115,000 16,000

WACC = 16,000 x 100 = 13.913%

115,000

Note:
Market value of Equity = 100,000 x 0.75 = 75,000
Market value of Debt (Loan) = 50,000 x 80 = N40,000
100

ILLUSTRATION 10 – 6

One of your clients has seen many references to the cost of capital in the financial
press and has asked you to give him some guidance on what could be an appropriate
figure for this organization. Ononobi Limited.

The following information is available for Ononobi:

Existing Capital Structure N’000
Issued Ordinary Shares – 12,000,000 12,000
Retained earnings 4,000
6% Preference shares 2,000
9% Debentures repayable 6,000
24,000

204
9% Debenture
(a) Issued in 1998 at par;
(b) Current price N92;
(c) A similar issue, if made now would require to be made at N90 of 6%

Preference Shares
(a) Preferences shares have a par value of N1 and were originally issued at 92k per
share;
(b) Current price is 43%
(c) A similar issue, if made now would require to be made at 40k per share.

Ordinary Shares
(a) The market price of an ordinary share is N7
(b) N6 Million in dividends were paid this year which represented 75% of earnings.
(c) Earnings are expected to grow at an annual rate of 5%
(d) If new ordinary share, were issued now, costs incurred would represent 25k per
share and a reduction below market of 50k per share would also be made.
The company tax rate can be assumed to be 50%

SUGGESTED SOLUTION 10 – 6

WACC
Source Market Value Cost Returns
N’000 N’000
Debentures 5,400 5% 270
Preference 800 15% 120
Equity 84,000 13.4% 11,256
90,200 11,646

Therefore, WACC = 11,646 x 100 = 12.91%

90.200

3.4 CONCEPT OF MARGINAL COST OF CAPITAL (MCC)

Whenever a company raises new finance, the risk profile of the company’s capital
structure is likely to change. Therefore, the project which compelled the company to
raise additional finance must pay for the increase in risk or benefits from the reduction
in risk implicit in the company’s new capital structure. This is the reason for
preference to marginal cost of capital (MCC) in the evaluation of new projects. The
MCC is the cost of new finance or additional fund.

According to Weston and Brigham (1980), new projects ought to be evaluated using
MCC in order to maximize return and minimize risk. Based on their argument, MCC
was defined as “the effective cost of additional finance normally required for the
execution of new projects”. I can be assumed to be the difference between the cost of

205
capital before the project is accepted and the cost of capital after the project has been
undertaken.

However, in calculating the MCC, market values should also be used in weighting the
various components of the capital structure. But where additional finance does not
change the risk profile of the capital structure, the MCC will be exactly equal to the
WACC. Therefore, if the risk in the capital structure increases, MCC will be higher
than WACC and vice-versa. The example below is used to illustrate the above
concept.

ILLUSTRATION 10 – 7

Ajuluchukwu Group of Companies is considering raising N100,000 by issuing 10%

debentures. At present, its capital consists entirely of ordinary shares being 200,000
25k ordinary shares valued at 40k. Cumulative dividend and the dividend which is
about to be paid is 4k. Dividend has been stable over the years but if the group’s level
of gearing is altered by the raising of these debentures, it is felt that the ordinary
shareholders will require a rate of return of 15% while the market value will remain
unchanged.

Calculate the marginal cost of the new debentures and the weighted average cost of
capital for the group with its revised capital structure.

SUGGESTED SOLUTION 10 – 7

(a) Calculation of Marginal Cost of Capital

N
100,000 Debentures @ 10% 10,000
Increase required by Equity (15% - 11.11%) x 72,000 2,801
12,801

Where current Ke = 0.04 = 11.11%

0.36

And market value of equity = 200,000 x (40k– 4k) = N72,000

Therefore, MCC = 12,801 = 12,801%

10,000

(b) Calculation of WACC

Source Market Value Cost Return

N N
Equity 72,000 15% 10,800
Debenture 100,000 12.80% 12,800
172,000 23,600

206
WACC = 23,600 x 100 = 13.721%
172,000

The revised capital structure is as follows:

N
Issued and fully paid:
200,000 25k ordinary share 50,000
10% Debentures 100,000
150,000

3.5 COST OF CAPITAL AND GEARING

Gearing
The term ‘gearing’ is a measure of the financial risk of a company, that is, a measure
of the relationship between equity capital and fixed interest capital including
securities. This can be expressed mathematically or by formulae as follow:
Gearing Ratio = MV of Debt
MV of Equity

Gearing, therefore, means the introduction of substantial debt into the financial
structure of a company.

In order to have a full appreciation of this concept, it will be discussed based on the
views of two schools of thought namely;
(a) Traditional School of Theory; and
(b) Modigliani and Miller (MM) Theory.

3.5.1 Traditional Theory:

This school believes that the cost of capital of a company is dependent on the level of
gearing and that there is an optimal level of gearing at which point the average cost of
capital is lowest. Their theory is based on the following propositions:

(a) As gearing increase, the cost of equity will not initially show a significant
increase, the reason being that, there will be sufficient profits to pay debenture
interest and still pay an acceptable level of dividends. However, as substantial
debt finance is introduced, (gearing increases) the cost of equity will show an
upward trend after an attained optimal gearing level. This is because; equity
providers of finance will require an extra return to compensate them for their
perceived increase in risk.

Under the above circumstances, there are two major areas of concern to the
shareholders, They are:
(i) will there be sufficient profits to pay dividend after the deduction of the
high debenture interest?

207
(ii) can debenture holders interfere in the management of the company in the
even of non-payment of either principal or interest or the disposal of a
charged asset?

(b) In the same manner, the returns required by existing and additional debenture
holders will show a significant upward trend after a particular level of gearing.
This level is known as the OPTIMAL GEARING LEVEL.

(c) As substantial level of gearing is introduced, the WACC will show a downward
trend up to optimal gearing level. This is because of the cheaper source of
finance (debt capital).

The main reason for the cheapness of debt are tax and lower risk. After the optimal
gearing level, as debt and equity costs increase, the WACC will also increase.

The above assumptions can be graphically shown as follows:

Cost (N)
Equity
WACC

DEBT

GEARING
Optimal Gearing
Level

Figure 10.1: Optimal Gearing Graph

In summary, the traditional theory states that, there is an optimal gearing level
(mixture of debt and equity) at which the WACC for every company is at the lowest.
They also stated that companies should determine and maintain that optimal level
because it is the point at which they will maximize their market values. Therefore,
companies will finance projects using the gearing mix of debt and equity funds.

3.5.2 MM Theory

This alternative theory believes that, the capital structure of a company will not
influence the level of a company’s cost of capital. Modigliani and Miller (1958)
provided a behavioural justification for the net operating profit or income approach.
They based their theory on the arbitrage process which entails investors switching their
funds from a geared company to price differential and make financial gains. They
believed that difference, in market value of companies, create the opportunity for
arbitrage.

Their propositions are as follows:

208
(a) As gearing increases, cost of equity will increase in a manner that is derivable
from the arbitrage process. This means that there will be movement of
investors from this geared company to other ungeared companies.
(b) The increase in the cost of equity will exactly offset the advantage of using the
cheaper debentures as a result of this arbitrage process. The arbitrage process
result in an equilibrium level of pricing of company’s shares or market value of
companies. Therefore, the WACC will remain constant irrespective of the level
gearing.

This can be graphically shown as follows:

Cost (N)

Equity

WACC

Debt

Gearing

Figure 10.2: Gearing Graph

The MM theory states that, it is not relevant for management to determine the optimal
gearing level because it does not exist. However, what is relevant in the valuation of
companies is the level of earnings of the company and the risk classification of such
earnings (business risk or financial risk). Therefore, companies in the same kind of
business and the same level of risk classification, will have the same market values if,
their level of earnings is the same irrespective of differences in their gearing or capital
structures.
However in 1962, Modiglian and Miller amended their original theory to recognize the
mutual impact of using debentures as a result of taxation. They now amended their
conclusion to state that, the WACC will initially show a downward trend as gearing is
introduced because of taxation after which it will remain constant as depicted in the
diagram below:
Cost (N)

Equity

WACC
Debt

GEARING

209
Figure 10.3: Modified Gearing Graph

Assumptions of MM Theory
(a) A perfect capital market exists.
(b) Individuals and companies can borrow and lend unlimited amounts of money at
the same rate.
(c) Individuals do not have fear of bankruptcy.
(d) Taxation can be ignored initially.
(e) Companies can be classified into the same risk class.
(f) Individuals will substitute personal gearing for corporate gearing.

The above classifications can be illustrated with the example below:

ILLUSTRATION 10 – 8

Mokun Limited and Lara Limited are quoted companies. The following figures are
from their current balance sheets.
Mokun Ltd Lara Ltd
Ordinary Share Capitals N’000 N’000
Authorized 2,000,000
Shares of 50k each 1,000 1,000
Issued 1,000,000 shares
Of 50k each 500 500
Reserves 1,750 150
Shareholders fund 2,250 650
6% Irredeemable debenture - 2,500

Both companies earn an annual profit, before charging debenture interest of N500,000
which is expected to remain constant for the indefinite future. The profits of both
companies before charging debenture interest are generally regarded as being subject
to identical levels of risks. It is the policy of both companies to distribute all available
profits as dividends at the end of each year.

The current market value of Mokun Ltd’s ordinary share is N3.00 per share cum-div.
Annual dividends is due to be paid in the very near future.

Lara Ltd., has just made annual dividend and interest both on its ordinary shares and
on it debentures. The current market value of the ordinary shares is N1.40 per share
and of the debentures, N50 per cent.

Mr. Bukunola owns 50,000 ordinary shares in Lara Ltd. He is wondering whether, he
could increase his annual income, without incurring any extra risk by selling his shares
in Lara Ltd. And buying some of the ordinary shares of Mokun Ltd. Mr. Bukunola is
able to borrow money at an annual compound rate of interest of 12%.

210
You are required to:
(a) estimate the cost of ordinary share capital and the weighted average cost of
capital of Mokun Ltd. and Lara Ltd.

(b) explain briefly, why both the cost of ordinary share capital and the weighted
average cost of Mokun Ltd differ from those or Lara Ltd.

(c) prepare calculations to demonstrate to Mr. Bukunola how he might improve his
position in the way he suggested, stating clearly any reservations you have
about the scheme

Ignore taxation for (a), (b) and (c).

SUGGESTED SOLUTION 10 – 8

Mokun Lara
(a) Ke = d = 0.50 0.35
MV (3 – 0.5) 1.40
= 20% = 25%

Ke = Interest Nil 0.06

MV 0.50
= 12%
WACC 20% 25% x 1.40 + 12% x 1.25
265 2.65

Note:
(a) The N150,000 deducted from N500,000 annual profit of Lara Ltd. is the
interest paid which is derived by taking 6% of N2,500,000.
(b) The cost of ordinary share capital differs in view of the fact that the
returns required by the equity shareholders of Lara Limited is higher
because of the higher risk they carry in relation to gearing compared to
Karim Limited.
Also the WACC differes because Lara Limited is using a cheaper source of
fund, that is, debentures to complement its financial needs.

(c) The current risk gearing ratio of Lara is given thus:

MV of Debt = 1,250,000
MV of Equity 1,400,000

N
Sales proceeds of 50,000 shares in Lara @ 1.40 70,000
Mr. Bukunola should borrow from the market in
the ratio of 1.25 x 70,000

211
1.40 62,500
Therefore, Total funds available to Mr. Bukunola 132,500

Mr. Bukunola will then buy shares from Mokun Limited @ N2.50

N132,500 = 53,000 shares

2.50

Gain (loss) to Mr. Bukunola can be determined as follows:

N N
Portion before switching (income)
50,000 shares in Lara @ 35k (17,500)
Portion after switching
53,000 shares in Mokun @ 50k 26,500
Less interest on borrowed funds
12% of N62,500 (7,500) 19,000
Gain 1,500

The solution above is derived by relaxing the assumptions of MM as stated below:

(1) Cost of borrowing may not be the same as that of the company
(2) Taxation has been ignored
(3) Transaction costs has been ignored
(4) There may be inability to raise up enough funds from the market.
(5) He may not be the only one that may be involved in the switching and thus the
sales value of his share and the switching and thus the sales of value of his
share and purchase of shares may not be as stated in the answer.

4.0 CONCLUSIONS

The cost of capital is the required rate of return of cut-off rate by which the
acceptability (or viability) of a proposed project is measured i.e. the cost of funds used
for a project. It is the opportunity cost of financing projects.
It can be calculated for equity, preference share, debentures and retained earnings on
an individual basis or collectively b determining the weighted average cost of the
different course of capital using either the market value basis or the book value basis.

5.0 SUMMARY

In this unit, we have discussed that one approach to estimating the cost of capital is by
the use of the Gordon growth or dividend valuation model.
Gearing is the ratio of fixed interest capital such as preference shares and debentures to
equity. Highly geared firm i.e. those with a higher ratio or fixed interest capital to
equity are more vulnerable to takeover bids under fluctuating trade conditions.
The capital Asset Pricing Model which measures the relationship between risk and
return in the capital market is an alternative method for the determination of the cost of
equity capital.

212
6.0 TUTOR MARKED ASSIGNMENT

1. A share has a current market value of 96k and the last dividend was 12k. If the
expected growth rate of dividend is 4% per annum, therefore the cost of equity
capital is
A 18%
B 17.5%
C 17%
D 19%
E 20.50%

2. Oweh Nigeria Limited has issue 10% debentures of a nominal value of N100.
The market price is N90 ex-interest. Therefore, the debt capital irredeemable is
A 11.3%
B 11.1%
C 11.4%
D 12.1%
E 12.4%

3. Prudence Nigeria Limited is financed partly by equity and partly by debentures.

The equity proportion is kept always at two thirds of the total. The cost of
equity is 18% and that of debt 12%. The weighted average cost of capital is
A 17.5%
B 17%
C 15%
D 14%
E 16%

4. Wale Limited has Ordinary Share capital with a market value of N450,000 and
cost of 20% per annum. It has debentures with a market value of N150,000 and
a cost of 10% per annum. The weighted average cost of capital is
A 17.5%
B 18.5%
C 19.5%
D 17%
E 18%

5. Every Sisters Limited has a 1 million Ordinary Share. Ex-dividend

market values are ordinary shares of N2.00. Dividend previously paid was 20k.
The growth of 5% on dividend is expected to grow indefinitely. The ordinary
equity cost of capital is
A 15.0%
B 15.5%
C 16.0%
D 16.5%
E 17.5%

213
6. The minimum acceptable rate of return on funds committed to the project is
called .............

7. What is the formula for calculating the imputed cost of capital?

8. What are the implications of cost of capital for accepting or rejecting a project?

9. Mention three factors to be borne in mind when marketing securities.

10. What is the formula for calculating the cost of equity when growth rate is
involved?

7.0 REFERNCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

214
MODULE III: QUANTATIVE METHODS AND MANAGEMENT
ACCOUNTING

Unit 11: The Application of Quantative Methods to Management Accounting

Unit 12: Working Capital Management
Unit 13: Capital Investment Decision
Unit 14: Decision Making under Risk and Uncertainty
Unit 15: Divisional Performance Evaluation

UNIT 11 THE APPLICATION OF QUANTITATIVE METHODS TO

MANAGEMENT ACCOUNTING

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Learning Curve Theory
3.1.1 Conditions under which learning curve theory operate
3.1.2 Learning curve applications
3.1.3 Learning curve procedures
3.1.4 Advantages of Learning Curve Theory
3.1.5 Limitations of learning curve theory
3.2 Inventory Control Techniques
3.2.1 Objectives of Inventory Control
3.2.2 Factors considered for effective stock control
3.2.3 Purposes for holding inventory
3.2.4 Factors influencing stock holding decisions
3.2.5 Stocks or inventory control systems
3.2.6 Periodic Review System
3.2.7 Stock levels control (Re-order level) system
3.2.8 Perpetual inventory system / continuous stock-taking
3.2.9 ABC Principle of Selective Approach
3.2.10 Economic Order Quantity
3.2.11 Assumptions underlying the operation of the E0Q Model
3.2.12 Simple EOQ Model
3.2.13 EOQ with discounts
3.2.14 EOQ with gradual replenishment
3.2.15 Limitations of the EOQ Model
3.3. Product mix with multiple constraints (linear Programming)
3.3.1 Definition
3.3.2 Assumptions of LP
3.3.3 Uses of Linear Programming
3.3.4 Methods of Linear Programming
3.3.5 Formulating a Linear Programming Problem
3.3.6 Shadow Price

215
3.3.7 Usefulness of shadow price
3.3.8 Simplex Method
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

Investment in stocks represents a major asset of most industrial and commercial

organisations, and it is essential that stocks be managed efficiently so that such
investments do not become unnecessarily large. We will also examine the use of linear
programming techniques and to consider how they can be applied to some specific
types of decisions that a firm may have to make.

2.0 OBJECTIVES

In this unit, readers would be able to understand:

 The learning curve theory and the situations when it can be applied.
 The computation of average and incremental labour for different output levels.
 The advantages and limitations of the learning curve theory.
 The various ways of classifying stock
 The various stock control techniques and their applications
 The weaknesses of the various stock control techniques;
 The situations when it may be appropriate to use the Linear Programming
technique;
 The various Linear Programming techniques and their applications
 The meaning and usefulness of the term ‘shadow price’.

3.0 MAIN CONTENT

3.1 LEARNING CURVE THEORY

Learning curve theory was first developed in 1925 at the Wright Patterson Airforce
Base in Ohio, United States. It was observed that as output doubled, the labour hours
required reduced by 20%. This was regarded as an 80% learning factor. The theory
assumes that as a worker becomes familiar with a new job, his experience increases
resulting in a decline in time required by him to perform the job. The learning curve
theory states that whenever a repetitive job is being performed, the average time spend
in producing a unit falls by the specific percentage whenever the activity level is
doubled.

This can be explained for the simple reason that as a worker carries out a repetitive
task:
(a) his dexterity will improve

216
(b) the initial bottleneck associated with the task will be overcome gradually.

(c) he becomes familiar with the problem areas and finds an appropriate solution to
take care of such areas.

As a result of all these taken together, a lot of time is saved and the time used in the
task reduces. However it must be appreciated that the reduction in time will not
continue indefinitely as it will get to a particular point where it will no longer be
possible for the average time spend in producing a unit to fall further. This can be
illustrated graphically as seen in figure 11.1 below:
Cumulative Time

T1
Very Steep Slope

T1
Relatively Stable

T1

T1

Q1 Q2 Q3 Q4 Level of Activity

Fig 11.1 Learning Curve Graph

At level of activity Q1 the cumulative time spent is T1, with the level of activity
increase to Q2, there is a sharp reduction in cumulative time to T2. At Q3, there was a
further decline in cumulative time spent to T3. By the time the activity level increase
to Q4, the reduction in time becomes less pronounced and the curve becomes
relatively stable.

Looking at the graph, at the onset, the concept of learning effect is heavily pronounced
because of the simple reason that, as more units are produced, the initial bottleneck or
problem starts to diminish. With continuous doubling of the activity level the initial
bottleneck is fully overcome and eliminated as shown by T2Q2 and T3Q3.

With a continuous increase in production and repetitive performance the rate of

efficiency continues to increase also until a point is reached when it will no longer be
possible for the average time spent in producing a unit to fall. This is because it is not

217
possible for a worker to spend a zero time in producing a particular unit or performing
a particular task.

3.1.1 Conditions under which Learning Curve Theory Operate

For the learning curve to operate, the following conditions must exist:
(a) The task must be repetitive in nature.
(b) The task must be such that it is labour intensive. In other words, the labour
content of the task must be very high. With mechanized task, there is little or
no scope for a lessening of operating time.
(c) Management must be able to motivate workers to be at their productive best.
(d) There should be little or no labour turnover.
(e) The task must be continuous (i.e. no frequent break).

3.1.2 Learning Curve Applications

Learning curve may be applied to the following situation:

(a) Cost estimation for example, determination of the cost of
prototype and the expected cost of future production.
(b) Pricing tenders for contracts, where the price must be competitive, but at the
same time profitable over the contract period.
(c) Project evaluation
(d) Deciding wage incentive plans.
(e) Production scheduling and manpower planning which could improve customer
relationships and possibly result in increased future sales.
(f) Cost control as the learning curve expectations of time to do a job may be much
more appropriate than a customer standard, thus efficiency being improved
upon.

3.1.3 Learning Curve Procedures

The following steps or procedures must be followed in determining the Learning

curve.
(a) Ascertain the learning rate or factor.
(b) Calculate the time expected to be used to produce the first unit.
(c) Determine the average time taken per unit for the first batch
(d) Calculate the average time taken per unit for the second batch.
(e) Calculate the cumulative time taken
(f) Repeat the calculations for each subsequent batch.

In applying the learning factor, it will be noticed that the batches are being doubled
each time. Where the batches do not double, the tabular approach described above
will collapse and the use of the algebraic approach will be feasible.

The algebraic approach is expressed as:

Y = axb

218
Where
Y = Expected average time per unit based on expected output.
a = average time per unit spent on the first batch
x = index of learning given as expected output divided by
Number of units in the first batch.
b = log of learning Curve
log of 2
ILLUSTRATION 11 – 1

A customer has asked a firm to produce a bill for the supply of 1,600 units of a
product. Production will be in batches of 100 units. The firm has estimated that the
time for the first batch of 100 units will average 50 hour per unit. The firm also
expects that an 80% learning curve will apply to the cumulative labour hours on his
contract.

Required:
(a) Prepare an estimate of labour hours of fulfilling this contract.
(b) Estimate the incremental hours of extending the production run of producing an
additional 1,600 units.
(c) Estimate the incremental hours of extending the production run from 1,600 to
2,000 units.

SUGGESTED SOLUTION 11 – 1

(a) and (b) using the Tabular Approach

(1) (2) (3) (4) (5) (6)
Units Cumulative Time Cumulative Average Workings
Produced Unit Spent Time per unit Time
100 100 5,000 5,000 50 -
100 200 3,000 8,000 40 50 x 0.80
200 400 4,800 12,800 320 40 x 0.80
400 800 7,680 20,480 25.6 32 x 0.80
800 1600 12,288 32,768 20.48 25.6 x 0.80
1600 3,200 19,660.8 52,428.8 16.38 20.48 x 0.80

The average labour hour for the first batch of 100 units is given as 50 hours per unit.
The average time per unit is shown in column (5) and the unit in the first batch which
is 100 is shown in column (1). The cumulative unit is 100 as shown in column (2).
The cumulative time spent is column (2) x column (5), giving us column (2). The
cumulative time spent is column (2) x column (5), giving us column (4). To double the
level of activity, that is the units to produce the cumulative unit becomes 200. The
average time per unit for these units will be 50 hours x 0.8 giving us 40 in column 5.
The cumulative time spent becomes 200 x 40 giving as 8,000 – 5,000 = 3,000 as
shown in column (3).

To double the level of activity again, the cumulative unit will become 400 units.

219
Average time per unit = 40 x 0.80 – 32 hours. Cumulative time will be 400 x 32 =
12,800. The time spend for the additional units will be 12,800 – 8,000 = 4,800. The
process is to continue as long as there is doubling in the level of activity.
To answer the question from table above
(a) An estimate of labour hours of producing the 1,600 units = 32,768 hours, that is
1,600 x 20.48.
(b) The incremental labour hours of extending the production run to produce an
additional 1,600 units is 52,428.8 – 32,768 = 19,660 hours.
(c) The incremental hours of extending the production from 1,600 units to 2,000
units cannot be determined with tabular approach since 2,000 units does not
amount to doubling 1,600 units, hence the algebraic approach will be used.

Y = axb log of 80
log of 2

= 50 x

- 0.3219
= 50 [20]
= 19.06 hours

Therefore, total hours for producing 2000 units will be 2,000 x 19.06 hours = 38,120
hours.

To determine the incremental hours of producing 2,000 units

Cumulative Hours of producing 2,000 units (2,000 x 19.06) 38,120
Cumulative Hours of producing 1,600 units (1,600 x 20.48) 32,768
Incremental Hours of producing 400 units 5,352

ILLUSTRATION 11 – 2

The average cost of producing the first batch of 2000 litres of flavoured milk by a
certain diary company is N20 per litre. From past experience, the company’s operating
cost decreases by 25% each time the output is doubled.

Required:
Use the data given above to demonstrate your understanding of the theory by finding
the learning curve ratio and the average cost of producing 64,000 litres of the product.

SUGGESTED SOLUTION 11 – 2

If the company’s operating cost reduces by 25% each time the output is doubled, it
implies that the learning curve ratio of the company is 75%.

220
Determination of the average cost of producing 64,000 litres.
Litres Cum. Litres Cost (N) Cum.Cost Average Workings
Cost
2,000 2,000 40,000 40,000 20 -
2,000 4,000 20,000 60,000 15 20 x 0.75
4,000 8,000 30,000 90,000 11.25 15 x 0.75
8,000 16,000 45,040 135,040 8.44 11.25 x 0.75
16,000 32,000 67,520 202,560 6.33 8.4 x 0.75
32,000 64,000 101,446 304,000 4.75 6.3 x 0.75

From the table, the average cost of producing 64,000 litres of the product is N4.75.

Alternatively this can be determined through the algebraic method thus:

log of .75
log of 2

Y = axb 64,000
= 20 1,000

- 0.4150
= 20 (32)
= 20 x 0.2373
= N4.75

ILLUSTRATION 11 – 3

You have been asked about the application of the learning curve as a management
accounting techniques.
Using the data given below:
Director labour needed to make the fist machine hours 1,000
Learning curve 80%
Direct Labour Cost N3 per hour
Direct Material cost N1,800 per machine
Fixed Cost for either size order N8,000

You are required to:

(a) Define the term learning curve;
(b) Explain the theory of learning curve;
(c) Indicate the areas where learning curves may assist in management accounting.
(d) Illustrate the use of learning curves for calculating the expected average until
cost of making:
(i) 4 Machines; and
(ii) 8 Machines.
SUGGESTED SOLUTION 11 – 3

221
Answer to (a), (b) and (c) can be taken from the text, while (d) will be solved as
follows:
Calculation of Average time of direct labour using algebraic approach
(i) Average Time at cumulative output of 4 machines
(ii) Average Time at cumulative output of 8 machines.

Cost per unit of making 4 machines will be

N
Material 1,800
Direct Labour cost (640 x N3) 1,920
Fixed Cost (N8,000/4) 2,000
5,720

Expected Average Unit Cost of making 8 machines

N
Material 1,800
Direct Labour Cost (512 x N3) 1,536
Fixed Cost (N8,000/8) 1,000
4,336

3.1.4 Advantages of Learning Curve Theory

(1) It is very useful in planning personnel numbers as well as other related cost.
(2) It is useful in estimating cost of future production.
(3) It can be used in deciding wage incentive plans.
(4) It is an effective basis of exercising cost control.
(5) It is an effective means of setting labour standard time.

3.1.5 Limitations of Learning Curve Theory

The learning curve theory suffers from some setbacks which can be listed as follows;
(1) It is only applicable to labour intensive operations.
(2) It is also only inapplicable to situation where continuous
increase in production does not occur.
(3) It assumes that there would be stable condition at work whereas
there could be high labour turnover.
(4) There may be insufficient data, hence there may be difficulty
in knowing what the learning curve is.
(5) It may be difficult to highlight cost reduction due to the effect
of learning curve in a situation where a new machinery-and improved
techniques are introduced leading to increase output and reduced cost.

3.2 INVENTORY CONTROL TECHNIQUES

In most manufacturing companies, inventories or materials carry a large proportion of

the investments, hence the need for proper control in order to ensure that losses due to

222
wastage, theft, production stoppages, idleness of employees, absenteeism, goodwill,
sales reduction etc. are brought to the barest minimum.

However, for one to appreciate the importance or significance attached to the element
of inventory or material, a proper classification need be made as follows:
(a) Raw materials- which are to be used in manufacturing a good or
product, for example. limestone, used for making cement; wheat used for
making beer and bread: cassava used for making "apu" or "lulu", even though
they might have gone through some forms of processing.
(b) Work-in-progress, which are used to maintain continuity within the
production cycle;
(c) Finished goods which are used to satisfy customers demand and
sustain goodwill;
(d) Consumable supplies which are items used proportionately to the
quantity or volume of a manufactured product, but which because of their small
value are identified for costing purposes with the cost centres where they are
used rather than with the cost units to which they relate, for example, nuts,
bolts, screws, nails, stationeries, lubricants, petrol etc.

3.2.1 Objectives of Inventory Control

The main objectives of stock control are:

(a) To maintain adequate stocks and thus minimise the risk of
shortages which could disrupt production or cause customer dissatisfaction.
(b) To avoid excessive stock level and consequent tying up of capital.
(c) To relieve management of taking frequent procurement
decisions for each item maintained in the store.

3.2.2 Factors Considered for Effective Stock Control

From the cost point of view, the essentials of materials control before the normal usage
in the production process are as below:
(a) Materials of the adequate quality and size should be bought
only when needed and properly authorised.
(b) In choosing the supplier(s) for the materials, proper care need
be taken in terms of quality, price and other terms of delivery.
(c) There should be adequate receipt and inspection of materials.
(d) The basis for pricing materials for production of goods.
(e) There should be adequate storage facilities and the consistent
checking of stock levels.
(f) Cost centre should be appropriately charged with the indirect materials
consumed by them.
(g) Stock taking should be well organised to ensure availability of stock quantities
when needed.
(h) The documentation, accounting procedures and controls at each stage must be
designed and efficient.

223
3.2.3 Purposes for Holding Inventory

There are three reasons or purposes for holding inventory.

(a) Transactionary Motive: The purpose is to meet demand for the stock item,
where the size of demand is known with certainty or replenishment of stock is
immediate when stock-out occurs.
(b) Precautionary Motive: Where either (or both) the demand for the stock item
or the re-supply or re-order is uncertain because it varies between one occasion
and the next, there will be need to avoid customer dissatisfaction and lost sales.
Therefore, safety stocks may be held to reduce the likelihood that the company
may run out of supply.
(c) Speculative Motive: A decision may be taken to increase
current stocks in anticipation of a price rise, so as to make a speculative profit.
The major control issue for speculative profit stock holding is administrative;
there is a clear need to ensure that limits to a firm's financial risks in speculative
stock holding are established and observed.

3.2.4 Factors Influencing Stock Holding Decisions

The factors influencing stock holding decisions are:

(a) Amount of cash available,
(b) The storage space available;
(c) The storage costs (insurance, interest on capital etc.);
(d) Delivery delays;
(e) Risk of stock losses (wastage, obsolescence etc.);
(f) Minimum ordering quantities imposed by the supplier;
(g) Purchase ordering costs (clerical, transportation etc.);
(h) Required service level to workers or customer.

3.2.5 Stocks or Inventory Control Systems

The following are the stocks control system and each will be discussed in turn:
(a) Periodic Review System;
(b) Re-order Level System;
(c) Perpetual Inventory/Continuous Stock Taking;
(d) ABC Principles or Selective Approach; and
(e) Economic Order Quantity (EOQ).

3.2.6 Periodic Review System

Under this system, purchase orders are placed at fixed intervals of time and the
quantity to be ordered on any occasion will be decided by reviewing the trend of
demand for or usage of the item concerned. This should help avoid over- ordering, but
if there should be an unexpected increase in demand, the stock of an item may be
exhausted before the next regular ordering state.

224
It may be necessary, therefore, to hold a safety stock or margin to cover possible
fluctuations in demand.

3.2.7 Stock Levels Control (Re-order Level) System

This system involves deciding a level of stock holding at which new purchase orders
should be placed. If stock falls to the re-order level, an order will be placed for fixed
quantity of the stock. However, the reorder quantity must have been decided having
regard to the normal delivery period, the rate of usage of stock, variations in delivery
time and the minimum level of stock.
To provide a safety margin against unforeseen situations, a minimum level of stock
holding will be fixed. If at any time stock falls below the said level, the storekeeper
will consider the need for special emergency order. This is the stock allowance to
cover errors in forecasting the lead time or demand during the lead time and it is set so
that management are warned when usage is above average and buffer stock is being
used.
The re-order quantity is the replenishment ordered frequently but not always the COQ.
This is to ensure that when goods are received, the stock holding will be restored to an
amount sufficient to last for a reasonable period ahead. The re-order quantity is set by
giving consideration to the rate of consumption, cost of holding stock against cost of
buying; bulk discounts; obsolescence and deterioration risks and transportation cost.
The upper figure in the diagram below is referred to as the maximum level. This is
used as an indicator to management to show when stocks have risen too high. This is
set so that management will be warned when demand is the minimum anticipated and
consequently stock may rise above maximum intended. This level is set after giving
effect to: rate of consumption; risk of obsolescence; cost of storing above normal
stocks; storage space availability: the re-order quantity; and the time necessary to
obtain the delivery of the materials.

The diagram below illustrates the above items.

Q
Instantaneous Replenishment

Maximum Stock Level

Average Stock Level (Q2)

Stock Level Time

O

Figure 11.2: Stock Control Levels

225
ILLUSTRATION 11-4

The data given below is to be used for calculating the following stock control levels.
(a) Re-order level
(b) Minimum level
(c) Maximum level and
(d) Average level
Average usage 50 units per day
Maximum usage 70 units per day
Minimum usage 30 units per day
Re-order period 11-13 days
EOQ 1000 units

SUGGESTED SOLUTION 11 – 14

Reorder Level = Maximum Usage x Maximum Reorder Period

= 70 x 13
= 910 units

Minimum Level = Re-order level - Average usage x Average reorder Period

= 910 - (50 x 12)
= 910 - 600
= 310 units

Maximum Level = Re-order Level + EOQ – (Minimum usage x Minimum reorder

period)

= 910 + 1000 – (30 x 11)

= 1,580 units

Average Level = Maximum Level + Minimum Level

2
= 1.580 + 310
2 = 945 units

ILLUSTRATION 11 – 5

(a) Calculate three control levels for a stock control system having the following
characteristics:
Average Usage 3000 units per week
Minimum Usage 220 units per week
Maximum Usage 4200 units per week
Reorder Period 10 – 14 weeks
EOQ – 35,000 units

SUGGESTED SOLUTION 11 – 5

226
Reorder Level = Maximum Usage x Maximum Reorder Period
= 4200 x 14
= 58.800 units

Maximum Level = Reorder Level + EOQ – (Minimum Usage Minimum Usage)

= 58,800 + 35,000 = (2.200 x 10)
= 93,800 - 22,000
71,800 units

Minimum Level = Reorder Level – Average Usage x Average Reorder

Period.
= 58,800 – (3,000 x 12)
= 58,800 – 36,000
= 22,800 units

3.2.8 Perpetual Inventory System/Continuous Stock Taking

The perpetual inventory system refers to a situation whereby after each issue or receipt
the physical balance is calculated. The total of the balanced represents the stock on
hand, thus making for the avoidance or wholesale periodic stock taking. However, the
continuous stock taking system may be adopted, and it is that which allows for the
comparison or checking of the actual stock against what is maintained in the stock
records on a continuous basis. The system is operated by checking a few items each
day so that all items are checked two or three times a year, thus rendering the annual
stock process a worthless assignment.

The procedures, however, are as follows:

(a) A small group of employees is assigned the job of stock check on a permanent
basis. Sometimes, cost department staff may be utilized for control purposes.
(b) Items are checked on a daily basis to ensure:
(i) Complete or full check of all items
(ii) Emphasis is laid on fast moving
(c) The balances on the store ledger card is not to be revealed to any staff
authorized to check physical stock in the stores.
(d) All the end of each stock account period, the staff given the task of counting
should report the physical units to the office who assigned the job.

ILLUSTRATION 11-6

(a) Daily Consumption = 130 – 180 units

(b) Lead Time = 16 – 20 days
(c) EOQ – 4,800 units
Holding cost per unit N
Required:

227
(a) Find the average stock level
(b) What is the total cost of the base stock per annum?
(c) Would your answer to (b) above differ, if the normal daily consumption is 160
units?

SUGGESTED SOLUTION 11 – 6

The average stock level cannot be ascertained except the following stock level are
known: re-order level; maximum stock level; and minimum stock level. Hence, we
calculate the above first, even though the question was silent on them.

Reorder Level = Maximum Usage x Maximum Lead Time

= 180 x 20
= 3600 units

Maximum Stock Level = ROL + EOQ – (Minimum Usage x Minimum Lead Time)
= 3600 + 4800 – (130 x 16)
= 8400 – 2080 = 6320 units

Minimum Stock Level = ROL – (Average Usage x Average Lead Time)

= 3600 – (155 x 18)
= 3600 – 2790 = 810 units

Average Stock Level = 6320 + 810 = 3565 units

2
(b) Cost of holding base stock = Qh
Q = Base Stock = 810
H = Annual Holding Cost/Unit = 10
Base Stock annual holding cost = N10 x 810 = N8100

(c) If the normal consumption is 160 units

Minimum Stock Level – ROL – (Normal Usage x Normal Lead Time)
= 3600 – (160 x 18)
= 3600 – 2880 = 720 units
Therefore, total cost of base stock = N720 x N10 = N72000
Hence, the difference in cost = N(8100 – 7200) = N900

Any difference(s) between the recorded figure and physical stock count is/are
immediately investigated. The typical causes of discrepancies between actual stocks
and recorded stocks are the following:
(a) errors caused by incorrect recording and calculations, for example, using the
wrong stock price.
(b) incorrect coding causing the wrong stock to be issued and wrong card to be
altered.
(c) under or over issues not noted
(d) parts and materials returned to stores not documented

228
(e) shrinkages, pilferage, evaporation, wastages etc.
(f) Loss of non usage of goods received notes, materials requisition notes and other
essential documentations.

The following are the advantages of the perpetual inventory/continuous stock taking
exercise:
(a) production or sales stoppages are easily tracked.
(b) likely errors are reduced by the usage of skilled staff.
(c) the process of investigation is accelerated
(d) staff morale is increased and standard raised
(e) discrepancies and losses are revealed sooner than they would be, if stock taking
were limited to an annual check.

3.2.9 ABC Principle or Selective Approach

Under this system, control of stock is maintained by classifying materials or items into
expensive, inexpensive or a middle cost range because of the advantages of
simplifying stores procedures without incurring unnecessarily high cost. The
segregation of materials for selective stores control purposes may be done having the
following in mind:
(a) expensive and medium cost materials are subject to careful stores control
procedures to reduce costs, that is, items or high values even though few in
number are given priority to avoid a high loss.
(b) inexpensive materials can be stored in large quantities with a slow turnover
period because the cost savings from careful stores control do not justify the
administrative effort needed to carry out the controls. Large quantities of these
items may be stored without increasing stores costs by any appreciable amount.

The selective method to stores control is at times referred to as the ABC method
whereby materials are classified into A, B and C groups according to their values to
the organization and it is better explained by the table and diagram below.

TABLE 11.1
Group Unit of Quantities % Values %
N
A 10 10 7,000 70
B 30 30 2,600 25
C 60 60 500 5
100 10,000
100

Cost (N) 95
7
70
0

Figure 11.3 ABC Control Graph

10 30 1 100 3 229 1
0 0 0
0
3.2.10 Economic Order Quantity

Inventory Costs

Inventory Control can be defined as the system used in a firm to control the firm’s
capital outlay on stock. Thus, typically, it involves the recording and monitoring of
stock levels, forecasting future demands and deciding when and how many units to
order.

However, the main purpose is to minimize, in total, the cost associated with stock,
which are hereby categorized into three groups viz:
(a) Carrying Cost
(b) Ordering Cost
(c) Stock-out Cost

(a) Carrying Cost: These are the cost of holding stock in the store and it may be
calculated as a percentage of purchase price of an item or materials. The
examples are:
(i) interest on capital invested in stock;
(ii) storage charges (rent, lighting etc.);
(iii) Stores staffing, equipment maintenance and running cost;
(iv) material handling costs;
(v) audit, stock taking, stock recording costs;
(vi) insurance;
(vii) deterioration and obsolescence;
(viii) pilferage, evaporation, etc.

(b) Ordering Cost: These are basically the costs of obtaining stocks and examples
are :
(i) transport costs
(ii) set up and tooling costs
(iii) clerical costs

(c) Stock-out Cost: These are costs of running out of stocks and examples are:
(i) lost contribution or profit through lost sales.
(ii) loss of future sales because of lack of patronage by customers
(iii) cost of production stoppages caused by lack of work in progress and raw
materials
(iv) extra costs associated with urgent, often small quantity, replenishment
orders.

3.2.11 Assumptions Underlying the Operation of the EOQ Model

The following are the assumptions underlying the operations of the EOQ model viz:
(a) there is a known constant holding or carrying stock.

230
(b) there is a known constant stock ordering cost.
(c) there is a known constant price per unit
(d) the rates of demand are known
(e) the replenishment of stock is made instantaneously.

It should be noted that all the assumptions mentioned may not be present in all
situations. In most cases, EOQ focuses on the holding and ordering costs. Therefore
from the foregoing, the EOQ can be explained to be a calculated re-order quantity
which minimizes the balances of costs between carrying costs and ordering costs.

The cost of holding stock could be reduced to some extent if the average quantity of
stock held could be reduced and this could be made possible by reducing the reorder
quantity but the implication is frequent orders being placed.

3.2.12 Simple EOQ Model

The EOQ model can be determined by either of the two methods as shown below
when there are no discounts:

(a) simple graphical method

(b) by formula (Algebraic method and Calculus)

(a) Graphic Method: The procedures to be followed if the graphical method is to

be used are the following:
(i) Put up a graph showing on Y-axis the total annual cost of buying and
holding stocks, and on the X-axis the selected range of possible order
quantities.
(ii) Select a number of order quantities and determine for each of the
following:
 The annual cost of buying which is determined by multiplying the
cost per ordering (Co) by the number of orders that would be
placed in a period (that is, the total annual quantity divided by
quantity ordered at each buying D/Q),
 The annual cost of carrying stock which is determined by
multiplying the annual cost of carrying one unit of stock by the
average number of units held in stock (that is, dividing the
opening stock and closing stock by 2). Thus, the annual carrying
cost: is ½ Q x Cc.
 The total annual cost of ordering and carrying cost is determined
by adding costs (a) and (b) above together.

(iii) Plot on a graph the total annual cost of ordering and holding or carrying
stock against each selected order quantity and consequently rule a
smooth curve through the identified points.

231
(iv) Determine the point at which the curve or line is at its minimum level
and this is the point where it is advantageous to place an economic order
since costs are at the minimum point.

The stated steps are depicted in Figure 11.4 as above.

(b) Formula method (Algebraic and Calculus Methods):

(i) Algebraic Method: For the EOQ to be determined, both ordering cost
and the carrying cost must be at their minimum levels, thus,
mathematically, the formula given will have to be equated to each other,
that is:
DC0 = OCc
Q 2

By cross multiplication
2DCo = Q2Cc
Q2 = 2DCo
Cc

EOQ =

Where:
Q = Economic Order quantity
Cc = Carrying Cost per item per annum
Co = Ordering cost per order
D = annual demand per annum

(ii) Calculus:
The Total Relevant Cost = Total Ordering Cost +
Total Carrying Cost

DC0 + QCc
Q 2
Differentiate total relevant cost with respect to Q
DTRC = – DCQ –2 + Cc
dQ 2
At the turning point = dTRC = 0
dQ
DCo = Cc
Q2 2

Q=

232
The above formula was based on the fact that stock can be replenished on a constant
basis.

The following illustrates the EOQ model for stock control purposes:

ILLUSTRATION 11-7

ALAYAKI Enterprises has an annual demand of 1000 units per month, the ordering
cost N350 per order, the units cost N8 each and it is estimated that carrying costs are
15% per annum of the purchase price. You are required to find the Economic Order
Quantity.

SUGGESTED SOLUTION 11-7

By formula EOQ =

Where:
D = 1000 x 12 = 12,000 units
Co = N350.00
Cc = N8 x 15% = N1.2

EOQ =

= 2,645 units

3.2.13 EOQ with Discounts

One of the major assumptions of the simple EOQ model is that the price is fixed and
known with certainty. However, in a real-life situation, it is possible for the price to
vary. This occurs when there are discounts resulting from bulk purchases. Whenever
there is a discount, the simple EOQ formula will break down. The illustration below is
used to determine EOQ whenever there is purchase discount.

ILLUSTRATION 11-8

A retailer has an annual demand for a certain non-perishable commodity of 1000 units.
He buys from a wholesaler at a cost of N5 per unit and the cost of ordering and
receiving delivery of a replenishment order is N25 each time. His stock holding cost
are 25% of the average stock value per year.

233
Required:
(a) How many units should the retailer order per occasion and how often should he
order this quantity to minimize the total relevant cost?
(b) What is the total stock cost?
(c) Suppose the wholesaler offer 5% discount on the purchase price per unit on
orders between 300 and 1999. 10% discounts on orders of 2000 or more.
Determine whether the retailer should take advantage of either of the discount
offered.

SUGGESTED 11 – 8

(a) (i) Q =
= 200 units
(ii) No. of Orders = D = 1,000
Q 200 = 5 times

(b) Total Stock Cost = Total Carrying Cost + Total Ordering Cost +
Total Purchase Cost

QCc + DCc + DX Purchase

= 2 Q
= 200 x 1.25 + 1,000 x 25 + 1,000 x 5
2 200
= 125 + 125 + 5,000
= N5,250.

(c) With discount of 5%

Q = = = 205 units = Not feasible

with discount of 10%

Q = = = 211 units = Not feasible

Recommendation:
He should not take advantage of the offer because the EOQ is below the given
range. If the does, he will incur higher carrying cost.

3.2.14 EOQ with Gradual Replenishment

234
EOQ (with gradual replenishment) =

Where R = Replenishment rate per annum

This can be illustrated with the example below:

ILLUSTRATION 11 – 9

A company uses 50,000 rings per annum which are N10 each to purchase. The
ordering and handling costs are N150 per order and carrying costs are 15% per annum.
However, on purchasing its own machinery: the company now has the capacity to
produce 250,000 rings per annum. You are required to calculate the EOQ (assuming
that there is now a gradual replenishment of stock).

SUGGESTED SOLUTION 11 – 9

= = = 3,535 rings

3.2.15 Limitations of the EOQ Model

According to Harper (1982), the EOQ model suffers from the following set-backs
(a) The fact that in practice, the total annual cost curve is relatively flat in the
vicinity of the EOQ, means that quite significant divergences from the quantity
will result in only minor cost increases. The EOQ, then is by no means a critical
figure.
(b) the actual optimum order quantity is in fact, often much more crucially
dependent on the storage space and facilities available, work load of purchase
office, economics of delivery and overall convenience of all involved in the
purchase such that, it is only a potential savings of a few naira.
(c) the cost of purchasing and holding stocks is often difficult to quantify with any
accuracy. Consequently, even when the EOQ has been calculated, there is little
certainty that the result is particularly accurate.
(d) charging prices or usage rates in theory requires recomputation of the EOQ,
with the consequential need to alter all the relevant records in the purchase
office and stores office. If interest rates change, then the order quantities and
records of all materials bought and stocked will need to be changed.
235
3.3 PRODUCT MIX WITH MULTIPLE CONSTRAINTS (LINEAR
PROGRAMMING)

3.3.1 Definition

The technique used in the allocation of resources where more than one key factor or
constraint is involved is referred to as LINEAR PROGRAMMING. It is a method of
solving equations and can be programmed for computer so that difficult and multi-
constraint problems will show how scarce resources in a firm can best be utilized. It is
a procedure to optimize the value of some objectives, for example, maximize profits or
minimize costs when the factors involved (for example, labour or machine hours) are
subject to some constraints.

3.3.2 Assumptions of LP

The basic assumptions underlying the operation of the technique are:

(a) Certainty: It is believed that all relevant information relating to a problem
situation are known, for example, the resources available.
(b) Linearity: It is believed that there is a proportional relationship between the
resources utilized and the contribution or the cost incurred.
(c) Non-Negativity: There is no negative output that will be produced, that is, at
worst we achieve zero level of production.
(d) Single-Objective: There is an assumption of only one economic objective, that
is maximization of profit or minimization of costs.
(e) Divisibility: It is generally believed that fractional output could be produced,
that is, all the variables are assumed to be completely divisible.

3.3.3 Uses of Linear Programming

The specific uses of the Linear Programme technique are:

(a) It can be used in determining the optimal product mix
(b) It is an effective method of solving capital rationing problems
(c) It can be used to plan the production activities effectively
(d) It is an effective aid to financial modeling
(e) It can assist in solving transportation and assignment problems

3.3.4 Methods of Linear Programming

Three main methods of solving linear programming problem are:

(a) Graphical solution method.
(b) Algebraic or Simultaneous Solution method.
(c) Simplex Solution method.

236
(a) Graphical Solution Method: It is simple but is very limiting in nature where
the variables are more than 2 unless 3 dimensional graph will help to determine
the optimal solution as in illustrations 15 and 16 below.

(b) Algebraic or Simultaneous Solution method: It will handle more than 2

variables and explore all the values and bring out an optimal value for
satisfying the objective function (see illustration 17 below).

(c) Simplex Solution Method: It is an algorithmic method in the sense that certain
steps will be given and followed to the end till the optimal solution is arrived at
(see illustrations 18 and 19 for details of procedures to be followed).

3.3.5 Formulating a Linear Programming Problem

In order to formulate a Linear programming problem, the following are the steps
involved:
(i) Determine the objective function
(ii) Formulate the constraint
(iii) Formulate the non-negativity constraint

ILLUSTRATION 11-10

The Okiki Farm Ltd. Manufacturers two models of garden cutters:

“Opeke” and the “Opaka” in a two stage process involving casting and machining.
When preparing the 2003 budget, it was found that the following weekly limitations on
capacity existed;
Foundry hours available 480
Machining hours available 600

Each “Opaka” takes two hours in the machine shop whereas an “Opeke” takes three
hours in each. In addition, the material required for the “Opeke” was in short supply
and only sufficient materials for 140 units per week could be guaranteed for the year.

If the profit contribution from “Opeke” is N8 and the “Opaka” is N6, formulate the
optimum production schedule and the weekly contribution using the linear
programming model.

SUGGESTED SOLUTION 11-10

OPEKE OPAKA
Foundry hours N3 N2 480
Machine hours N3 N4 600
Direct material N1 N- 140
Contribution N8 N6

Formulation: Let B represents Opeke and R represents Opaka

Maximum weekly contribution: 8B + 6R

237
Subject to the following constraints:
3B + 2R ≤ 480 - Foundry hours
3B + 4R ≤ 600 - Machine hours
B ≤ 140 - Direct material
B, R ≥ 0 - Non negativity

ILLUSTRATION 11-11

A manufacturer wishes to produce 100 tons of a product containing at least 50% factor
of A and 30% factor of B. He can use two ingredients, X costing N20 per ton, which
will yield 60% of A and 20% of B and Y costing N40 per ton which will yield 40% of
A and 50% of B.

Required:
Formulate the programme for the expected mix of X and Y that is needed to yield the
minimum material cost of production and state what the objective function should be.

SUGGESTED SOLUTION 11-11

Let X represent tons of ingredients X and Y tons of ingredient Y.

Objective function: Minimize 20X + 40Y
Subject to: 0.6X + 0.4Y ≥ 50 factor A constraint
0.2X + 0.5Y ≥ 30 factor B constraint
X + Y ≥ 100 production constraint
X, Y ≥ 0 non negativity constraint

ILLUSTRATION 11-12

Abiola Farms uses two crop yielding ingredients (Vim and Moom) on its farms in
order to enhance its production capacity.

The local agricultural centre has advised Abiola Farm to spend at least 4,800kg of a
special nitrogen fertilizer ingredient and at least 5,000kg of a special phosphate
fertilizer ingredient in order to increase his crops. Neither ingredient is available in
pure form.

A dealer has offered 100kg bags of Vim at N1 each. Vim contains the equivalent of
20kg of nitrogen and 80kg of phosphate. Moom is available is 100kg bags at N3 each,
it contains the equivalent of 75kg of nitrogen and 25kg of phosphate.

Required:

238
Express the relationships as inequalities. How many bags of Vim and Moom should
Abiola Farms buy in order to obtain the required fertilizer at minimum cost? Solve
graphically

SUGGESTED SOLUTION 11-12

Let Vim be represented by V and Moom represented by M
Objective function: Minimize Cost V + 3M
Subject to: 20V + 75M ≥ 4800 ……….(1)
80V + 25M ≥ 5000 ……….(2)
V, M ≥ 0
V M
In equation 1: 20V + 75M = 4800 0 64
240 0
In equation 2: 80V + 25M = 5000 0 200
62.5 0

The graph is now plotted as below:

V
280 A 20V +275M =A4,800
240 8
200 0
160 2
120 4
80 0 FEASIBLE REGION 80V + 25M = 5,000
B B
2
C
0 40 60 80 100 120 140 180 200 M
20

Points V Figure 11.5:

0MLP graph V + 3M
A 240 0 240 + 3(0) = 240
1
B 46.36 51.64 46.36 + 3(51.64) = 201.28
C 0 6200 0 + 3(200) = 600
0
The objective point is Point B where we have the lowest cost of N201.28 when the
1 of Vim and Moom.
firm will have to buy 46.36kg
2

3.3.6 0 Price
Shadow
8
It can be defined as the amount by which the profit of a company will increase if an
additional unit of a scarce 0resource is made available i.e. it is the maximum amount
which a company is prepared to pay for the use of an additional unit of a constraint.
Generally, only binding constraints have shadow price, the shadow price of the
feasible region and the resources are fully utilized at that optimal level.

239
3.3.7 Usefulness of Shadow Price

(1) It is the extra profit that may be earned for having an additional unit of a
constraint.
(2) It can be used to determine the maximum amount which a company is willing
to pay for scarce resource.
(3) It will generally indicate the effect of unit change of the constraints, that is, it
provides a measure of the sensitivity of the resources.

11.3.8 Simplex Method

This involves algorithms and the following procedures or steps are to be taken in order
to formulate the tableau for the purpose of determining the optimal solution:

(a) Formulate the objective function.

(b) Formulate the non-negativity constraints
(c) Formulate the constraints
(d) Get rid of inequality signs in constraints by introduction of slack variables
(e) Set up the initial simplex tableau.
(f) Locate the pivot column in the tableau set up in the initial simplex tableau.
(g) The pivot column is one that house the lease element on the objective function
row if you are maximizing and the maximum value on the objectives function
row if you are minimizing.
(h) Locate the pivot row by dividing each position element of the pivot column into
the corresponding constant value of the last column. Select the row with the
least quotient. This is the pivot row. The element in the pivot row and the pivot
column is the pivot element.
(i) The pivot element is then turned to unity by dividing through all the elements in
the pivot column by the pivot element.
(j) Using a procedure to obtain zeros in the pivot column other than the pivot
element, by adding suitable products of the pivot row to the remaining ones i.e.
we use pivot row to eliminate all other rows.
(k) If a negative number remains in the objective function row, go to step (f) and
start all over if we are maximizing. If none of the element in the objectives
function row is negative, the optimum solution has been found.

On the other hand, if we are minimizing and one of the elements in the objectives
function row is still negative, then we have not arrived at the optimal solution, if all the
elements in the objective function row are zero or positive, then we have arrived at the
solution.

The examples below are used to illustrate the equation of the simplex method of
solving linear programming problems.

240
ILLUSTRATION 11-13

Given the following below information, use the simplex method in arriving at the
optimal solution:
Maximize P: 8x1 + 6x2
4x1 + 2x2 ≤ 60
2x1 + 4x1 ≤ 48
x1, x2 > 0

SUGGESTED SOLUTION 11-13

Introduce the slack variable and the equation becomes:

4x1 + 2x2 + S1 = 60
2x1 + 4x2 + S1 = 48
P = 8x1 + 6x2 + 0S1 + 0S2
Therefore, P – 8x1 – 6x2 – 0S1 – 0S2 = 0

x1 x2 S1 S2 P C
(4) 2 1 0 0 60 T2
T1 2 4 0 1 0 48 NR1 = R1 + 4
-8 -6 0 0 1 0 NR2 = R2 + 0
NR3 = R3 + 0
The pivot column is x1
The pivot row is that with 15 (1st row) that is, (60/4)
The pivot element is 4

x1 x2 S1 S2 P C

1 ½ ¼ 0 0 15 T3
T2 2 4 0 1 0 48 NR2 = R2 – 2R1
-8 -6 0 0 1 0 NR3 = R2 + 8R1

x1 x2 S1 S2 P C
1 ½ ¼ 0 0 115 T4
T3 2 4 0 1 0 18 NR2 = R2 + 3
0 -2 2 0 1 120 NR3 = R3 + 0

Since we still have a negative in the objective function row, we have to go back to step
(f), the pivot column is x and the pivot row is that containing 3.

x1 x2 S1 S2 P C
1 ½ ¼ 0 0 15 T5
T4 0 1 -1/6 1
/3 0 6 NR1 = R1 – ½R2
0 -2 2 0 1 120 NR3 = R3 + 8R1

241
x1 x2 S1 S2 P C
1
1 0 /3 -1/6 0 112
T5 0 1 -1/6 1
/3 0 6
5 2
0 0 /3 /3 1 132

Proof: P = 8x1 + 6x2

x1 = 12
x2 = 6
Therefore, P = 8(12) + 6(6) = 96 + 36 = 132

4.0 CONCLUSIONS

Manufacturing inventory can be conveniently categorized into raw materials, work in

progress, finished goods and consumable stores and they are held for precautionary,
transactionary and speculative reasons with the attendant costs of holding, ordering
and if any stock out.

The various methods for controlling stocks are re-order level, periodic review system
and economic order quantity.

The overall objective of inventory control is to maintain stock at a level, which

minimizes total stock costs.

Linear programming technique is a resource allocation technique which provided a

valuable extension to cost-volume-profit-analysis.

The assumptions thereof are: linearity, single objective function, non-negativity and
divisibility.
Linear programming problem can be solved by using any of the following methods:
graphical, simultaneous equation and simplex method.

The major limitations of Linear Programming techniques are: the assumptions of

linearity, certainty and continuity.

5.0 SUMMARY

The underline logic behind this theory is premised on the fact that human being unlike
machine acquires a lot of skills, experience, exposure, specialisation and dexterity for
performing a repetitive assignment.

6.0 TUTOR MARKED ASSIGNMENT

1. Bogu Plc has recently developed a new product. The nature of Bogu Plc’s work
is repetitive and it is usual for there to be an 80% learning curve effect when a

242
new product is developed. The time taken for the first unit was 22 minutes.
Assuming that an 80% learning effect applies, the time to be taken for the
fourth unit is nearest to
A. 9.91 minutes
B. 9.97 minutes
C. 14.08 minutes
D. 15.45 minutes
E. 17.60 minutes.

Use the below data to answer questions 2 and 3

A domestic appliance retailer with multiple outlets stocks a popular toaster
known as the Autocycle 2000, for which the following information is available
Average sales 75 per day
Maximum sales 95 per day
Minimum sales 50 per day
Lead time 12 – 18 days
Re-order quantity 1,750

2. Based on the above, at what level of stocks would a replenishment order be

issued?
A. 1050
B. 1330
C. 1710
D. 1750
E. 1760

3. Based on the data above, what is the maximum level of stock possible?
A. 1750
B. 2860
C. 3460
D. 5210
E. 5310

4. Tunde Limited mixes four raw materials to produce a plastic. Material W costs
N40 per kg, Material X Costs N112 per kg, Material Y costs N90 per kg, and
quality to the plastic and it is required to use the least cost mix.
The objective function therefore is:
A. N40x1 + 120x2 + 80x3 + 260x4
B. N40x1 + 80x2 + 120x3 + 260x4
C. N40x1 + 260x2 + 120x3 + 50x4
D. N40x1 + 120x2 + 90x3 + 260x4
E. N40x1 + 100x2 + 90x3 + 260x4

243
5. Zulu Plc uses the economic order quantity formular (EOQ) to establish its
optimal re-order quantity for its single raw material, the following data relates
to the stock costs:
Purchase price N15 per item
Carriage costs N50 per order
Ordering costs N5 per order
Storage cost 10% of purchase price plus N0.20 unit per annum.
Annual demand 4000 units
What is the EOQ to the nearest whole unit?
A. 153 units
B. 170 units
C. 485 units
D. 509 units
E. 500 units

6. A mathematical technique concerned with the allocation scarce resources is

called _________________________

7. In the pricing model, the increase in the value of the objective function which
would be achieved if one unit of the resources was available is called
____________________________

8. That linear programming refers to the quantification of an objective and usually

takes the formal maximizing profits or minimizing costs is called
_______________________________

9. When can graphical solution method be used in linear programming?

10. What is a slack variable?

7.0 REFERNCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

244
UNIT 12 WORKING CAPITAL MANAGEMENT

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Definition of working capital
3.2 Working capital requirements
3.3 Over-Trading and Over-Capitalisation
3.4 Working Capital Ratio
3.5 Operating Cycle
3.6 Methods of Financing Current Assets
3.7 Credit Control
3.7.1 Reasons for granting credit
3.8 Factoring
3.8.1 Factoring Features
3.8.2 Functions of Factor
3.8.3 Types of Factoring
3.8.4 Costs and Benefits of factoring
3.9 Stock Management
3.10 Cash / Treasury Management
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

The term working capital refers to the capital available for running the day to day
operations of an organization. It is defined as current assets less current liabilities.

2.0 LEARNING OBJECTIVES

In this unit, the readers will be able to understand:

 The definition of working capital management and its component.
 The need for managing current assets and current liabilities.
 The proper mix of short-term and long-term financing for current assets.
 Factors that affect credit policy.
 The techniques of inventory management.
 The techniques used in cash management.
 The preparation of cash flow statement.

3.0 MAIN CONTENT

245
3.1 DEFINITION OF WORKING CAPITAL

Working capital may be defined as the excess of current assets over current liabilities.
Working Capital is therefore concerned with the availability of fund to run a business.
It also assists in measuring the amount of credit applicable to the running of an
enterprise.

Working capital comprises four balance sheet items which are regarded as the short-
term areas of the balance sheet.
 Stock: This includes raw materials, work in progress and finished goods,
engineering spares, etc.
 Debtors and prepayments: These are amounts owed to the company by its
customers in respect of credit sales
 Cash: These are physical cash balances in the till boxes of the company, cash
balances in the Banks and short-term investments in form of bank deposits,
quoted investments and other cash equivalents that could be turned into cash
within the shortest possible time.
 Creditors and accruals: These represent the amount owed to suppliers of
materials, services, unpaid taxes, unpaid dividends and other accrued expenses.

A company may make profit and still groan under serious debt burden that could
hinder both long and short term performance. In order to prevent the occurrence of
such situation, there is a need to manage working capital effectively in an organisation.

3.2 WORKING CAPITAL REQUIREMENTS

There are no set rules or formulae to determine the working capital requirements of
firms. Several factors, each having a different importance may over time influence
changes in working capital needs of firms. Therefore, an analysis of relevant factors
would be made to determine total investment in working capital.

Factors that influence the working capital requirements are:

(a) Nature of Business
The nature of the business determines the requirements of the working capital.
Some companies require little working capital while others are working capital
intensive, for example, retail businesses and construction firms need to invest
substantially in working capital and lesser amount in fixed assets. In contrast,
parastatals such as NEPA, now PHCN, etc. have a very limited need for
working capital and have to invest abundantly in fixed assets.

(b) Sales and Demand conditions

The availability of fund, type of the products and sales environment will
determine the extent of the working capital requirement. The class of
customers, the price and quality of the product, the location of the business as
well as climate are some of the factors that determine the level of sales
achievable. Some products also have a high degree of seasonal variability, for

246
example, household consumptions. Some products are purely sold in cash
depending upon the demand of the products.

(c) Technology and Manufacturing policy

The production process has a lot of impact on the working capital requirement.
The time-lag of the production from the input of raw materials to finished
goods also affects the requirement, for example, the manufacturing cycle of
products such as detergent powder, soaps, chocolates etc. may be produced
within a day, and the sales proceeds could be realised within shortest time.

(d) Credit Policy

The credit policy of the firm is influenced by the nature of the business, the type
of the products, the size of the company and its perceived market share. The
credit terms to be granted to customers may depend upon the norms of the
industry to which the firm belongs, for example, pharmaceutical companies
deal mainly in cash while hoteliers may give, say, two weeks to a month for
corporate guests to settle their bills. Companies have to be flexible in
determining their credit policy.

(e) Credit Granted by Suppliers

The working capital requirements of a company are also affected by credit
terms allowed by its suppliers. A company will need less working capital if
liberal credit terms are available to it. The availability of credit from banks also
influences the working capital requirements, for instance, a company that
enjoys less credit period than it gives its customers would have high incidence
of working capital requirements and the need for short-terms funds may
become necessary. A firm, which can get bank credit easily on favourable
conditions, will operate with less working capital than firms without such a
facility.

(f) Price Level Changes

Price is relevant to purchases of material, printing of finished goods and
eventual sales. The increasing shifts in price level make functions of financial
managers difficult. He should anticipate the effects of price level changes on
working capital requirements of the firm. Generally, rising price levels will
require a firm to maintain higher amount of working capital. Same levels of
current assets will need increased investment when prices are increasing.

3.3 OVER-TRADING AND OVER-CAPITALISATION

A company that is not making optimum use of its resources is either overcapitalised or
under-trading. Over-trading arises when a company tries to conduct a volume of trade
over and above that for which it is financially equipped. This can be extremely
dangerous in the longer-term.

Symptoms of Over-trading include:

247
(a) A poor current ratio and quick ratio caused by:
(i) Excessive creditors or bank overdrafts, and
(ii) High stock levels (the business having unnecessarily acquired heavy
stocks on credit in excess of normal demand levels within an accounting
period.
(b) A high stocks to net current assets ratio.
(c) Bank overdraft consistently at disproportionately high level.
(d) New fixed assets on hire purchase.
(e) Fall in profit margin as a result, for instance, of cash discount given to debtors
in order to reduce the average collection period.

Over-Capitalisation - When a company manages its working capital inefficiently, so

that there are excessive stock, debtors and cash and very few creditors, there will be
an-over-investment by the company in current assets, that is working capital will be
excessive and the company will be overcapitalised. The return on capital employed
(ROCE) would therefore be lower than it should be and long-term funds would be
unnecessarily "tied up" when they could be invested elsewhere to earn profit.

3.4 WORKING CAPITAL RATIO

This measures the relationship among the various sequents of balance sheet, profit and
loss items in order to determine the optimum level of the working capital required to
maximize the shareholders' wealth. This could be done by giving a close monitoring of
the various working capital ratios and the operating cycle.

The ratios which can assist in judging whether investment in working capital is
reasonable to avoid over-trading or over-capitalization are as follows:

(a) Sales/Working Capital

The volume of sales as in multiple of the working capital investment should be
able to indicate whether, in comparison with previous years or with similar
companies, the normal volume of working capital is too high.

(b) Liquidity Ratios

A current ratio in excess of 2:1 or a quick ratio in excess of 1:1 may indicate
over-investment in working capital.

(c) Turnover Periods (Working Capital Cycle)

Excessive turnover periods for stocks and debtors or a low period of credit
taken from suppliers would indicate whether the volume of stocks or debtors is
unnecessarily high or the volume of creditors too low.

The turnover periods may be calculated approximately as follows:

(i) Raw materials stock turnover
= Average raw materials stock x 365 days
Purchases per annum

248
(ii) Work-in-progress (WIP) turnover stock turnover =
Average WIP x 12 months [or 365 days]
Cost of production per annum

Readers should be conscious that cost of sales [or even sales] may be a necessary
alternative to cost of production in an examination question.

(iii) Finished goods stock turnover = Average finished goods stock x 365
Cost of production per annum

(iv) Debtors turnover period = Average debtor x 365

Sales per annum

(v) Creditors turnover period = Average Trade creditors x 365

Purchases of raw materials per annum

Average stock, debtors and creditors should be used but an examination question may
only give the end of year balance sheet figures and these should then be used.

3.5 OPERATING CYCLE

There is a difference between current and fixed assets in terms of their liquidity. A
firm requires many years to recover the initial investment in fixed assets such as plant
and machinery or land and buildings. On the contrary, investment in current assets is
turned over many times in a year. The shorter the length of the turnover period, the
better for the company. Alternatively, the higher the number of times investment in
current assets is turned over, the better. Investment in current assets such as
inventories and debtors, that is, account receivable is realized at least more than once
within an accounting year.

Operating cycle, therefore, is the time duration required to convert sales, after the
conversion of resources into inventories, into cash. The operating cycle of a
manufacturing company involves three phases:
 Acquisition of resources such as raw materials, labour, power and fuel etc.
 Manufacturing of the product which includes conversion of raw materials into
work-in-progress then into finished goods.
 Sales of the product either for cash or on credit. Credit sales create account
receivable for collection.

The operating cycle may be expressed as a period of time, for example:

(a) Raw materials stocks are obtained from suppliers who are paid thereby cash is
paid out.
(b) The trade creditors are paid, therefore, cash is paid out.
(c) Raw materials are held in stock until they are issued for production (work-in-
progress). At this time, additional creditors (for labour and other expenses) may
be incurred.

249
(d) On completion of production, the finished goods are held in stock until sold.
(e) Cash is received eventually when the debtors pay up.
The operating cycle is, therefore, the period between the payment of cash to creditors
(cash out) and the receipt of cash from debtors (cash in).

As the turnover periods for stocks and debtors get longer and as payment period to
creditors becomes shorter:
(i) The operating cycle will be lengthened, and
(ii) The investment in working capital will increase and this could create a serious
liquidity problem for the company.

A good knowledge of the operating cycle would help management in cash budgeting
and also financial planning especially where sales and production are subject to
seasonal variations.

The computation of the length of operating cycle for a firm:

Turnover periods [working capital cycle] — Excessive turnover periods for stocks and
debtors or a low period of credit taken from suppliers would indicate whether the
volume of stocks or debtors is unnecessarily high or the volume of creditors too low.

ILLUSTRATION 12 – 1

The following figures have been extracted from Lamina Company Limited balance
sheet.

CURRENT ASSETS N’000

Stocks – Raw Materials 10,800
Debtors 16,000
Cash 20
26,820
CURRENT LIABILITIES
Creditors 5,040
Net Current Assets (Working Capital) 21,780

Purchases during the year were N52,560,000 while total sales were N84,000,000.

You are required to:

(a) Calculate the following working capital ratios:
(i) Current Ratio
(ii) Quick ratio or acid ratio.

(b) Determine the operating cycle for the working capital

SUGGESTED SOLUTION 12 – 1

LAMINA COMPANY LIMITED

250
(a) i. Sales/Working Capital Ratio = 84,000
21,780
= 3.86:1

ii. Current Ratio = Current Assets

Current Liabilities
= 26,820
5,040
= 5.32:1

iii. Acid Test Ratio/Liquidity Ratio:

= Total Current Assets – Stock
Current Liabilities
= 26,820 – 10,800
5,040
= 3.18:1

(b) Operating Cycle

(i) Raw Material Stock Turnover
= Average Raw Material Stock x 365 days
Purchases per annum 1
= 10,800 x 365
52,560
= 75 days

(ii) Debtors Turnover Period

= Average Debtors x 365
Sales
= 16,000,000 x 365
84,000,000
= 70 days

(iii) Creditors Turnover Period

Average Trade Creditor x 365 = 35 days

Purchases per annum 110 days

Net Operating Cycle = 5,040,000 x 365

52,560,000 1
= 35 days

ILLUSTRATION 12-2

The following data relates to Beula Limited, a manufacturing Company:

251
Turnover for the year N3,000,000
Direct Material 30%
Direct Labour 25%
Variable Overheads 10%
Fixed overheads 15%
Selling and distribution 15%
On average:
(a) Debtors take 2½% months before payment
(b) Raw materials are in stock for 3 months
(c) Work in progress represents 2 month’s half produced goods:
(d) Finished goods represents 1 month’s production;
(e) Credit taken as follows:
(i) Direct materials - 2 months
(ii) Direct labour - 1 week
(iii) Variable O/heads - 1 month
(iv) Fixed overheads - 1 month
(v) Selling and distribution - ½ month
Work-in progress and finished goods are valued at materials, labour and variable
expense cost. Compute the working capital requirement of Beula Limited assuming the
labour force is paid for 50 working weeks.

SUGGESTED SOLUTION 12-2

BEULA LIMITED

(a) The cost incurred will be: N

Direct materials 30% of 3,000,000 = 900,000
Direct labour 25% of 3,000,000 = 750,000
Variable overheads 10% of 3,000,000 = 300,000
Fixed overheads 15% of 3,000,000 = 450,000
Selling and distribution 5% of 3,000,000 = 150,000
(b) Current Assets Raw
materials 3/12 x 900,000 225,000
*Work-in-progress
Materials 2/12 x 900,000 150,000
Labour 1/12 x 375 131,250
Variable overheads 1/12 x 150 125,000 237,500
Finished goods 65% x 1,500 x 1/12 162,500
(material, labour, variable overheads)
Debtors 2 x 1,500 625,000
1,250,000

Less Current Liabilities

Creditors – materials 2/12 x 450,000 = 75,000
” – labour 1/50 x 375,000 = 17,500

252
” – variable o/head 1/12 x 150,000 = 12,500
” – fixed overhead = 18,750
” – selling and distribution
1
/24 x 75,000 = 13,125 116,875
Working capital required 508,125

It has been assumed that all the direct materials are allocated to work-in-progress when
production is commenced. (Materials is 100% complete while labour and variable
overheads are assumed to be 50% complete).

3.6 METHODS OF FINANCING CURRENT ASSETS

There are different ways by which a company may adopt to finance current assets.
Some of which are:
(a) Long-term financing: A more permanent form of long-term finance includes
ordinary share capital, preference share capital, and reserves and profit (retained
earnings). Other forms of long-term finance that are less permanent in nature
are long-term borrowings, loans, finance leases, debentures, etc.

(b) Short-term financing: This is fund obtained by refundable within a year,

usually from the banks or any other financial institutions. Examples are
commercial papers, debt factoring, disposal of investments in stocks, etc.

(c) Spontaneous financing: These are financing arrangements obtained in the

course of ordinary business. Examples are credit granted by the suppliers,
accured expenses, etc. There is no cost for this type of financing.

3.7 CREDIT CONTROL

Credit connotes short term leverage. It refers to a situation whereby a company makes
sales for which cash is now wholly collected immediately. To the seller, credits boost
sales, increases market share and profits. To the buyer, credit facilitates that raw
materials could be bought with relative ease and at minimal cost to the business and
ensures that factory works at a steady rate. The value of credit depends on the length
of time given. The seller creates trade debtors/receivables in its records while the
buyer creates trade creditors in its own financial records. The lengthier the credit
period, the larger the debtors and creditors values and hence, the need for control to
avoid high cost to the business.

3.7.1 Reasons for Granting Credit

The following may be considered as factors for granting credit:

(a) The level of competition among companies in the same industry may force the
company to grant credit to boost sales.
(b) The type of product the company produces would enhance its bargaining
power. For example, a monopolist or oligopolist supplier may refuse to grant

253
credit to customers for example, large telecommunication companies, such as,
MTN, VMOBILE, in Nigeria.
(c) Relationship with customers – A long built-up relationship and has strong
financial discipline may be granted credit.
(d) Launching New Product – The launch of a new product may force the company
to grant credit in order to penetrate into the market.

ILLUSTRATION 12-3

The following information relates to Tayo Limited:

Current Policy Option 1 Option 2

Expenditure on debt collection
Procedures, per annum N240,000 N300,000 N400,000
Bad debt losses (% of sales) 3% 2% 1%
Average collection period 2 Months 1½ Months 1 month

Current sales are N9.6 million per annum, and the variable cost of sales is 90% of sales
value. The company requires a 15% return on its investments.

SUGGESTED SOLUTION 12-3

Current Policy Option 1 Option 2
N N N
Average debtors 1,600,000 1,200,000 800,000
Cost of average debtors (90%) 1,440,000 1,080,000 720,000
Reduction in work capital
[Note] - 1,360,000 720,000

Savings:
(a) Reduction in losses - 96,000 192,000
Benefits of each option

(b) Interest saving [15% of

reduction in working capital 54,000 108,000
Bad debt losses
[sales value] 1 288,0001, 192,000 96,000

(a) + (b) - 150,000 300,000

Less Extra costs of debt collection - 120,000 320,000
Benefit/(Loss) from option N30,000 N(20,000)

Conclusion: Option 1 is preferable to the current policy, because option 2 is more

costly. The reduction in debtors has been taken as the reduction in the cost of debtors,
although there is an argument that the sales value of debtors should be used instead.

254
Using sales values rather than variable costs the interest savings would be N60,000 for
Option 1 and N120,000 for Option 2, giving net benefits/(losses) of N38,000 for
Option 1 and (N8,000) for Option 2. The conclusion is still the same.

Credit Control: Individual Accounts

Credit control involves the initial investigation of potential credit customers and the
continuing control of outstanding accounts. The main points to note are as follows:
(a) new customers should give two good references, including one from a bank,
before being accepted;
(b) credit rating should be checked through a credit consultants
(c) a new customer’s credit limit should be fixed at a low level and only increased
if the payment record warrants it;
(d) for large value customers, files should be maintained of any available financial
information;
(e) age lists of debts should be produced and reviewed at regular intervals;
(f) the credit limit for existing customers should be periodically reviewed, but
should only be raised at the request of the customer and if his credit standing is
good.
(g) Personal judgment or favouritism should be ignored.

Debt Collection
There are three main areas which need to be considered in connection with the control
of debtors.
(a) paperwork;
(b) debt collection;
(c) credit control.

It is important that sales paperwork should be dealt with promptly and accurately;
(a) invoices should be sent out immediately after delivery;
(b) checks should be carried out to ensure that invoices are accurate
(c) the investigation of queries and complaints and, if appropriate, the issue of
credit notes should be carried out promptly;
(d) if practical, monthly statement should be issued early so that they can be
included in the customers’ monthly settlement of bills.

The use of pre-printed letters to remind customers to pay their accounts is ineffective.
Although it will be more expensive, it is usually better to adopt a more personal
approach. A good method of positive debt collection may include the following stages;
(a) request for payment by telephone;
(b) telegram or letter
(c) personal visit e.g. by sales representative;
(d) withdrawal of credit facilities;
(e) place debt in hands of a debt collection agency;
(f) legal proceedings.

255
Discount Policies
Varying the discount allowed for early payment of debts:
(a) shortens the average collect period
(b) affects the volume of demand [and possibly, therefore, indirectly affects bad
debts losses].

It is necessary to compare the cost of the discount with the benefit of a reduced
investment in debtors. We shall begin with examples where the offer of a discount for
early payment does not affect the volume of demand.

ILLUSTRATION 12-4

An Extension of the payment period allowed to debtors may be introduced in order to

increase sales volume. For example, suppose that Clara Limited currently expects sales
of N100,000 per month. Variable costs of sales are N80,000 per month (all payable in
the month of sale). It is estimated that by extending the credit allowed to debtors from
30 days to 60 days, sales volume would increase by 10%. All customers would be
expected to take advantage of the extended credit. If the cost of capital is 12½% per
annum (or approximately 1% per month), is the extension of the credit period
justifiable in financial terms?

SUGGESTED SOLUTION 12-4

N
Current debtors (1 month) 100,000
Debtors after implementing the proposal (2 months) 240,000
Increase in debtors 140,000
Financing cost (12½% of increase in debtors) 117,500
Contribution p.a. from additional sales
(12 months x 10% of N10,000) 124,000
Not benefit from extension of credit period, per annum N6,500

Advice
Different credit policies are likely to have differing levels of bad debt risk. The higher
the turnover resulting from easier credit terms should be sufficiently profitable to
exceed the cost of:
(a) bad debts; and
(b) the additional investment necessary to achieve the higher sales.

3.8 FACTORING

Credit management requires professional skills because it involves a lot of time and
efforts of a company in collecting their debts from their credit customers. Collection of
debts is a problem on its own, particularly for small scale enterprises. A company can
engage the services of a professional to assist in collection of its debts, this services are
known as factoring. Factoring is a popular mechanism for managing, financing and

256
collecting debts.

Factoring is not yet common in Nigeria business environment but gradually, it is being
introduced. What is in vogue in the country is the use of debt collectors.

Factoring usually involves executing legal agreement which is intended to create legal
relations between the factor and a business concern (the client) selling goods or
providing services to credit customers whereby the factor purchases the client's book
debts and administers the controls of credit extended to customers.

3.8.1 Factoring Features

Factoring differs from other types of short-term credit in the following ways:
(a) It involves 'sale' of book debts.
(b) It is a unique professional service which provides not only financial succour to
the client in time of needs but also could involve the total management of
client's book debts.

3.8.2 Functions of Factor

The functions of the factor would substantially depend on its agreement with the sales
company (the principal) that engages it. Generally, these functions may include:
(a) Assisting the company by providing immediate advance as part of debt
underwritten to ease the cash flow problem.
(b) Maintenance of accounts ledger of debtors.
(c) Recovering of debts.
(d) Protection against default in payment by debtors, having assumed responsibility
for all the book debts
(e) Providing information on prospective buyers.
(f) Assist in managing the client's liquidity.

The agreement between the supplier and the factor specifies the factoring procedure.
Usually, the firm sends the customer's order to the factor for evaluating the customer's
creditworthiness and agrees to buy receivables, the firm dispatches goods to the
customer. The customer will be informed that his account has been sold to the factor,
and he is instructed to make payment directly to the factor. To perform his functions of
credit evaluation and collection for a large number of clients, a factor may maintain a
credit department with specialized staff. Once the factor has purchased a firm's
receivables and if this is on the basis of factoring without recourse, he will have to
provide protection against any bad-debt losses to the firm.

3.8.3 Types of Factoring

Although, in Nigeria, the commonly used methods of managing book

debts are the offering of discounts, credits and appointment of debt
recovery agents, the use of factoring is slowly but gradually gaining acceptance.

257
The following are four popular types of factoring facilities:
(a) Full service non-recourse (old line)
(b) Full service recourse factoring
(c) Bulk/agency factoring
(d) Non-notification factoring

(a) Full Service Non-Recourse

Book debts are purchased by the factor with 100% risk protection. The total
amount of invoices has to be paid to clients in the event of debt becoming bad.
Based on the agreement that subsists between the factor and the company the
factor may also advance cash up to 60 - 70 per cent of the book immediately to
the client. Payments will therefore be domiciled directly to the factor. The
factor on its own part maintains the customers account and sends reports to the
client periodically.

A company may employ this approach if it operates a compact or slim staff

profile; debtors are usually substantial and has limited capability to monitor the
credit management system of the organisation.

(b) Full Service Recourse Factoring

Under this method of factoring, the factor does not take full responsibility of
debts because Ile is not protected against the risk of bad debts.

Most companies practise recourse factoring since it is not easy to obtain credit
information, and the cost of bad debt protection is very high. This type of
factoring is often used as a method of short-term financing, rather than pure
credit management and protection service.

(c) Bulk / Agency Factoring

Under this method, factors provide temporary cash advance against the
expectation of recovering the book debt. The client maintains its sales ledger
and administer the credit either on recourse or without recourse.

(d) Non-Notification Factoring

The customers are not informed about the existence of the factor. The factor
maintains the sales ledgers of the client and pursues the recovery of the debt
with customers without revealing that he has vested interest in it. Clients that
can muster the financial commitment use this method.

3.8.4 Costs and Benefits of Factoring

There are two types of costs involved:

(a) The factoring commission or service fee
This relates to the remuneration for the professional services of evaluation,
ascertainment and collection of the book debts. The service fees would be

258
charged for keeping the books and records and advise on credit rating of
customers, etc.

(b) The interest on advance granted by the factor to the firm.

If factoring is so expensive, why should firms go for it? There are certain
benefits which result from factoring receivables, and they more than offset the
costs of factoring. Factoring has the following benefits:
(i) Factoring provides specialized service in credit management, and thus,
helps the firm's management to concentrate on manufacturing and
marketing,
(ii) Factoring helps the firm to save cost of credit administration due to the
scale of economies and specialization.

ILLUSTRATION 12 – 5

Jimo Ltd. has a total credit sales of N16 million and its average collection period is 80
days. The past experience indicated that bad-debt losses are round 1 per cent of credit
sales. The firm spends about N240,000 per annum on administering its credit sales.
This cost includes salaries of one officer and two clerks who handle credit checking,
collection, etc., telephone and telex charges.

These are avoidable costs. A factor is prepared to buy the firm’s debts. He will charge
2 per cent commission and also pay advance against debts to the firm at an interest rate
of 18 per cent after withholding 10 per cent as reserve.

What should the firm do?

SUGGESTED SOLUTION 12 – 5

Let us first calculate the average level of debts. The average collection period is 80
days and credit sales are N16,000,000; therefore, assuming 360 days in a year.

Average level of debtors = 16,000,000 80

360 x 1 = N3,555,556

The advance which the factor will pay will be the average level of receivables less
factoring commission, reserve and interest on advance. The factoring commission is 2
per cent of average receivables (80 days):
Factoring commission = 0.02 x 3,555,556 = N71,111
and reserve is:
Reserve = 0.10 x 3,555,556 = N355,556

The amount available for advance is:

Advance available 3,555,556 – 71,111 – 355,556 = N3,128,889

However, the factor will also deduct 18 per cent interest before paying the advance for

259
80 days.

Therefore, the amount of advance to be paid by the factor is:

Advance to be paid = 3,128,889 – (0.18 x 3,128,889 x 80 / 360)
= 3,128,889 – 125,156 = N3,003,733

The annual cost of factoring to the company include the following:

Factoring commission 71,111 x 360/80 320,000
Interest charges 125,156 x 360/80 563,202
N883,202

The firm saves the following costs:

Cost of credit administration 240,000
Cost of bad-debt loss, 0.01 x 16,000,000 160,000
400,000

The net cost of factoring to the firm is:

Net cost of factoring = 883,202 – 400,000 = N483,202
The effective rate of interest of firm is:
Effective rate of annual cost = 483,202
3,003,733 = 16 per cent

The effective rate of financing the factory is 15%. Jimo Ltd would have to evaluate
and compare alternative short-term financing options. The decision should be the
option that provides the lower effective rate.

Forms of Bank Finance

A firm can draw funds from its bank within the maximum credit limit sanctioned. It
can draw funds in the following forms:
(a) overdraft
(b) bills purchasing or discounting, and
(c) venture capital loan
(d) direct equity participation
(e) commercial paper.

3.9 STOCK MANAGEMENT

Stock comprises a very large part of a business working capital and therefore, it is very
important to control it effectively.

Amey and Egginton (1973) identified three reasons for holding stocks;
(a) transactional)' motive - that is, to meet demand for the stock item, where the
size of demand is known with certainty or replenishment of stocks is immediate
when stock-out occurs.
(b) precautionary motive - that is, either ( or both) the demand for the stock item, or
the re-supply 'lead' time, is uncertain because it varies between one occasion

260
and the next. To avoid customer dissatisfaction and lost sales, 'buffer stocks' or
safety stocks may be held to reduce the likelihood that the company runs out of
supply.
(c) speculative motive - that is, a decision may be taken to increase current stocks
in anticipation of a price rise, so as to make a speculative profit. The major
control issue for speculative stock holding is administrative: there is a clear
need to ensure that limits to a firm's financial risks in speculative stockholding
are established and observed.

Costs of Holding Stocks

The costs of holding stocks are as follows:
(a) obsolescence: when materials or components become out of date and are no
longer required, existing stocks must be thrown away and written off as a loss
to the profit and loss account;
(b) deterioration: when materials in store deteriorate to the extent that they are
unusable, they must be thrown away (with the likelihood that disposal cats
would be incurred). The value written off stock plus the disposal costs would be
a charge to the profit and loss account;
(c) theft and pilferages;
(d) interest charges: holding stocks involves the tying up of capital (cash) on which
interest charges must be paid;
(e) costs of storage and stores operations: stocks require more storage space and
possibly extra staff and equipment to control and handle them.

The costs of the stock themselves - that is, the supplier's price, or the cost of
production, will also need to be considered.

Management Accountant and Stock Control

The interest of management accountants in stock control is one of cost control. The
volume of stocks held should be kept to an optimum level which minimizes their cost
to the organization.

It is possible to decide what quantities of stocks should be ordered at any one time
(that is, in each 'batch') in order to minimize the costs of having stocks.
(a) The basic stock order decision model known as the Economic Order Quantity
(EOQ) or Economic Batch Quantity (EBQ), indicates the cost-minimising order
size;
(b) The model cannot be used in isolation where there are bulk purchase discounts
for large-sized orders from suppliers, or reductions in unit variable costs for
larger batches when materials are produced that is, supplied internally. The bulk
purchase discount 'model' may, therefore, need to be applied; and
(c) Where demand for an item is variable and uncertain, or supply lead times are
similarly unknown, uncertainty analysis should be applied to determine the
optimum size of safety stocks.

261
The stock order quantity decision models use relevant costs, just as any other decision
requires relevant cost data.

Once the relevant costs have been supplied, most stock ordering decisions can be
programmed to take place automatically without management intervention. Many
companies have computerised stock control systems, part of whose functions is
automatic re-ordering of stock items in optimal order quantities. Management
accountants have the more difficult task of ensuring that the relevant cost data are
complete and sufficiently accurate, so that correct decisions can be made.

3.10 CASH / TREASURY MANAGEMENT

Cash management involves the planning and controlling of cash to ensure that cash is
available when required and that it is used efficiently.

Cash are held by companies for the following reasons:

(a) Transactionary Motive: This is to meet the payments in the ordinary course of
business to creditors, employees, etc.
(b) Precautionary Motive: This is held for unexpected needs during the course of
the business.
(c) Speculative Motive: This is required for immediate unexpected purchase or
other business related expenses.

Cash activities would cover the following area:

(a) Planning and Controlling cash levels - There would be need for continuous
reviews of the organisation's liquidity policy and the working capital position.
(b) In case there is any surplus in cash holding, it may be necessary to consider the
efficient allocation of these surpluses to profitable use.
(c) Ensuring that cash is available to meet all running costs, taxation, payments and
dividends.
(d) There will be need to provide insurance protection to ensure that cash can be
provided in case of emergency as the needs arises.
(e) It is essential that the organisation develop a good understanding and
relationship with their bankers.

4.0 CONCLUSIONS

Working capital is the term used to express the relationship between current assets and
current liabilities. The difference could be either positive or negative, where the
current assets are more than the current liabilities respectively or vice-versa. However,
the gross working capital is the firm's investment in current assets.

The current assets are made up of cash, short-term securities, debtors, bills receivables,
prepayments and stocks (inventory) while the current liabilities include creditors, bills
payable, bank overdraft and accrued expenses.

262
It is considered important that the finance manager maintains an optimum balance or
level of current assets and current liabilities, that is, he should not allow excess or
inadequate working capital.

The Finance Manager would consider the need to invest funds in current assets; the
quantum of investment, the proportion of long-term and short-term funds to finance
current assets and the determination of appropriate sources of funds to be used to
finance current assets.

It is equally important to determine the need for working capital and its determinants;
the dimensions of working capital and determination of the optimum level of current
assets in terms of the estimation and financing of current assets.

5.0 SUMMARY

Some general remarks highlighting the need for effective utilization of working capital
and some possible approaches for the same have been discussed in this unit. But the
ingredients of the theory of working capital management should cover a wide range.

6.0 TUTOR MARKED ASSIGNMENT

1. Wasa Nigeria Limited made sales of N250,000 in the year and had outstanding
debtors balances of N15,000 at the end of the year. Calculate the company’s
debtors collection period.
A 20.90 days
B 21.90 days
C 22.90 days
D 23.90 days
E 19.90 days.

Use the data below to answer questions 12.2 and 12.3

The demand for a commodity is 40,000 per year at a steady rate. It costs N20
to place an order, and 40k to hold a unit for a year.

2. Find the batch size to minimize inventory costs

A 2200 units
B 2000 units
C 2400 units
D 3200 units
E 3100 units.

3. The length of the inventory cycle

A 2.5 weeks
B 2.8 weeks
C 2.6 weeks

263
D 2.7 weeks
E 2.4 weeks.

4. If in Monilabi Limited, it takes 10 days to convert raw materials into work-in-

progress, and it takes another 5 days for work-in-progress to be converted to
finished goods and that the finished goods will stay another 7 days before being
sold on credit and debtors are allowed 8 days of grace. It is also assumed that
all the above scenario will work well. Determine the working capital cycle.
A 31 days
B 32 days
C 29 days
D 30 days
E 34 days.

5. A trade discount is
A reduction in price per unit
B discount for early payment
C special sales promotion
D reduction in overhead cost per unit
E reduction in production cost per unit.

6. State three determinants of working capital

7. State three assumptions underlining EOQ model.

8. What are the symptoms of over-trading?

9. What is credit standard in granting credit to a customer?

10. What is factoring?

7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

264
UNIT 13 CAPITAL INVESTMENT DECISION

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Capital Budgeting Techniques
3.1.1 Payback Period 'Method (PEP)
3.1.2 Accounting Rate of Return Method (ARR)
3.2 Concepts in capital budgeting decisions
3.2.1 Concept of Time Value of Money
3.2.2 Concept of Annuity
3.2.3 Relevant cash flows
3.2.4 Further assumptions
3.3 Discounted Payback Period Method
3.4 Net Present Value Method (NPV)
3.5 Internal Rate of Return Method (IRR)
3.5.1 Modification of IRR
3.5.2 Steps for Calculating Incremental IRR
3.6 Capital Rationing
3.6.1 Single Period Capital Rationing
3.6.2 Profitability Index (PI)
3.6.3 Different Situations of Capital Rationing
3.6.4 Multi-Period Capital Rationing
3.6.5 Limitations of Capital Rationing
3.7 Inflation in Capital Budgeting
3.7.1 Relevant Concepts
3.7.2 Other Considerations
3.8 Taxation in Capital Budgeting
3.9 Lease or Buy Decisions
3.9.1 Qualitative factors affecting Lease or Buy Decision
3.9.2 Assumptions
3.9.3 Choice of Cost of Capital
3.9.4 Nature of Cash Flows
4.0 Conclusions
5.0 Summary
6.0 Tutor Marked Assignments
7.0 References/Further Readings

1.0 INTRODUCTION

Capital budgeting can be explained in the context of a firm's decision to invest its
current funds in long term activities in anticipation of an expected flow of future
benefits over a number of years. However, the investment decisions could be in the
form of acquisition of additional fixed assets, replacements and modifications of

265
activities or expansion of a plant. Therefore, the financial manager should give due
consideration to the following factors when capital budgeting decisions are involved:
(a) Availability of investment capital and its alternative uses.
(b) The huge expenditures or large cash outlay.
(c) The gestation period between initial expenditures and returns and
(d) The expectation of higher returns because of factors (a) and (b) above.

2.0 OBJECTIVES

In this unit, readers will be able to understand:

 The opportunity cost of an investment;
 The concepts of payback period, accounting rate of return, net present value and
the internal rate of return;
 The limitations of the various concepts;
 How to calculate PBP, ARR, NPV and IRR;
 Superiority of NPV over the IRR;
 Exclusive projects with unequal lives;
 Capital rationing and select the optimum combination of investments when
capital is rationed for a single period;
 The concept of profitability index;
 Treatment of inflation in capital investment appraisal.

3.0 MAIN CONTENT

3.1 CAPITAL BUDGETING TECHNIQUES

There are two major methods of appraising capital projects. These are:
(i) The Non-Discounted Cash Flow (Traditional) method
(ii) The Discounted Cash Flow (DCF) method.
These are briefly discussed below.
(a) Payback Period (PBP) Method Non-Discounted
(b) Accounting Rate of Return (ARR) Method Cash flow Techniques

(c) Net Present Value (NPV)

(d) Internal Rate of Return (IRR) Discounted Cash flow Techniques

3.1.1 Payback Period Method (PBP)

This technique measures projects on the basis of the period over which the investment
pays back itself or the period of recovery of the initial investment. This means that we
would measure the full recovery of the projects' cash outflow through the projects cash
inflows. Payback is defined as the period usually expressed in years, in which the cash
outflows will equate the cash inflows from a project (CIMA). It is evident that this
method pays attention to the shortness of the project i.e. the shorter the period of
266
recovery of initial outlay, the more acceptable the project becomes and this constitutes
the decision rule.

ILLUSTRATION 13 – 1

Kokori Limited is a manufacturing outfit, having a project which involves an

immediate cash outlay of N200,000. The company estimates that the net cash inflows
from the project will be as follows:

Year Cash flows

N
1 20,000
2 40,000
3 220,000
4 80,000
Calculate the payback period for the above project.

SUGGESTED SOLUTION 13 – 1

KOKORI LIMITED – INVESTMENT APPRAISAL

Year Cash flows Cumulative Cash Flows

Cash flows N N
0 (200,000) (200,000)
1 20,000 (180,000)
2 40,000 (140,000)
3 220,000 80,000
4 80,000

Payback Period = 2 years + 140,000 x 12 months

220,000

Payback Period = 2 years + 7.6 months  2 years 8 months

Decision Rules:
(a) Using the payback method, accept all projects whose payback period are shorter
than the company's predetermined minimum acceptable payback period.
(b) If mutually exclusive projects are involved, whereby only one of the projects
can be undertaken and others rejected, the rule is to accept the project with the
shortest payback period.

Advantages
(a) It is simple to calculate and understand
(b) Of all the methods of capital budgeting, it least exposes the firm to problems of
uncertainty, since it focuses on shortness of project to pay back the initial
outlay.

267
(c) It is a fast screening technique, especially for the firms that have liquidity
problems.

Disadvantages:
(a) It does not incorporate time value of money that is it does not recognise the fact
that the value of N1 today will be far more than the value of N1 in two or three
years time. This constitutes the alternative forgone of money due to passage of
time and not inflation.
(b) It ignores cash flows after the payback period.
(c) It does not take into account the risks associated with each project and the
attitude of the company to risk.

3.1.2 Accounting Rate of Return Method (ARR)

This method is derived from the concept of return on capital employed (ROCE) or
return on investment (RO1), in that it measures the ratio of -accounting profits to the
accounting investments and evaluates projects based on this ratio or return. The
following two ways of determining the ratio are acceptable for examination purposes:
(a) ARR =

Where the initial capital invested is equal to original cost of a new project or the
written down value or net book value of an existing project. The reason for this
assertion is that since companies are going concern, there must be replacement of
assets that is, the need for depreciation.

(b) ARR =

Where the average capital invested is equal to initial capital invested plus scrap value
(if any) divided by 2.

It should be noted that if a particular question specifically defines the accounting rate
of return, such definition as stipulated in the question must be adopted in solving the
problem.

ILLUSTRATION 13 – 2

Mr. Millenia recently convinced his friends and relations to grant him a loan of
N200,000, which he intends to invest in a farming project. He estimates that the
project will yield the following returns annually for next five consecutive years.

Year N
1 60,000
2 60,000

268
3 80,000
4 60,000
5 40,000

There was no scrap values, at the end of the fifth year and the company desires to
evaluate the project on the basis of accounting rate of return.

Required:
Provide the accounting rate of return of this project on the assumption that the annual
returns are profits after depreciation but before taxation.

SUGGESTED SOLUTION 13 – 2

If option (a) under the ARR method is used, then the ARR will be:
= Average Profits
Initial Investments

= N60,000 + 60,000 + 80,000 + 60,000 + 40,000 = N60,000

5

Therefore, ARR = N60,000 x 100 = 30%

N200,000 1

If option (b) under the ARR method is adopted, then the ARR will be:

Average Profits x 100

Average Initial Investment of Capital 1

Average Capital = N200,000 = N100,000

2

Therefore, ARR = N60,000 x 100 = 60%

N100,000

Decision Rules:
(a) The rule is to invest in all projects whose accounting rate of return are higher
than the company's predetermined minimum acceptable ARR.
(b) Where mutually exclusive projects are concerned, the rule is to accept the
project with the highest ARR.

Advantages of ARR
(a) It is easy to calculate.
(b) Unlike the payback period, it makes use of all the profits for all the years of
project.
(c) For divisionalised companies, managers would find the technique easier to

269
understand because it is similar to their normal annual performance evaluation
technique.

Disadvantages of ARR
(a) It does not recognise the time value of money
(b) It is an average concept and as such will hide the sizes and timing of the
individual cash flows.

(c) It is based on accounting profits which may differ as a result of differences in

accounting methods and does not necessarily represent relevant cash flows.
(d) It recognises depreciation instead of the more relevant capital allowances.
(e) It does not take into consideration the risk associated with each project as well
as the attitude of the management of the company to risk.
(f) There is no unique definition for ARR. For instance "average profits " may be
profits after depreciation, interest and before tax or profit after depreciation,
interest and tax. Initial investment could be initial investment plus scrap value
or just initial investment.

3.2 CONCEPTS IN CAPITAL BUDGETING DECISIONS

To understand the relevance of the other two methods (that is, NEW and IRR) we shall
explain some basic concepts as they apply to capital budgeting decisions. The concepts
are the following:
(a) Concept of time value of money
(b) Concept of annuity
(c) Concept of perpetuity
(d) Concept of relevant cash flows.

3.2.1 Concept of Time Value of Money

This concept recognises the opportunity cost of receiving the same amount of money
sometime in future instead of now. This alternative forgone is as a result of lost returns
or interest on the money, due to passage of time. This concept is based on the
compound interest formulae.

The compound interest formulae states that the future value (FV) of
money receivable in a period at a specified interest rate shall be equal to:

FV = P(1 + r)n

Where:
FV = future value of money receivable in a period
PV = Principal or present value
r = the rate of interest or cost of capital
n = number of years

270
Therefore, by deduction, the present value (PV) can be determined as follows:

PV =  PV = FV x

where,
1/(1 + r)n = (1+ r)-n is the discount factor

ILLUSTRATION 13 – 3

Calculate the present value of N10,000 receivable in 5 years time if the interest rate is
10%.

SUGGESTED SOLUTION 13 – 3

PV = = FV x = 10,000 x = 10,000 x 0.6029

= N6,209

3.2.2 Concept of Annuity

An annuity is a constant sum of money receivable or payable over a specified period

of time.

The present value of annuity can be calculated using the annuity formula as follows:

Pv = 1 - (1 + r)-n
R
Where A = the constant or equal annual sum
n = number of years
r = rate of interest or cost of capital

ILLUSTRATION 13 – 4

Calculate the present value of N10,000 receivable every year for 5 years at the interest
rate of 10% per annum.
A = N10,000
N = 5yrs
R = 10% = 0.1

SUGGESTED SOLUTION 13 – 4

PV = A 1 – (1 + r)-n
R

= 10,000 1 – (1 + 1)-5
0.1

271
= 10,000 1 – 0.6209
0.1

= 10,000 0.3791
0.1

= 10,000 x 3.791 = N37,910

3.2.3 Relevant Cash Flows

Where the present value is used, in which case, time value of money
has been incorporated, we state that the cash flows used are Discounted Cash Flows
(DCF). The DCF techniques namely the NPV and IRR for evaluation of capital
projects recognise only the relevant cash flows of a project or a decision. During
examination, a list of cash flows both relevant and irrelevant may be provided,
therefore, in order to properly evaluate projects, we need to determine the relevant
cash flows and this is done by taking the following steps:
(a) Determine the decision to be taken, for example, accept or
reject a project, scrap a product line, make or buy an item etc.
(b) Any cash flow that will influence or affect (a) above is relevant.
(c) Look beyond the decision or project being evaluated and examine its effects on
the other operations of the company.

This is referred to as the opportunity cost concept which can be a function of

cost or revenue thus:
(i) If the decision will result in additional expenses or increased running
costs in other operations of the company, then this cost must be included
as relevant cash outflows in the original decision in (a) above.
(ii) Similarly, if the decision or project being evaluated will result in
additional contributions or savings from other operations of the
company, then those savings must be treated as relevant cash inflows in
the evaluation of decisions in (a) above,
(d) The following are not relevant for decision or projects being evaluated, namely:
(i) all appropriations, reserves and other non-cash items.
(ii) all fixed costs except incremental or attributable fixed costs.
(e) All historical or past or sunk costs.

3.2.4 Further Assumptions

The following additional assumptions may be required in capital budgeting situations:

(a) Year zero is the initial period of investments or the point at which the
investment decision is to be made. It is always the
beginning of investments of year one or the first year and it is to be taken as a
year on its own.

272
(b) Apart from year zero, there is no other beginning of a year in the stream of cash
flows i.e. all cash flows after year zero are assumed to arise at the end of the
year to which they relate.
(c) For working capital, in case of practical situations or problems, assumption (b)
above may not hold. In this case, we are to assume that working capital required
in year 'n' will be provided in year n - 1.
(d) It may also be assumed that working capital utilized in a project will be
recovered in full at the end of the project i.e. the total sum of all working capital
used for the life of the project will be treated as relevant cash flows at the end
of the project.

You need to realise that where a project becomes profitable only on the full
recovery of working capital, we must bring the attention of management to the
control of working in our recommendation for the acceptance of the project.

3.3 DISCOUNTED PAYBACK PERIOD METHOD

The principles and decision rules are the same as in the normal payback period
method, the only difference, is that the cash flows to be used are discounted at the
given or appropriate cost of capital. Therefore, this version of payback technique, will
not suffer from the disadvantage of discountenance of time value concerned.

ILLUSTRATION 13 – 5

Using the Mr. Millenia example, calculate the discounted payback of the project, if the
cost of capital is 10% per annum.

SUGGESTED SOLUTION 13 – 5

Year Cashflow DCF @ 10% PV Cumm. Cash flow

0 (200,000) 1.0000 (200,000) (200,000)
1 60,000 0.9091 54,546 (145,454)
2 60,000 0.8264 49,584 ( 95,870)
3 80,000 0.7513 60,104 ( 35,766)
4 60,000 0.6830 40,980 5,214
5 40,000 0.6209 24,836

PBP = 3 yrs + 35,766 x 12

40,980 = 3 years 10 months.

3.4 NET PRESENT VALUE METHOD (NPV)

The net present value is a summation of all discounted cash flows (PV) associated with
a project i.e. (the difference between the PV of cash outlay or outflow and the positive
PV of the cash inflows).

273
Decision Rules:
(a) Accept all projects that produce positive net present value (NPV)
(b) If mutually exclusive projects are involved, the rule is to accept the project that
produces the highest positive net present value.

ILLUSTRATION 13 – 6

At a cost of capital of 10% per annum. Calculate the NPV of Mr. Millenia’s project.

SUGGESTED SOLUTION 13 – 6

Year Cash flows DF @ 10% PV

N N N
0 (200,000) 1.0000 (200,000)
1 60,000 0.9091 54,546
2 60,000 0.8264 49,584
3 80,000 0.7513 60,104
4 60,000 0.6830 40,980
5 40,000 0.6209 24,836
+ NPV 30,050

Advantages of NPV:
(a) The time value of money is recognised.
(b) It measures in absolute terms (Nvalue), the increase in the wealth of the
shareholders.
(c) It is additive, in that decisions can be reached on a combination of projects,
through the addition of their respective NPVs.
(d) Unlike the payback period, it measures projects by the utilization of all cash
flows of the project.
(e) It is more preferable to IRR in decisions under capital rationing i.e. shortage of
investments funds.

Disadvantages of NPV:
(a) It is more difficult to calculate than PBP and ARR.
(b) It relies heavily on the correct estimation of the cost of capital i.e. where errors
occur in the cost of capital used for discounting the decision, using the NPV
would be misleading.
(c) Unlike the IRR, non-accounting managers may not be conversant with the
decision rule of NPV, especially in large decentralised organisations.
(d) Like all the other methods, it-does not take risk into account.
(e) It ignores inflation.

3.5 INTERNAL RATE OF RETURN METHOD (IRR)

The IRR is that cost of capital, or return that will produce an NPV of zero if applied to
a project. It is a break-even point cost of capital. It is also the cost of capital or

274
discount rate that will equate the cash inflows of a project with the cash outflows of
that project. In order to generate the cost of capital that will produce exactly zero NPV,
the following procedures may be followed:
(a) Generate two (2) opposite values of NPV (+ and - values) using two different
discount rates earlier calculated.
(b) Interpolate between the two discount rates generated in (a) above in order to
estimate the cost of capital that will produce an NEW of zero. The assumption
here is that there is a linear relationship between the cost of capital and the
NPV. Moreover, it is implied that the higher the cost of capital, the lower the
NPV and vice-versa.
(c) The interpolation formulae can be defined as:
Let R1 be the lower cost of capital that will generate positive NPV1; and
R2 be the highest cost of capital that will generate negative NPV2.

IRR= R1 + NPV1 x R2 - R1
(NPV1 + NPV2)

Note: The absolute value of the negative NEW is used in the computation.

4% 8.33% 10%

A B C
NPV200 0 -80
A
Therefore, IRR = 4% + 200 x [10% - 4%]
200 + 80
= 4% + 200 x 6%
280
= 8.33%

ILLUSTRATION 13 – 7

Using the same Mr. Millenia example, calculate the IRR for the project.

SUGGESTED SOLUTION 13 – 7

Year Cashflows DF @ 10% PV DF @ 20% PV

N N N
0 (200,000) 1.00 (200,000) 1.00 (200,000)
1 60,000 0.9091 54,546 0.8333 49,998
2 60,000 0.8264 49,584 0.6944 41,664
3 60,000 0.7513 60,104 0.5787 46,296
4 60,000 0.6830 40,980 0.4822 28,932
5 60,000 0.6209 24,836 0.4109 16,436
30,050 -NPV (16,674)

275
R1 = 10%, NPV1 = N30,050
R2 = 20%, NPV2 = (N16,674)

IRR = R1 + NPV1 x R2 – R1
(NPV1 + NPV2)

IRR = 10% + 30,050 x [20 – 10]%

16,674 + 30,050

= 10% + 6.43%
= 16.43%

Decision Rules:
(a) Using the IRR technique, the rule is to accept all projects whose IRR are greater
than the company's cost of capital.
(b) If mutually exclusive projects are being considered, the rule is to accept the
project that produces the highest IRR.

Advantages of IRR
(a) It recognises the time value of money.
(b) It is more attractive to divisional managers in large organisations
since they are used to the return approach in evaluations.
(c) It provides to us a margin of safety in the calculation of a company's cost of
capital i.e. it measures all allowable margin of errors.

Disadvantages of IRR
(a) It is difficult to calculate than the other methods.
(b) Where the cash flows of a project are unconventional in which case, cash
inflows occur in between cash outflows and vice-versa, the IRR technique will
produce more than one IRR for a project. It can lead to a situation of sub-
optimal decision.
(c) Where mutually exclusive projects are being considered, the IRR may produce
a decision that will conflict with the NPV decision in that the IRR, being a rate
of return, does not recognise the size or scale of project.
(d) A project may produce more than one IRR. This also occurs when a project has
unconventional cashflows.

3.5.1 Modification of IRR

The IRR can be modified under the following circumstances:

 Where the cash flows are unconventional.
 Where projects are mutually exclusive.

However, the above can be taken care of by the following two methods:
 extended yield method
 incremental yield approach.

276
(a) Extended Yield Method
By this method, we modify the IRR technique in order to produce a unique IRR
rather than multiple IRR. The following steps may be adopted:
(i) Convert the unconventional cash flows into conventional cash flows by
discounting all future cash flows backwards at the given cost of capital
until they are fully absorbed by the positive cash flows (cash inflows) or
they become year zero cash flow.
(ii) Calculate the IRR of the revised (conventional) cash flows in the normal
way. This is the required IRR.

(b) Incremental Yield Method

Where projects are mutually exclusive, it means that we cannot undertake all
the projects. We must undertake only one and this assumes that acceptance of
only one project is equivalent to rejection of all other mutually exclusive
projects.

IRR will produce conflicting result with NPV where mutually exclusive
projects are involved because IRR does not recognise the scale or size of
investments. For this reason, we must modify the cash flow of mutually
exclusive projects if we are forced to evaluate them using IRR. Hence, the
method for this modification is called INCREMENTAL YIELD APPROACH.
Under this method, we revise the cash flows to generate differential or
incremental cash flows. Thereafter, we calculate the IRR of these incremental
cash flow and base our decision for project selection on the project that
generated this incremental cash flows, that is, the project that was kept
constant).

3.5.2 Steps for Calculating Incremental IRR

The following Steps are to be followed in calculating the incremental IRR.

(a) Calculate the incremental cash flows by keeping one project constant (i.e.
subtracting the cash flows of the other project from the cash flows of the project
that was kept constant e.g. protect Y – Z - if incremental cash flows are
generated from Y - Z, then Y must be kept constant.
(b) Calculate the1RR of these incremental cash flows in the normal way.

(c) If the IRR of these incremental cash flows is greater than the company's cost of
capital, then the project that was kept constant must be better than the other
project and must be accepted. On the other hand, if the 1RR of the incremental
cash flows is lower than the cost of capital, then the project that was kept
constant must be rejected.

ILLUSTRATION 13 – 8

Dike Ltd’s two accountants are in disagreement as to which of two mutually exclusive

277
projects to undertake. One has based his conclusions on an IRR computation, and the
other, using NPV. Dike required rate of return is 10%. The first project requires an
investment of N1,410,400 and will generate net cash savings of N300,000 per annum
for 10 years. The second project requires N867,800 to be invested to generate
N200,000 per annum for 10 years.

Required
(a) Produce the calculation of the two accountants.
(b) Produce an unambiguous result by considering the internal investment.
(c) If the alternative investment rate was 14%, which of the two projects would be
accepted.
(d) Compare your conclusions in (c) with calculation of the NPV of the both
projects at the alternative rate of 14%.

SUGGESTED SOLUTION 13 – 8

(a) Project 1 Project 2

Year Cashflow DF PV Year Cashflow DF PV
N @ 10% N N @ 10% N
0 (1,410,400) 1.0000 (1,410,400) 0 (867,800) 1.0000 (867,800)
1-10 300,000 6.1446 1,843,380 1-0 200,000 6.1446 1,228,9
+NPV 432,980 +NPV 361,120

@ 20%

Year Cashflow DF PV Year Cashflow DF PV

N @ 20% N N @ 10% N
0 (1,410,400) 1.0000 (1,410,400) 0 (867,800) 1.0000 (867,800)
1-10 300,000 4.1925 1,257,750 1-0 200,000 6.1446 838,500
+NPV (152,650) NPV (29,300)

IRR = 10% + 432,980 x 10% IRR = 10% + 361,120 x 10%

585,630 390,420
= 10% + 7.39 = 10% + 9.25
= 17.39% = 19.25%

Using NPV, Project 1 should be accepted, because project 1 has the higher
NPV.
Using IRR, Project 2 should be accepted, because project 2 has the higher IRR.

(b) Project 1 Project 2

Year Cashflow Year Cashflow Incremental Cashflow
N N N
0 (1,410,400) 0 (867,800) (542,600)
1-10 300,000 1-10 200,000 100,000

278
Incremental Cash Flows

Year Cashflow @10% PV @20% PV

N N N N
0 (542,600) 1.00 (542,600) 1.00 (542,600)
1-10 100,000 6.1446 614,460 4.1925 419,250
+NPV 71,860 -NPV 123,350

Since the IRR of the incremental cash flows is greater than the company’s cost
of capital, it means project 1, which was held constant, should be accepted. This
agrees with the result of the NPV.

(c) If the investment rate is now 14%, it means the decision to accept project 1 will
no more hold as the incremental IRR is lesser than the cost of capital of 14%.
Therefore, project 2, now looks more attractive and should be accepted.

(d) Project 1 Project 2

Year Cashflow DF PV Year Cashflow DF PV
N @14% N N @14% N
0 (1,410,400) 1.0 (1,410,400) 0 (867,800) 1.00 (867,800)
1-10 300,000 5.2161 1,564,830 1-10 200,000 5.2161 1,043,220
+NPV 154,430 +NPV 175,420

From the calculations of this NPV based on 14% cost of capital, Project 2 shows
higher NPV, and therefore should be accepted. This confirms the decision in (c)
above.

NPV Vs IRR
Since the two methods belong to the same class of appraisal technique, one will expect
that their decisions will tally at all times.

However, on few occasions, (like when the cash flows are unconventional and where
there is difference in the initial cash flow),the decision will not tally. For instance,
NPV may say accept project A and reject project B, whereas IRR will say accept B
and reject A. This shows that there is a conflict in the decision of NPV and IRR.

As a management accountant, if you are faced with this situation, which of the two
appraisal techniques would you recommend for acceptance.

The solution to the above problem is that whenever there is a conflict in the decisions
of NPV and 1RR,NPV decision is superior. This is because NPV has many technical
advantages over IRR.
(a) NPV is technically superior to IRR and is simpler to calculate.
(b) Where cash-flow patterns are non-conventional, there may be nil or several
internal rates of return making the IRR impossible to apply.

279
(c) NPV is superior for ranking investments in order of attractiveness
because shareholders prefer absolute figures than percentages.
(d) With conventional cash flow patterns, both methods give the same accept or
reject decision.
(e) Where discount rates are expected to differ over the life of the project such
variations can be readily incorporated into NPV calculations, but not in those
for the IRR.
(f) The NPV calculations assume that funds generated by the project, are
reinvested at the firm's cost of capital. IRR assumes reinvestment at the
calculated IRR which could be unrealistic if the IRR is significantly higher than
the firm's cost of capital. A modified IRR can be calculated based on the
assumption that funds generated are reinvested at the firm's cost of capital.
However, this introduces a further layer of assumption and calculation merely
in order to overcome one of the inherent characteristics of the IRR approach.
(g) Notwithstanding the technical advantages of NPV over IRR, IRR is
widely used in practice so that it is essential that students are aware of its
inherent limitations.

3.6 CAPITAL RATIONING

A capital rationing situation is one in which a company does not have sufficient fund
to execute worthwhile investment projects. Under this situation, a company has
projects with positive NPV whose combined outlays exceed all available finance to the
company for the same period.

Capital rationing is the technique for selecting projects during a period of funds
restriction which normally requires the ranking of projects in a descending order of
desirability and accepting them in that order until all available funds have been
exhausted.

3.6.1 Single Period Capital Rationing

This is where restriction is for only one period, we must use the profitability index.

3.6.2 Profitability Index (PI)

This concept is based on the contribution per limiting factor approach. It is actually a
benefit/cost analysis of projects, that is, the N receivable per N of expenditure. It can
be measured as the ratio of NPV or in some cases, Gross Present Value (GPV) of a
project to the outlay required for the project during the year of restriction. The PVs are
the contributions while the expenditure, or the outlays are the limiting factors.
However, two definitions of PI are allowable as follows:

(a) PI = NPV of a project

Outlay required during the year of restriction

280
(b) PI = Gross Present Value (GPV) of a project
Outlay required during the year of restriction.

Where GPV will normally equal to NPV + Initial Outlay

Steps to be taken in a Single Period Capital Rationing Situation

The following are recommended when questions are being attempted concerning a
single period capital rationing situation:
(a) Identify the year of restriction.
(b) Calculate the NPV of projects (if not given).
(c) Rank all projects using the PI.
(d) Allocate available finance or funds to all projects in a descending order of the
Pl.
(e) If a project does not require outlay during the year of restriction, its PI would be
an infinite sum (i.e. NPV +0) and such projects must be ranked first and must
be selected.

ILLUSTRATION 13-9

Alubarika Ltd. has a capital budget of N500,000 for the year to 30th June, 2003. The
available projects have been identified and quantified by the Technical Director and
the Works Manager as listed below. The individual project’s related profitability index
has been computed by a financial management team and stated hereunder.

Projects Initial Outlay Profitability Index

N N
A 250,000 1.10
B 100,000 0.95
C 200,000 1.25
D 200,000 1.23
E 250,000 1.05
F 100,000 1.20
G 50,000 0.99

(a) Which projects should the company invest in?

(b) What difference would the absence of capital rationing make to your selection
in (a) above.

SUGGESTED SOLUTION 13-9

(a) Projects Initial Outlay Profitability Index Ranking

A 250,000 1.10 4th
B 100,000 0.95 7th
C 200,000 1.25 1st

281
D 200,000 1.23 2nd
E 250,000 1.05 5th
F 100,000 1.20 3rd
G 150,000 0.99 6th
Allocation N1000
Available Funds 500
Select Project C (200)
300
Select Project D (200)
100
Select Project F 100
NIL
The company should invest in Projects C, D and F in that order of priority.
(b) If there is no capital rationing, the company should undertake all projects with
positive NPV. In this case, the company should invest in all projects except
Projects B and G which have negative NPV.

3.6.3 Different Situations of Capital Rationing

The different situations of capital rationing are as follows:

(a) Where projects are divisible
(b) Where projects are not divisible
(c) Where projects are mutually dependent.
(d) Where projects are mutually exclusive.

Divisible Projects
In this case, there is an implicit linearity assumption between the initial outlays and the
NPVs of project. This follows from the basic assumption that fractions of a project can
be undertaken. Therefore, a fractional investment in the outlay would yield a
proportionate fractional return in NPV e.g. Investment of 20% in outlay, would yield
20% of NPV.

Indivisible Projects
Projects are not divisible fractions and cannot be undertaken and it is only in this case,
that you have surplus funds and the latter represents the balance of available funds
after allocation that cannot meet the requirement in full for the remaining projects.
Where this situation exists, you are to explain the need to invest such surplus funds in
the bank. This is one of such situations where a company can invest at a rate below its
cost of capital.

ILLUSTRATION 13-10

SUMREM Ltd. is experiencing a shortage of funds for investment in the current year,
when only N100,000 is available for investment. No fund shortages are foreseen
thereafter. The cost of investment funds is 20%. The following projects are available:

282
Projects 1 2 3 4 5 6
Initial outlay N50,000 N80,000 N60,000 N30,000 N25,000 N40,000
Annual receipts
From projects to
Perpetuity 15,000 20,000 18,000 10,000 8,000 10,000
You are required to advise management on the projects which you would recommend
for acceptance if they were:

(a) divisible
(b) indivisible
(c) would your answer to (b) change if surplus could be invested at 12%? Ignore
Taxation.

SUGGESTED SOLUTION 13-10

(a) Projects Outlay Annual NPV Pl Rank

Receipts (N) N N
1 50,000 15,000 25,000 0.50 3rd
2 80,000 20,000 20,000 0.25 6th
3 60,000 18,000 30,000 0.50 4th
4 30,000 10,000 20,000 0.67 1st
5 25,000 18,000 15,000 0.60 2nd
6 40,000 10,000 10,000 0.25 5th

If the projects are divisible:

Allocations N1000
Available funds 100
Select Project 4 (30)
70
Select Project 5 (25)
45
Select 90% of Project 1 45
NIL

Management should accept Project 4, 5 and 90% of Project 1

If the Projects are indivisible
Allocations N’000
Available funds 100
Select Project 4 (30)
70
Select Project 5 (25)
45
Select Project 6 (40)
Surplus Fund 5

283
Since projects are indivisible, management should accept projects 4, 5 and 6.

(c) The answer would can change, except that management will be advised to
invest the surplus funds at the 12% rate rather than not having any returns since
12% is still under cost of investments to the company. This will make the
management to earn some interest, rather than losing it.

Working Note:
(i) NPV is derived by the perpetuity formula of
for example, Year 1 is
A = 15,000 = N75,000 – 50,000 = N25,000 etc.
r 0.2

(ii) Profitability index is

For example, Year 1 is
NPV of a Project = 25,000 = 0.5 etc.
Initial Outlay 50,000

Where projects are mutually dependent

In this case, an acceptance of one of the mutually dependent projects automatically
implies an acceptance of the remaining mutually dependent projects, e.g. if projects A
and B are mutually dependent, it means that one can only accept or reject both projects
and not undertake only one of them. However, any of two methods may be adopted as
follows:

(i) In ranking all the projects, one can decide to rank all the mutually dependent
projects as soon as or immediately after any of the mutually dependent projects
is ranked irrespective of the sizes of their respective profitability index. For
instance, if projects A and B are mutually dependent in a group of the under
listed projects, our ranking can be done as follows:
PI Initial Outlay Ranking
Projects
A 1.1 200 3rd
B 1.6 100 2nd
C 1.7 200 1st
D 1.2 300 5th
E 1.3 400 4th

Therefore, one can select and allocate funds in that order as above

(ii) If one wants to arrive at a more accurate solution, he has to combine all
mutually dependent projects into a unique single project. Where the latter
would have as its initial outlay, a combined total of all initial outlays of the
mutually dependent projects. The Pl would be weighted average Pl, where the
weight to be attached to the Pl will be initial outlays of the respective projects.

284
Using the same group of projects as above, we can rank these projects after a
combination of projects A and B as follows:

PI x Initial Outlay
300

PI = 1.100 x 200 + 1.6 x 100 = 1.27

300
A and B = 1.27

The new ranking/project is 1st 2nd 3rd 4th

C = 1.7 E = 1.3 AB = 1.27 D = 1.2

Where Projects are Mutually Exclusive

In this case, an acceptance of one project group implies the rejection of all the other
project group. To resolve this issue, there is a need to modify the ranking procedures
and it is done as follows:

(i) create as many groups of projects as long as they are mutually exclusive i.e.
each group must contain only one of the mutually exclusive project and would
of course exclude the others.
(ii) rank and select projects in each group
(iii) calculate the total NPVs of the selected projects in each group.
(iv) the decision would be to accept projects from the groups that produces
maximum total NPVs.

ILLUSTRATION 13-11

Dele and Okafor have just received their gratuities which amounted to N250,000 and
they are prepared to invest in a new venture XYZ Ltd. The Bank of Nigeria Ltd has
expressed the desire to grant them long-term loan of up to N950,000. They have
presented the following investment proposals to you for financial advice.

PROJECTS 1 2 3 4 5 6 7 8 9 10
PROFITABILITY
INDEX 1.19 1.20 1.17 1.20 1.221.15 1.10 1.15 1.22
1.16
OUTLAY (N’000) 150 150 200 300 400 400 300 200 100 100

Their expected cost of capital is 15%. Projects 3 and 6 are mutually exclusive while
Projects 1 and 4 are mutually dependent.

(a) As a financial adviser, what projects would you recommend that the new
venture should embark upon?
(b) What is the opportunity cost of the accepted project?

285
SUGGESTED SOLUTION 13-11

Group A (includes Project 3)

Ranking
Project Profitability Index Initial Outlay NPV
N’000 N’000
9 1.22 100 22
5 1.22 400 88
2 1.20 150 30
1 of 4 1.197 450 88.65
3 1.17 200 34
10 1.16 100 16
8 1.15 200 30
7 1.10 300 30

Allocation N’000 NPV

Available funds 1,200
Select Project 9 (100) 22
1,100
Select Project 5 (400) 88
700
Select Project 2 (150) 30
550
Select 1 (450) 88.65
100
Select 50% of Project 3 100 17
NIL 245.65

Group B (Includes Project 6)

Ranking
Project Profitability Index Initial Outlay NPV
N’000 N’000
9 1.22 100 22
5 1.22 400 88
2 1.20 150 30
1 1.197 450 88.65
3 1.17 200 34
10 1.16 100 16
8 1.15 200 30
7 1.10 300 30

The total NPV here is 22 + 88 + 30 + 88.65 + 16 = 244.65. Since they constitute

projects for which the total allocation of funds is made.

286
However, the company is advised to select projects 9, 5, 2, “1 of 4” and 50% of 3
because they produced the higher NPV of N245.65 compared to that of Group B of
N244.65.

Note: The P1 for “1 of 4” is derived thus:

P1 = 1.19 x 150 + 1.20 x 300 = 1.197
150 + 300

The projects are assumed to be divisible.

(b) The opportunity cost of accepted projects is the lost NPV from projects not
accepted. These actions were as a result of capital rationing and the nature of
the relationship between the projects. This is equal to NPVs of 50% of Project
3, 6, 7, 8 and 10 which sum up to N153. The position of project 6 in this regard
may be debated, and the argument is that with or without capital rationing we
would not undertake project 6, if Project 3 is undertaken, therefore, the
opportunity cost of accepted projects should not include the NPV of Project 6.
However, the acceptance of Project 3, is the opportunity cost of project 6 and
vice-versa.

3.6.4 Multi-Period Capital Rationing

Where capital is restricted in more than one period, the requirement is likely in the
least, a formulation of the Linear Programming required, to select projects which will
maximise the NPVs for the company. For this reason, the following steps will be
required.
(a) Identify the relevant variables (e.g. available funds, required fund for each
project, years of restriction of respective projects and the resultant NPV etc.)
(b) Specify these variables in a form adaptable to mathematical manipulation by
representing the variables in (a) above with symbols Let x represent the
LAGOS project etc. or let y represent the fraction of SHOGUNLE project
accepted.
(c) State the objective function, which normally is the maximisation of the NPVs
of all the projects.
(d) Specify the constraints as follows:
(i) Financial constraints: this ensures that total required funds for all the
projects and other operations of the company do not exceed the available
funds for each corresponding period.
(ii) Non-negativity constraints: this ensures that projects are either accepted
or rejected and in no situation would a negative portion of a project be
accepted.
(iii) Logical constraints: this ensures that fractions of projects can be
undertaken whereas no project will be repeated.

Note: Steps (b), (c) and (d) will constitute the Linear Programming formula or plan for
multi-period capital rationing.

287
3.6.5 Limitations of Capital Rationing

The following constitute the limitations of capital rationing:

(a) The assumption of divisibility of projects may not be possible in practice for all
projects.
(b) In addition to (a), we also assume linearity between outlays and NPV of
projects i.e. a fractional investment in outlay will yield the same fraction of
NPV. In practice, because of economies and diseconomies of scale, this may
not hold.
(c) On many occasions, capital rationing treats projects in isolation. It does not
recognise the interdependence of projects e.g. an investment in a project may
result in substantial savings only if another project is undertaken, which capital
rationing ignores.
(d) Where more than two projects are involved and capital is restricted in more
than one period, the profitability index approach will no longer be sufficient for
resolving project acceptance under capital rationing. In such cases, linear
programming technique may be applied.

3.7 INFLATION IN CAPITAL BUDGETING

Inflation in capital budgeting refers to increases in estimates as a result of changes in

price levels. This means that, if we ignore inflation we may end up overstating or
understating our net cash flows in which case the NPVs used for decision making
would be wrong.

A school of thought believes that inflation can be ignored, because it affects both
variables that make up NPV on which we base our decision whereby the variables are
the cash flows and cost of capital. They argue that, since inflation will generate
increases in cash flows and cost of capital, the provider will increase their required
returns to meet changes in price level. Therefore, the effect of inflation will be
cancelled out in arriving at the NPV.

The above assertions may be contested because of the following reasons:

(a) Inflation does not affect the cash flows and cost of capital in the same way.
Cash flow may increase, whereas providers of funds especially shareholders
may not ask for the proportionate increase in their required return (i.e. cost of
capital).
(b) Even among the cash flows, inflation will not affect them in the same way A
company may translate expected inflation rate into estimates of materials and
overhead costs. It will be wrong if estimates for sales related cash flows also
incorporate the same expected inflation rate. This inability of the company to
adjust for inflation in its selling price is dependent on the nature of the demand
for its product or service.
(c) Labour cost and labour related cash flows may not move in line with
the general inflation rate because of the actions of labour and industrial unions.
(d) For the manager, making estimates for inflation rate will be

288
compounded by the fact that there must be full provision for variable cost of
production with full effects of inflation if the company intends to remain in
operation.

From the above reasons, we will arrive at sub-optimal decisions if we ignore inflation.
The presence of inflation will complicate planning and forecasting problems of the
manager, predicting the estimates of future cash flows is troublesome in its own case
and would be worsened if inflation is recognized.

3.7.1 Relevant Concepts

Inflation can be incorporated in capital budgeting by the usage of any of the following
two concepts:
(a) money cost of capital
(b) real cost of capital

Concept of Money Cost of Capital

The money cost of capital is the normal cost of capital of a company
which would have been calculated by reference to money market rate
of interest of the providers of capital or funds. It is the cost of capital that has not been
adjusted for inflation (i.e. it does not incorporate inflation). Where cash flows are
inflated or incorporates inflation, or are given in money terms, we should discount
such cash flows using the money cost of capital.

Concept of Real Cost of Capital

The real cost of capital is, the cost of capital that has been adjusted for inflation and
the adjustment formula is as follows:

1+r=1+m -r =1+m–1
1+I 1+i

Where i = inflation rate

m = money cost of capital
r = real rate or real cost of capital

In order to use the real cost of capital, we must ensure that the cash flows to be
discounted are the real cash flows. The real cash flows are cash flows given in today's
prices, also known as current values or year zero cash flows. To use the real cost of
capital, we must bring this cash flows to year zero values. We shall get exactly the
same result whether real or money cost is applied i.e. it is not material which concept
is applied as long as the concepts are properly applied.

ILLUSTRATION 13 – 12

The Directors of Newsline Nigeria Ltd. are considering under taking the manufacture

289
of a new product. The company’s current cost of capital is 20% in money terms.
Construction of the plant required to produce the new product would take one year; i.e.
production would commence on 1 January 1996. The plant would cost N500,000 of
which N300,000 is payable immediately and N200,000 on 31 December 1995. The
construction cost is fixed by contract. One hundred thousand units of the new product
would be produced and sold each year from 1 January 1996 until 31 December 1999.
Revenues and costs expected, expressed in terms of 1 January 1994 price level are as
follows:

Per Unit
Selling price N5.0
Variable cost (excluding labour) N1.50
Labour N1.00

Additional overhead costs N60,000 per annum, selling price, variable costs (excluding
labour) and additional overhead costs are expected to increase in line with general
price index. For a number of years, this index has increased at an annual compound
rate of 10% and it is generally expected to continue increasing in line with the wage
rate index which has been increasing at an annual compound rate of 20%. The same
rate of increase is expected in the future. All revenues and costs occur at the end of the
year in which they arise. Advise the directors of Newsline Nigeria Ltd. whether the
manufacture of the new products is worthwhile. Ignore taxation.

SUGGESTED SOLUTION 13 – 12

Evaluation
Year Item Cash Flows DF/AF at the PV
N appropriate rate
0 Plant (300,000) 20% 1.00 (300,000)
1 Plant (200,000) 20% 0.8333 (166,660)
2 – 5 Sales less Overhead (319,000) 0.09% 2.964 945,516
and Labour
2–5 (120,000) 10% 4 (480,000)
NPV (1,144)
Decision Rule:
Management should not manufacture the product since it results in negative NPV of
N1144.

Note:
(a) Year 0 1 January 1995
1 31 December 1995
2 31 December 1996
3 31 December 1997
4 31 December 1998
5 31 December 1999

290
(b) Real Cost of Capital
(i) For selling price, additional overhead, variable cost (excluding labour)
inflation rate: 10%

r = 1 + m – 1 = 1 – 20 – 1 = 9.09%
1+i 1.10
Inflation : 10%
r = 1 + m - 1 = 1.20 - 1 = 0%
1+I 1.20

(c) Revenues and costs are given in 1 January, 1994 index:

(i) Year 1 January, 1995
Selling Price = 5.0
Variable Costs = 1.50
Contribution = 3.50 x 100,000 = 350,000 x 110%
= N385,000

(ii) Additional Overhead = 60,000 x 110% = Year 0

= N66,000
(iii) Labour costs 1 x 100,000 = 100,000 x 120%
= Year 0 = N120,000
(iv) Contribution = N385,000
Less Additional Overhead = N66,000
Profit or Cash inflows = N319,000

3.7.2 Other Considerations

(a) The real cost of capital should be used under the following conditions:
(i) where the inflation rate for the same cash flow will differ annually e.g.
sales will increase by 10% in first year; 20% in second year etc.
(ii) ff in addition to inflation, relevant cash flows concept or any other
capital budgeting concept or decision is being tested, usage of real cost
of capital approach may become cumbersome.
(iii) where the inflation rate is greater than the real cost of capital, in this
case, the real cost of capital is a negative cost.

(b) The differential inflation rate is a situation where different rates of inflation
apply to different cash flows of a project. We can still apply the real cost of
capital approach as follows:
(i) calculate the real cost of capital for a collection of cash
flows that have the same inflation rate.
(ii) calculate the present values of each cash flows that have
the same inflation rate.

291
(iii)
a summation of all the relevant PV of the project will be equal to the
NPV.
3.8 TAXATION IN CAPITAL BUDGETING

In this area, and in other areas where cash flows are to be used, we must reflect in the
solution, as far as information is available which will allow the following:
(a) All capital allowances claimable including balancing allowances.
This should be reflected as tax savings in the cash flows. These tax savings will
result in cash inflows which should be calculated thus: Tax Rate x Capital
Allowances = Tax Savings.
(b) All balancing charges will give rise to additional tax payments known as tax
cost. This tax cost should be recognised as relevant cash out flows and
calculated as; Tax Cost = Tax Rate x Balancing Charges.
(c) Additional tax cost or tax savings from allowable income and expenditure
respectively. Additional income = Tax Costs which is relevant cash outflows
and determined thus; Tax Rate x Additional Income. Additional expenditure =
Tax Saving which is relevant cash inflows and is determined thus: Tax Rate x
Additional Expenditure.
(d) Timing of tax related cash flows. The inflows and outflows above arising from
tax costs and savings should be incorporated in the cash flow during the period
for the payment of tax in relation to the allowable timing period for tax. It is
usual to assume, where there is silence on the issue of tax, that it is payable one
year after the end of the period to which the tax cash flow relates. If no tax rate
is given or you are asked to ignore taxation, you need not adjust for taxation in
the cash flow.

3.9 LEASE OR BUY DECISIONS

These decisions are usually mutually exclusive, hence the usage of the incremental
approach will hasten the rate of attempting problems in this area. Capital allowances
would substantially affect our lease or buy decision, therefore the earlier explained
adjustment for capital allowances are expected under lease or buy decision with
particular reference to the buy option. However, in financial management it is assumed
that the lessee whether in operating or finance lease arrangement would not enjoy
capital allowance, that is, implicit assumption of leases as operating lease for capital
budgeting.

3.9.1 Qualitative Factors Affecting Lease or Buy Decisions

The following qualitative factors need be considered when lease or buy decisions are
involved:
(a) Liquidity
(i) Do we have enough funds now to buy the asset instead of
leasing it?

292
(ii) Will we have sufficient funds in future to meet lease obligations?
(b) Off balance sheet financing: Leasing will be more attractive than borrowing
or buying if a company is already highly geared.
(c) Availability of spare parts and ease of maintenance:
Most lease contracts contain maintenance clauses. In many
cases it will be more economical for the lessor who has more exposure units to
import spare parts and runs maintenance centre.
(d) Changes in technology or obsolescence: Leasing may become attractive, if the
asset is exposed to frequent changes in technology e.g. leasing is a regular
feature in the Hi-tech industries like aircraft and computer.
(e) Inflation: This may affect lease or buy decisions in terms of changes in prices
visa-vis replacement cost, scrap value and maintenance charges.
(f) Beneficial ownership
(i) It is advisable not to lease specialised equipment or accommodation,
(ii) Purchase increases the asset base of companies, thereby improving the
company's ability to raise further finance.
(g) Distribution in production: This will lead to Losses if the lessor repossesses
the asset for any reason.
(h) Changes in taxation rate: This factor can also affect either the lease or buy
decision.

3.9.2 Assumptions

Logical assumptions are allowed to be made in this area of decision making and the
major issue of choice centres around the cost of capital to be used in discounting the
relevant cash flows. Therefore, as a guide, the following may be adopted:

3.9.2 Choice of Cost of Capital

(i) Nature of cost of capital: lithe company is in a taxable position,

use the after tax cost of capital, whereby the after, tax cost of
capital is that cost of capital that has been directly or indirectly adjusted for
taxation. Tax adjustments are considered direct if
the specific calculation of the cost of capital has recognised
taxation. It is indirect if the figure for the cost of capital is adjusted using the
following formula:
After Tax Cost = Cost of Capital x (1 - Tax Rate)
e.g. Cost of Capital = 10% and Tax Rate = 40%
After Tax Cost of Capital = 10% x (1 - 0.4) = 6%
However, if the company is not in a taxable position, we should use before tax
cost of capital. A company is in a taxable position if it is required to pay tax
during its normal course of business. If a company is currently making losses
and therefore not paying taxes, it does not mean that the company is not in a
taxable position. The loss position of the company will only mean a deferral of
tax payments.

293
(ii) Specific cost of capital: The choice of a particular cost of capital
to use for either the lease or buy decision can be by reference to
source of finance or by reference to nature of cash flow. If the source of finance
for the decision is specified or known, we
should use the specific cost or cost of borrowing. However, if the
source is from the company's pool of funds, we should use the company's
weighted average cost of funds (WACC).

3.9.4 Nature of Cash Flows

Cash flows are considered certain if they do not fluctuate over time
and they are not linked to sales or production, for example, lease rentals, hire
purchases etc. On the other hand, cash flows are uncertain
if they are dependent on the level of activity of the company or if they
can be linked with the demand or sales of the company's production or services, for
example, all variable cost including sales price, labour etc.

The example below is used to illustrate the effect of taxation in capital

budgeting decisions as well as the element of lease or buy decision by a firm.

ILLUSTRATION 13 – 13

MOSORIRE NIG. LTD. intends to obtain the use of an asset, but is uncertain of the
best financing method to be employed. The financing methods under consideration
are:

(a) To borrow and purchase the asset: borrowing would cost 12% before tax, the
current competitive market rate for debt. The asset would cost N90,000 to
purchase and will have a guaranteed salvage value of N10,000 in five years.
Expenditure on the asset qualifies for capital allowance at 25% per annum on
the reducing balance.
(b) To lease the asset, two financial leases are being considered, the details are:

Payments to be made
YEAR LEASE A (N’000) LEASE B (N’000)
0 20 4
1 20 8
2 20 16
3 20 30
4 20 50

If the asset is leased the entire salvage value will accrue to the leasor. The firms
weighted average cost of capital is 15%. Advise on the best method of financing the
use of the asset if the firm is:
(a) subject to company tax at 35% with a one year delay and has large taxable

294
profits.
(b) permanently in a non-taxable position.

SUGGESTED SOLUTION 13 – 13

BUY DECISION

(a) (b) (a + b)
Year Cash flow Tax Savings/Cost Net Cash Flow DF @ 7.8% PV
0 (90,000) - - 1.0000 (90,000)
1 7875 7875 0.9276 7,305
2 5906 5906 0.8605 5,082
3 4430 4430 0.7983 3,536
4 3322 3322 0.7405 2,460
5 10,000 2492 3975 0.6372 2,533
6 3975 12492 0.6869 8,581
NPV (60,503)

Lease A
(a) (b) (a + b)
Year Cash flow Tax Savings/Cost Net Cash Flow DF @ 7.8% PV
0 (20,000) - (20,000) 1.0000 (20,000)
1 (20,000) 7000 (13,000) 0.9276 (12,059)
2 (20,000) 7000 (13,000) 0.8605 (11,187)
3 (20,000) 7000 (13,000) 0.7983 (10,378)
4 (20,000) 7000 (13,000) 0.7405 (9,627)
5 - 7000 7,000 0.6869 4,808
(58,443)

Lease B
(a) (b) (a + b)
Year Cash flow Tax Savings/Cost Net Cash Flow DF @ 7.8% PV
0 ( 4,000) - (4,000) 1.0000 (4,000)
1 ( 8,000) 1,400 (6,600) 0.9276 (6,122)
2 (16,000) 2,800 (13,200) 0.8605 (11,359)
3 (30,000) 5,600 (24,400) 0.7983 (19,479)
4 (50,000) 10,500 (39,500) 0.7405 (29,250)
5 - 17,500 17,500 0.6869 12,025
(58,185)

Decision Rule:
Lease from B since it has the lowest figure in terms of the investment cost or present
value of cost.

295
Working Notes:
(a) Cost of borrowing is 12%
after tax cost of borrowing = 12% x (1 – 0.35) = 7.8%
(b) Capital allowance calculation
Year 1 90,000 x 25% = 22,500 x 35% = 7875
2 67,500 x 25% = 16,875 x 35% = 5906
3 50,625 x 25% = 12,656 x 35% = 4430
4 37,969 x 25% = 7,119 x 35% = 2492

Written Down Value (WDV) = 28,477 – 7,119 = 21,358

Balancing Allowance = WDV less scrap value

= 21,358 – 10,000
= 11,358 x 35% = 3975

4.0 CONCLUSIONS

Investment decisions are long — run decision where consumption and investment
opportunities are balanced over time after taking into consideration investor's beliefs in
the future, the alternatives available and attitude to risks.

The appraisal techniques are of two main types viz: Traditional and discounted cash
flow (DCF) whereby the traditional elements are payback period and accounting rate
of return while the DCF that uses cash flows rather than profits and take account of the
time value of money are net present value and internal rate of return.

With the conventional projects, 1RR and NPV give the same accept or reject decision.
NPV is an absolute measure whereas 1RR is a relative one, hence the superiority of the
NPV over 1RR when the decision making is involved.

Capital rationing is where all apparently profitable projects cannot be initiated because
of shortage of capital and decision rule under this instance is to maximise the return
from project(s) selected rather than simply accept / reject decision of projects in
isolation.

The probability index is used in ranking single period projects in terms of the expected
value having regards to mutually exclusive projects.
Multi-period capital rationing with divisible projects is usually solved by linear
programming technique which produces the optimal solution.
Specific inflation is of more direct concern in investment appraisal and differential
inflation is commonly encountered with the need to distinguish between real and
nominal value of money.

Because taxation affects the cash' flows of a project, it is a factor to be considered

because it affects a project in three ways: taxes on profits, investment incentives and
effects on cost of capital.

296
5.0 SUMMARY

Based on the factors listed above under introduction regarding Capital budgeting
Decisions, the manager must not fail to make appropriate investment or selection of
good projects because, the volume of fixed assets far exceed current assets and the
owners of the company (shareholders) are long term investors, whose high expected
returns can only be met with the higher returns from long term assets. These
assertions, call for the need to examine the different methods of selecting investments
in long term assets.

6.0 TUTOR MARKED ASSIGNMENT

1. Dotun is considering an investment that gives a positive net present value of
N3,664 at 15%. At a discount rate of 20%, it has a negative net present value of
N21,451. What is the internal rate of return of this investment?
A 15.75%
B 16.0%
C 19.30%
D 19.90%
E 18.40%.

2. Ayo Limited is planning on paying N300 into a fund on a monthly basis starting
3 months from now for 12 months. The interest earned will be at a rate of 3%
per month. What is the present value of these payment?
A N2816
B N2733
C N2541
D N2986
E N2886.
The following data relates to question 13.3 and 13.4.
Yemi Limited is considering investing in a manufacturing project that would
have a three years life span. The investment would involve an immediate cash
outflow of N50,000 and have a zero residual value. In each of the three years,
4000 units would be produced and sold. The contribution per unit based on
current price is N5. The company has an annual cost of capital of 8%. It is
expected that the inflation rate will be 3% in each of the next three years.

3. The net present value of the project to the (nearest N500) is

A N4500
B N5000
C N5500
D N6000
E N6500.

297
4. If the annual inflation rate is now projected to be 4%, the maximum necessary
cost of capital for this project to remain viable is (to the nearest 0.5%)
A 13.0%
B 13.5%
C 14.0%
D 14.5%
E 15.0%.

5. If N400 is invested today and generate N500 in one year’s time. What is the
internal rate of returns?
A 30%
B 32%
C 31%
D 25%
E 27%.

6. Explain the concept of Capital Rationing.

7. What is a Profitability Index?

8. State any four main factors to be considered in a lease or buy decision.

9. What is Internal Rate of Return?

10. The discount rate used in DCF calculation is known as_______

7.0 REFERNCES/ FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

298
UNIT 14 DECISIONS MAKING UNDER RISK AND UNCERTAINTY

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Risk and Uncertainty
3.1.1 Risk
3.1.2 Uncertainty
3.1.3 Adjusting for risks and uncertainties
3.2 Asset Replacement Decisions
3.2.1 Identical Replacement
3.2.2 Non-Identical Replacements
3.2.3 Where no cost of capital is given
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

In this unit we will be discussing Risk and Uncertainly as relevant issues in investment
appraisal with reference to individual project uncertainty, the decision makers’ attitude
to risk and the diversification effect

2.0 OBJECTIVES

In this unit, readers will be able to understand:

 The terms risk and uncertainty;

 Payback, risk premium and finite horizon methods;
 The application of probability in project appraisal;
 The calculation and explanation of expected value;
 The terms standard deviation and coefficient of variation as measures of risk
and their limitations;
 The construction of a decision tree when there is a range of alternatives and
possible outcomes.
 The description and calculation of the value of perfect and imperfect
information;
 The maximin, maximax and regret rules;
 Sensitivity analysis and its application to project appraisal; and
 Portfolio analysis and its implication for project appraisal;
 Asset replacement decisions.
3.0 MAIN CONTENT

299
3.1 RISK AND UNCERTAINTY

In capital budgeting decisions, it is assumed that the variables and estimates 'used are
known with certainty However, under the risk and uncertainty situations, we are faced
with the fact that the actual returns that will be realised from a project may differ from
the expected return (usually NPV) on which we have based our decision. The risk is
that, we may have accepted a project that should have been rejected or rejected a
project that should have been accepted. Furthermore, another problem that may be
solved by incorporating risk and uncertainty is the estimation of errors needed in
determining the risk factor.

Based on the above, there will be need for us to define the elements of risks and
uncertainty as well as the techniques used in adjusting for such risks and uncertainty in
long term decision making processes especially when projects are to be rejected or
accepted.

3.1.1 Risk

A risk is a situation in which we do not know exactly the occurrence of future

uncertain events but we can quantify the possibilities of such future events. The
quantification of occurrence of such events is usually called PROBABILITIES.
However for long term decision making, such future events can be categorised into;
(a) Cash flows
(b) Project lives.
(c) Cost of capital.

3.1.2 Uncertainty

An uncertainty is a situation in which we cannot quantify the probability or possibility

of occurrence of such future events. Therefore, the inability to be able to quantify the
possibility of occurrence may be as a result of lack of experience in that area of
business or absence of research data in that area.

The above distinctions between risks and uncertainty is purely theoretical and would
not affect our methods for adjusting or incorporating risks and uncertainties in long
term decisions. The reason, is that most long term projects will have elements of both
risks and uncertainties.

3.1.3 Adjusting for risks and uncertainties

Any of the following methods can be used to adjust for risk and uncertainty in long
term projects;
(a) Accounting Rate of Return Adjustment (ARR)
(b) Payback Adjustment
(c) Finite Horizon Method

300
(d) Risk Premium Method
(e) Expected Value Approach or Probability Theory
(f) Risk Analysis
(g) Sensitivity Analysis
(h) Simulation Analysis
(i) Pay-Off Matrix
(j) Decision Tree
(k) Portfolio Theory.

A discussion of the methods in turn are as follows; however, a

knowledge of capital budgeting is assumed for the first four methods.

(a) ARR Adjustment Method

Under this method, projects that are considered risky are evaluated by using a
higher ARR than the normal ARR for the company, for example, if a company
usually evaluates projects at an ARR of 30%, it may evaluate risky projects at
40%.

(b) Payback Adjustment Method

Like in the method above, risky projects would require a more stringent
condition, that is, risky projects would meet a payback period that is shorter
than the company's normal payback period e.g. if a company usually evaluates
projects using a three year payback period, risky projects may be required to
payback within two years.

(c) Finite Horizon Method

This method involves evaluating a project that is considered risky within a
reduced number of years that the appraiser will be comfortable with. This
reduced number of years is usually called the FINITE HORIZON or the
foreseeable future. The assumptions for using this method are the following:
(i) Cash flows of future years for conventional projects would
normally be the net cash in-flows.
(ii) Our inability to forecast cash flows of distant future years
is unavoidable.
(iii) The present values of such distant future cash flows will be insignificant
or immaterial since they will tend to zero, for example, a project with a
ten year life-span may be evaluated with cash flows of only the first five
years.

(d) Risk Premium or Risk Adjusted Discount Rate Method

In this case, the adjustment for risk is done on the cost of capital. Risky projects
will then be evaluated at a cost of capital that will be higher than the company's
normal cost of capital, for example, if the company's normal cost of capital is
10% per annum, then, a risky project may be evaluated at 15% per annum cost
of capital. The difference between the company's normal cost of capital and the
risk adjusted cost of capital is known as the RISK PREMIUM which in this

301
case is 5%, that is, (15% -10%). Readers should refer to chapter 10 for a full
understanding of the concept of cost of capital.
(e) Expected Value Approach or Probability Theory Method
Decision making under risk generally involves the use of probability, and by
probability, we mean the likelihood of an event occurring. The values of
probabilities range between 0 and 1 and the higher the probability the more
likely or certain the occurrence of that event. Basically, there are two major
types of probability namely:
(i) Objective probability: by this we mean, the frequency of the
occurrence of an event if repeated several times over, for example, the
probability of having a "3", when a fair dice is cast is 1/6th.
(ii) Subjective probability: they are probabilities based on the decision
makers' personal experience, guesses, judgement and initiatives. This is
due to the fact that, most business problems are not repeatable in nature
and, therefore, the rate of frequency of the occurrence of that event
cannot be easily determined. In using this method, probabilities are
already attached to a stratified form of the variable, that is, the variable
would be broken down for each period into units or strata which a
question can also refer to as states of the world or possibilities.

However, whenever probabilities are attached to variables, the weighted

average of those variables must be used in the quantification of any
decision to be arrived at under a given circumstance. In calculating the
weighted average, the weights to be attached will be the respective
probabilities of each unit. The weighted averages for the variables are
known as EXPECTED VALUES. Thus, this expected value would be
used in the normal discounting technique to arrive at an expected net
present value (NPV). The expected net present value is considered to be
a risk adjusted net present value (NPV).

The advantages of probability theory in decision making are:

(i) A constructive effort is made to deal with uncertainty or forecasting of specific
output or event.
(ii) It assists in achieving a better result in the preparation of realistic budget which
would be of assistance to management.
(iii) Questioning of budget variables lays a better foundation for the control of
actions and cost.
(iv) The final figure may be more acceptable to management approving the budget
or expenditure because management may see it as the outcome of a more
considered management process.

The examples below are used to illustrate the application of

the techniques of adjusting for risk on investments or projects.

ILLUSTRATION 14 – 1

302
(a) Kosalabaro Plc can introduce one new product with its range of products next
year. The extra cost will be N750,000 for either product x and y. The selling
price of X would be N20 and for Y, N25. The variable costs would be N10 and
N13, respectively.

From past experience with similar products, the demand probabilities have been
estimated at:

Demand in units Probabilities

X Y
50,000 0.2 0.1
75,000 0.4 0.2
100,000 0.3 0.4
125,000 0.1 0.3
1.0 1.0

You are required to compute the breakeven point for each product and advise with
reasons, which product should be chosen.

(b) Three choices are being considered for honouring a two year free service
guarantee. Your company had an offer to obtain the sale of 2,000
communication sets to a hotel group. The choices are;
(i) Do the servicing with own staff based on past experience, the costs will
be:

Probability of Event of Total Cost

Occurrence Servicing (N)
0.30 Very little trouble
(500 Calls/year) 7,000

0.50 Usual trouble

(1,000 Calls/year) 12,000

0.20 A lot of trouble

(1,500 calls/year) 25,000

(ii) Sub contract to firm K who has quoted a fixed cost of N14,000 plus N2
for each visit in excess of 750 visits over the two year period.

(iii) Sub-contract to firm P who has quoted a fixed cost of N16,000 plus.

You are required to advise the management on the choice they should adopt. Justify
your recommendations.

SUGGESTED SOLUTION 14.1

303
(a) Calculation of BEP for product X and Y are as follows:
BEP in units = Fixed Cost or FC
Contribution Per Unit C/U
OR
BEP in N sales = Fixed cost or FC
Contribution Margin Ratio CMR

Products X Y
BEP Sales in units 750,000 750,000
20 – 10 25 – 13
= 75,000 units 62,500 units
CMR = 10/20 12/25
= 0.5 0.48
BEP in N sales = 750,000 750.000
0.5 0.48
= N1,500.000 N1,562,500

EXPECTED DEMAND

PRODUCT X
Units Probabilities Expected Demand
50,000 0.2 10,000
75,000 0.4 30,000
100,000 0.3 30,000
125,000 0.1 12,500
82,500

PRODUCT Y
Units Probabilities Expected Demand
50,000 0.1 5,000
75,000 0.2 15,000
100,000 0.3 30,000
125,000 0.4 50,000
100,000

ADVICE:
Product Y should be chosen because of the following reasons:
(1) It reports a higher contribution margin
(2) There is a higher margin of safety
(3) There is a higher expected demand
(4) There is lower breakeven point.
(b) (i) Use own staff

Total Cost Probabilities Expected Demand

N N

304
7,000 0.3 2,100
12,000 0.5 6,000
25,000 0.2 5,000
13,100

(ii) Sub-Contract to firm K

N
Fixed Cost 14,000
Variable Cost 2,300
16,300
Note: Variable costs are determined thus:

No. of Visits Probabilities Expected Visits

500 0.3 150
1000 0.5 500
1500 0.2 300
Expected Visits 950

For 2 years (950 x 2) = 1,900

Less visits for 2 periods 750
1,150
Excess visits 1150 x N2 = 2,300

(iii) Sub-contract to firm P – N16,000 plus

Decision – Management should use own staff as they would incur the lowest
cost of N13,100 as against the other alternatives.

The following are the advantages and disadvantages of the Expected value approach to
decision making.

Advantages of Expected value Approach

(a) It is simple to understand and easy to calculate
(b) It takes account of expected variability of all outcomes
(c) It represents the whole distribution by a simple figure
(d) It leads directly to a simple optimizing decision rule.

Disadvantages of Expected Value Approach

(a) It makes a general assumption that the decision maker is risk neutral
(b) It is in itself meaningless, only by coincidence will it be an actual outcome.
Infact, it is not an expected value, but more of a weighted average.
(c) By asking for a series of forecast, the forecasting procedure is complicated and
infact inaccurate forecasting is a major weakness in most business decisions.
(d) By representing the whole distribution by a single figure, it ignores the other
characteristics of the distribution.
(f) Risk Analysis

305
This method measures the risks in projects through an examination of the
standard deviations. Harry Markowitz in his article “Portfolio Selection”
equated risk to standard deviation. The argument being that decisions on long
term projects where probabilities are attached are based on the expected values.
The expected value is a central measure under a normal distribution. It follows,
therefore, that deviations from the mean will capture the risks in projects which
is the inaccuracy of our decisions.

Standard deviation (SD) can be measured as follows:

SD of cash flows =
2
where variance = (x1 – 1) P1

Therefore, SD = = –

where x = each possible outcome

= expected or mean outcome
p = probability attached to each outcome
The rule is, the higher the standard deviation, the higher the risk.

The major problem with using standard deviation as a measure of risk is that it
does not recognize differences in sizes or scales of projects. The reason is that
standard deviation is not a relative measure of dispersion.

A more perfect measure is the co-efficient of variation.

The co-efficient of variation = =

The rule remains, that is, the higher the co-efficient of variation (COV) the
higher the risk. It is clear that the correct way to measure risks among projects
if the expected value or scales are not the same is the co-efficient of variation
(COV).

(g) Standard Deviation of Projects

The discussions on projects will normally be based on NPV rather than cash
flows. For this reason, it is more relevant to calculate the risk on a project by
calculating the standard deviation of NPV rather than standard deviation of cash
flows. The standard deviation of NPV of a project can be calculated through the
stream of cashflows in a project as follows:

(a) If the cash flows are dependent annually, the standard deviation of NPV
of a project is:

306
SD of NPV = S = + + + --- + n

Where  = standard deviation of cash flows

The cash flows are considered dependent, if each years’ cash flow will
occur on the basis of a particular level in previous years of will influence
future level of cash flows.

(b) However, where cash flows are independent annually, the standard
deviation of the project will be calculated as below:

SD of NPV of Project = 1
n
n
2
S = + + + --- +

Where = S(x – x)2 P the variable of each year’s cash flows.

The example below can be used to illustrate the operation of this method.

ILLUSTRATION 14 – 2

Omoba Aseye Enterprises Limited has two investment options, each of which involves
an initial outlay of N3,000 and an expected life of 3 years.
Annual net cash flows from each project being one year after the initial investment is
made and have the following probability distributions.

State of the World Probability Annual net cash flows

(N)
Project A i 0.2 2,400
ii 0.6 3,000
iii 0.2 3,600
Project B i 0.2 2,400
ii 0.6 3,000
iii 0.2 3,600

(a) What is the expected value of the annual cash flow from each project?

(b) What is the risk adjusted net present value of each project if the company
has decided to evaluate the riskier project at 10% and the less riskier
project at 8%.

SUGGESTED 14 -2

(a) The expected value of the annual cash flow are determined as follows:

PROJECT A PROJECT B
State of Probabilities Cash Expected Probabilities Cash

307
Expected
the world Value Flows Value Value Flows
Value
N N N N
i 0.2 2,400 480 0.2 0 0
ii 0.6 3,000 1,800 0.6 3,000 1,800
iii 0.2 3,600 720 0.2 7,500 1,500
Expected annual cash flow 3,000 Expected Annual Cash flow 3,300

(b) PROJECT A
SD of cash flows = S(x – x)2 P

X P XP X– (X – (X –
2400 0.2 480 (600) 360,000 72,000
1000 0.6 1,800 - - -
3600 0.2 720 600 160,000 72,000
= 3,000 144,000

Therefore, standard variation = = 379

Therefore, Co-efficient of variation = 379
3,000
= 0.126 = 12.60%
PROJECT B

X P XP X– (X – )2 (X – )2 P
0 0.2 0 (3300) 10,890,000 2,178,000
3000 0.6 1,800 (300) 90,000 54,000
7500 0.2 1,500 4,200 17,640,000 3,528,000
= 3,300 5,760,000

Therefore, standard variation = = 2,400

Therefore, Co-efficient of variation = 2,400
3,000 = 0.727
= 72.7%

From the computations above, Project B is riskier than Project A. Therefore, the risk
adjusted net present value can be determined thus:

PROJECT A
Year Cash Flows DCF @ 8% PV
N N
0 (3,000) 1 (3,000)
1–3 3,000 2,577 7,731
ENPV 4,731

PROJECT B
308
Year Cash Flows DCF @ 10% PV
N N
0 (3,000) 1,000 (3,000)
1–3 3,300 2,487 8,207
ENPV 5,207

(h) Sensitivity Analysis

Sensitivity Analysis is a term used to describe any technique whereby decision
options are tested for their vulnerability to adverse changes in its constituent
“variables” such as expected sales, volume, sales per unit, material cost, labour
cost, etc.

In practice, many companies try to resolve some of the risks in projects by

applying sensitive analysis to the major component of the project. The aim is to
quantify the impact of changes in the variables of a project on the decision.
Since decisions are always based on NPV and ultimately change our decisions.

If the percentage change that will affect our decision is very small, then the
project will be considered very sensitive to the particular variable being
examined. A major advantage of sensitivity analysis is that it will identify the
key variables of a project before a decision is taken and with this, management
will take a more accurate decision. Secondly, it makes the management to be
more accurate decision. Secondly, it makes the management to be more
conscious of the errors and dangers in incorrect estimations. Finally, it will
enable the management to make contingency plan should the sensitive changes
occur.

However, a major problem with the sensitivity analysis is the fact that the
variables of a project are inter-related in many cases. Therefore, it does not
make much sense to examine in isolation the effect of changes in a particular
variable only. Nonetheless, many companies try to cope with this problem by
examining a combination of related variables and in this way, they look at
different scenarios. But where the number of variables and interrelationships
are large or complicated, it may be better to use simulation analysis. There are
two (2) popular ways of analyzing the sensitivity in project as follows:

(a) The first method involves changing the values of different project
variables arbitrarily and checking the effect of those changes on our
decisions (NPV).

(b) Alternatively, we may want to calculate the percentage change in a

variable that would change our decision. As a guide, the following
definitions may apply:

(i) Sensitivity of a project to cash flows is determined thus:

NPV of the Project x 100

309
PV of the Cash flow

(ii) Sensitivity of a project to cost of capital can be thus:

IRR - Cost of Capital x 100
Cost of Capital

(iii) Sensitivity of a project to the life of the project is thus:

Project Life – BEP of Project Life x 100
Project Life

The example below is used to illustrate the application of the above method as that
used in adjusting for risk in projects.

ILLUSTRATION 14 – 3

A project costing N20,000 is expected to last four years. Annual sales and related
costs are shown below:

N N
Sales (50 Units) 21,500
Direct Material 4,000
Direct Labour 3,000
Direct Factory Overhead:
Variable 1,500 8,500
Contribution 13,000
Fixed Cost 5,000
Annual Profit 8,000

Required:
(a) Calculate the project’s NPV
(b) Prepare a statement showing how sensitive the NPV is to errors of estimation in
each component of your calculation in (a) above, namely:
(i) Annual Sales Volume
(ii) Unit selling price
(iii) Direct material cost
(iv) Direct Labour cost
(v) Variable overhead
(vi) Annual fixed costs
(vii) Initial Outlay
(viii) Product Life
(ix) Cost of Capital

SUGGESTED SOLUTION 14 – 3

(a) The project’s NPV is determined thus:

310
Year Cash Flows DCF @ 10% PV
N N
0 (20,000) 1,0000 (20,000)
1–4 8,000 3,1699 25,359
Net Present Value N5,359

The project should be accepted since it has positive NPV of N5,359

(b) (i) Sensitivity of annual sales volume

NPV x 100
DCP contribution 1

5359 x 100 = 13%

13,000 3,1699

The annual sales volume must not fall below 13% otherwise the project will be
unacceptable.

(ii) Sensitivity of unit selling price:

NPV x 100 = 5,359 x 100

DCF of Sales Value 1 21,500 3,1699
= 7,86% = 8%

The unit selling price must not decrease below 8% otherwise the project
becomes unacceptable.

(iii) Sensitivity of direct material cost

x = x = 42%

The direct cost must increase by more than 42% otherwise, the project becomes
unacceptable.

(iv) Sensitivity of Director Labour Cost

x = x = 56%

The direct labour cost must not increase by more than 56%.

311
(v) Sensitivity of variable overhead cost
x = x = 112%

The variable overhead cost must not increase beyond 112%

(vi) Sensitivity of fixed overhead cost

x = x = 34%

(vii) Sensitivity of Initial Outlay

x = x = 27%

The initial outlay must not increase more than 27% for the project to be
acceptable.

(viii) Sensitivity of product life

NPV @ 3 years
Year Cash Flows DCF @ 10% PV
N N
0 (20,000) 1 (20,000)
1–3 8,000 2,4869 19,895
NPV (105)

3 years + 105 x 1 = 105 = 3 + 0.02 years

5,359 + 103 5,464
= 3.02 years.
Therefore, 4 – 3.02 x 100 = 24.5%
4

The product life should not fall by more than 24.5%, that is, 9 months of project
life. Otherwise, the project becomes unacceptable.

(ix) Sensitivity of Cost of Capital

The IRR is calculated rist thus:

Year Cash Flows DCF @ 10% PV

N N
0 (20,000) 1 (20,000)
1–4 8,000 2,855 22,840
+ NPV 2,840

Try DCF @ 20% N

312
0 (20,000) 1 (20,000)
1–4 8,000 2.5887 20,710
+ NPV 710

Try DCF @ 25% N

0 (20,000) 1 (20,000)
1–4 8,000 2,3616 18,893
+ NPV 1,107

IRR = 10 + 5,359 x 15% (25% - 10) – 24.36%

6,466

The cost of capital must not increase by more than 14.36% or the cost of capital
should not be more than 24.36% otherwise the project will become
unacceptable.

(i) Simulation Analysis

Simulation analysis is fashioned after Monte-Carlo simulation which is based
on the idea of taking random samples from mathematical models that represent
a real life system. However, the use of this method involves establishing a
probability distribution for each of the variables that make up the model.
Basically, from the distribution of values, one particular value is selected at
random whereby the individual values selected are therefore combined and used
to determine the appropriate decision.

Uses and Applications of simulation Technique

The technique is applicable to decision making situations as follows:
(a) It can be used in determining stock requirements, for example; Canteen,
filling station etc.
(b) It can be used to determine the optimal number of facilities in complex
sequence situations e.g. production scheduling.
(c) It is very useful in evaluating alternative investment policies.
(d) It can be used to determine optimum stock levels in situations involving
a variation of supply and demand.

Advantages of Simulation Technique

(a) It enables various alternatives to be deeply examined.
(b) The degree of assumption is not as great as it is with analytical method.
(c) It provides a means of solution for problems which are of a kind and for
which the application of analytical method is unsuitable.

Disadvantages of Simulation Technique

(a) It is non-optimizing instead a good enough solution is obtained
(b) It involves the use of computers which is above the reach of many firms.
(This technique can be used to illustrate how decisions can be taken as in
the example below):

313
ILLUSTRATION 14 – 4

Ugochukwu Nigeria Limited is considering the following investment opportunities;

The project is expected to have a life of two years. Estimate of initial outlay is as
follows:

ESTIMATED PROBABILITY
Initial Outlay
(N)
200,000 0.25
250,000 0.40
300,000 0.35
The volume of sales in the years is estimated as follows:

Year 1 Year 2
Volume (In Units) Probability Volume (in Units) Probability
500,000 0.24 400,000 0.30
600,000 0.60 560,000 0.50
800,000 0.16 600,000 0.20

The volume in Year 2 is independent of volume achieved in Year 1. The contribution

per unit is also subject to uncertainty and the following probability distribution is
assumed.

Contribution per unit Probability

(N)
0.30 0.l5
0.50 0.58
0.80 0.27

Cost of capital is 10%

Required:
Carry out a simulation of the above project and determine whether or not the
project should be accepted. Random number digits to be used for the various
outcomes are 935381, 03882322, 9679061494. The use of these random
number is to start with the initial cost, followed by volume in Year 1, followed
by volume in Year 2 and then contribution – Strictly in That Order.

SUGGESTED SOLUTION 14 – 4

Simulation of the project is calculated as follows:

(a) Initial Outlay

Cost Prob. Cum Prob. Allocation of

314
N Random Numbers
200,000 0.25 0.25 0 – 24
250,000 0.40 0.65 25 – 64
300,000 0.35 1.00 65 – 99

(b) Volume in Year 1

Volume Prob. Cum Prob. Allocation
500,000 0.24 0.24 0 – 23
600,000 0.60 0.84 24 – 83
800,000 0.16 1.00 84 – 99

Volume Prob. Cum Prob. Allocation

400,000 0.3 0.3 0 – 29
560,000 0.5 0.8 30 – 79
600,000 0.2 1.00 80 – 99

Volume Prob. Cum Prob. Allocation

0.3 0.15 0.15 0 – 14
0.5 0.58 0.73 15 – 72
0.8 0.27 1.0 73 – 99

Year Cash Flow DCF @ 10% PV

N N
0 (300,000) 1.0 (300,000)
1 180,000 0.9091 163,638
2 180,000 0.8264 148,752
+NPV 12,390

Decision:
The project should be accepted since it has a positive net present value of N12,390.
Note: The cash inflow of constant amount in the two years is derived thus:

Year 1 Volume of 600,000 x 0.3 (contribution per unit) = N180,000

Year 2 Volume of 600,000 x 0.3 (contribution per unit) = N180,000

Therefore, N180,000 is the contribution on the sales volume of the respective years.

(1) Pay-off Matrix

When a decision maker is under a complete uncertainty, that is, the probability
of occurrence of non-occurrence of the event cannot be quantified, then any of
the following decision criteria could be used:
(i) Maximax Decision Rule: The decision maker believes that the best out
of the best possible outcomes will always happen to him. This is the
decision rule of an optimist.

315
(ii) Maximin Decision Rule: Under this situation, the decision maker
believes that the best out of the worst possible outcomes will always
occur. This is the decision rule of a pessimist. The shortcoming of the
maximax and maximin criteria is that they both fail to account for the
uncertainty inherent in the decision making problem, that is, they ignore
the likelihood or the probability of the various events occurring.

(iii) Minimax Regret Rule: Here, the decision maker believes in

minimizing the possible maximum opportunity cost to be suffered or
incurred. Example is a military strategist who wants to win a war with
minimal casualty.

Concept of Value of Perfect Information

Generally, information has no value, unless it is used to change the course of events.
Therefore, perfect information, is an information that will predict what will happen
with 100% certainty. In most cases, when a decision maker opts to obtain information,
he does not know in advance what the information will tell him about the future
outcomes, but, he does know that whatever the information turns out to be, he can rely
on it completely with 100% accuracy.

Imperfect information on the other hand, only adds to what the decision maker knows,
but the information cannot be relied on for accuracy with 100% certainty. The
information might be wrong, but whether it is right or wrong, can only be judged later
in retrospect. Therefore, the decision maker has no option but to act on the
information as though it is accurate.

The value of information can, therefore, be quantified only if it is going to change the
course of event and the value, therefore, is the expected value of benefits that
information might provide to the decision maker by making him change his mind from
what it would have otherwise been and so choose a different alternative.
Therefore, in order to determine the Naira value of perfect information, the following
need to be determined.
(a) Expected value based on perfect information
(b) The optimal expected value under risk
(c) A comparison of the two i.e. (a) and (b) above.

3.2 ASSET REPLACEMENT DECISIONS

This decision area is also referred to as Optimum Replacement Theory. In asset

replacement decision, we concentrate on productive machine and expect that all other
assets can have replacement decision model in a similar manner. We evaluate the
relevant cash flows associated with the replacement cycles and period of the assets.
This involves striking an ideal balance between the cost and advantage of early
replacement against the cost and advantage of later replacement. However, the
following concepts should be properly explained:

316
(a) Replacement Cycle: This covers the frequency of replacement of an asset with
an implied assumption that the asset will be put to continuous usage over an
indefinite period, for example, if an asset has a three year life span, we can
replace it every year, or every two years or every three years. Therefore, these
options are referred to as replacement cycle.

(b) Replacement period: This relates to a point in time for discontinuing usage of
an existing asset. It relates mainly to old assets that are being replaced with
new assets that are unidentical, for example, if an existing asset with a
remaining life span of three years is to be replaced with a new non-identical
type, it means that we can replace the old asset now or after one year, or after
two years or after two years or after three years. Therefore, these options are
referred to as replacement period for the old asset.

Assets are considered to be identical if cash flows streams and the life span of
the assets are the same, even though the assets need not be physically identical,
that is, we are concerned with financially identical asset. Whereas, non-
identical assets are those that are not financially identical i.e. replacement of an
old asset with a new asset that is not financially identical.

The above issues form the basis for taking decisions when assets are to be
replaced or decision taken on them for replacement purposes.

3.2.1 Identical Replacement

As earlier mentioned, this involves the replacement of existing assets with new assets
that are financially identical with existing ones. Our decisions are normally based on
replacement cycle (replace every year, every two years, every three years, etc.) that
provides the least present value of cost of the highest present value of revenue.

However, for the purpose of making the decisions, the following methods can be
adopted:
(a) Least Common Multiple method:
(b) Finite Horizon method; and
(c) Annual Equivalent Cost Method.

(a) Least Common Multiple Method (ICM)

This method examines the cash flows of all possible cycle of the machine over
an equal number of years. This period is usually the least common multiple
(LCM) of all cycle, for example, for a machine that has a life span of four
years, we can choose to replace it every year, every two years, every three years
or every four years.

The LCM approach required the examination of the relevant cash flows of these
cycle over a period of twelve years. The cycle with the least present value, of
cost or highest present value of revenue would be chosen.

317
A major draw back of this method, is that an asset with a long life span will
require computation over a very long period, for example, if the LCM of a
seven year period is four hundred and twenty years.

(b) The Finite Horizon Method:

This method examines cash flows of all cycles over a foreseeable period. This
period is normally the length of time within which the company’s financial
management team can generate reliable estimates. As a result of availability of
decision makers to accurately forecast the distant future cash flows and the fact
that the present value of such future cash flows will tend to zero, a company
will only evaluate replacement decisions over a specified period of time, for
example, an asset that has a life span of eight years, may be evaluated on the
cycle of the cash flows for the first ten years.

A major drawback of this method is that the choice of the foreseeable future or
the finite horizon is subjective and varies among decision makers.

(c) Annual Equivalent Cost Method (AEC)

This is the most popular of all the asset replacement techniques and it consists
of the following steps.
(a) identify the relevant cash flows for the relevant cycle (every year, every
two years etc) of the asset.
(b) Calculate the present value of each cycle
(c) Calculate the annual equivalent cost of revenue for each cycle, thus:

AEC Present value of each cycle

Cumulative discount factors (annually factors) for each year

(d) The optimal replacement cycle is the cycle with the least annual equivalent cost
or the highest annual equivalent revenue.

Remember that the equivalent annual method is recommended especially where there
is no inflation, as it is quicker and less cumbersome than any of the previous two
methods described above. The identical replacement decision is illustrated in 14.10 as
follows:

ILLUSTRATION 14 -5

Isaac Boro Limited with a fleet of 20 motor vehicle is considering its vehicles
replacement policy. Under an existing policy, the fleet is exchanged every three years.
In addition, to the trade in values, a discount of 5% is given from the list of the
replacement vehicles.

318
The company is considering an offer from another motor dealer which gives allowance
of 100% of the total cost price for companies exchanging their vehicle annually. A
guarantee covering repairs and breakdown is also included in the offer. The
company’s cost of capital is 10%.
(1) Cost Price of each vehicle is N2,200
(2) Estimated trade in value of each vehicle
After Per Vehicle
N
12 Months 1,600
24 Months 1,200
30 Months 1,000

(3) Estimated annual repairs and running costs:

Year Per Vehicle
N
1 50
2 100
3 200

As the Management Accountant of the company, you are required to determine, from
the above estimates of the vehicle trade in values and repair costs whether the
company should adopt the new policy of changing their fleet of vehicle each year.

Note: Ignore taxation.

SUGGESTED SOLUTION 14 -5

Replace every three years

Year Cost DCF @ 10% PV
N N
0 (41,800) 1,0000 (41,800)
1 (1,000) 0,9091 (909,1)
2 (2,000) 0,8264 (1,653)
3 (4,000) 0.7513 (3,005)
4 20,000 0.7513 15,026
+ NPV 32,341.1

Replace every year

Year Cost DCF @ 10% PV
0 (39,600) 1,0000 (39,600)
1 - - -
1 32,000 0,9091 29,091
NPV 10,509

319
Annual Equivalent Csot (AEC) = NPV = Net Present Value
AF Annuity Factor

AEC
Ever 3 years: = NPV = (32,341)
Annuity Factor (AF) for 3 years = 2,4868
Therefore, AEC = (32,341) = N(13,005)
2,4868

Every 1 year:
NPV = N10,509
AF for 1 year = 0.9091
Therefore, AEC = 10,509 = (N11,509)
0,9091

The company should change policy and replace annually since it results in a saving in
cost of N2,496, that is, (13,005 – 10,509).

Workings:
(i) For replacement every 3 years.
Year 0 cost flow = 2,200 x 20 x 95% (100 – 5) = 41,800
Year 1 repairs and running costs = N50 x 20 = N1,000
Year 2 repairs and running costs = N100 x 20 = N2,000
Year 3 repairs and running costs = N200 x 20 = N4,000
Year 3 scrap value = N1,000 x 20 = N20,000

(ii) For replacement every 1 year

Year 0 cost flow = 2,200 x 20 x 90% (100 – 10) = 39,600
Year 1 Scrap Value = 1,600 x 20 = N32,000

3.2.2 Non Identical Replacements

In this case, we are examining the replacement of existing assets (machines) with new
assets that are not financially identical. The question will no longer be how often do
we replace the machine. The relevant question will be when do we replace the old
(existing) machine. For instance, if the old machine can still be used for two more
years, we need to identify the optimal replacement period for these old machines. The
possible replacement period will be to replace the old machine now, or after one year
or to replace the old machine after two years.

The basic assumption in this case derivable from the going concern is that the new
machine would be replaced indefinitely with identical machine. Therefore, we must
always determine first the optimal replacement cycle for the new machine. Because of
this assumption of indefinite replacement for the new machine, the relevant cash flow
for the machine will be a perpetuity of the optimal replacement cycle that is equal to
AEC/r where ‘r’ is the cost of capital.

320
Steps for Non-Identical Replacements
(a) Identify the optimal replacement cycle for the new machine.
(b) Calculate the NPV of the relevant cash flows of each replacement period of the
old machine (replace now or after one year etc).
(c) To arrive at the NPV in (b) above, you must incorporate at the end of each
replacement period, the cost of the new machine (assets). This cost is equal to
the perpetuity (Annual Equivalent Cost)/r.
(d) The optimal replacement period for the old machine is that period that produces
the lowest NPV of cost or highest NPV of revenue.

3.2.3 Where no cost of Capital is Given

Where no cost of capital is given, we are not to assume any cost of capital. It means
that time value of money has been ignored or that there is a zero% of cost of capital.
In this case, our decision will be based on the average cash flow concept, therefore, the
following steps would be involved.

(a) Identify the relevant cash flow for each cycle or period
(b) Add the relevant cash flows for each cycle or period.
(c) Calculate the average cost or average revenue for each cycle or period. The
average costs is equal to:
To cash flows for each cycle
Number of years in each cycle
(d) Optimal replacement cycle or period is that cycle which produces the least
average cost or highest average revenue.

ILLUSTRATION 14.5

Baguda Rentals Limited estimated the following cost possible for “Workaholic”, one
of its equipment costing N57,200.

Age (Years) 1 2 3 4 5 6
N N N N N N
Annual Running Cost 8,800 9,900 11,000 13,200 15,400 19,250
Resale Price 44,000 34,100 27,500 24,200 20,900 18,150

(a) At what point should Baguda Rentals Limited replace “Workaholic”.

(b) Assuming the “Workaholic” will be on hire for 120 days per annum and that
Baguda wants a minimum annual return of 25% on the initial cost of the
equipment, what will be the minimum daily hire rate?

SUGGESTED SOLUTION 14 – 5

321
(a) (a) (b) (c) (d) = (c)/(a)
Year Net Cash Cumulative Average Annual
flow NCF NCF NCF
N N N
1 22,000 22,000 22,000
2 19,800 41,800 20,900
3 17,600 59,400 19,800
4 16,500 75,900 18,975
5 18,700 94,600 18,920
6 22,000 166,600 19,433 *minimum

Decision:
(a) Baguda Rentals Limited should replace workaholic at the end of year 5, when
the average annual NCF is least.

(b) In order to achieve the minimum return of 25% throughout the life of
“workaholic” we have to select the highest daily rental which is N302.50. This
incidentally occurs at years 1 and 6.

Workings:
(a) Since the company’s cost of capital is not given. It is assumed that the
replacement of the equipment will be at the point in time when the average
annual net costs now is minimum

(b) The net cash outflow (NCF) = depreciation + running costs where the
depreciation in this case is the difference in cost price between what the asset
can be sold for at the beginning of the year and what it can be sold for at the
end of the same year, for example, for year 1, depreciation is N57,200 –
N44,000 = N13,200 etc.

(c) The calculation of the NCF for each year is as follows:

Age (years) 1 2 3 4 5 6
N N N N N N
Value at beginning
of age 57,200 44,000 34,100 27,500 24,200 20,900
Value at end of age 44,000 34,100 27,500 24,200 20,900 18,150
Depreciation (a) 13,200 9,900 6,000 3,300 3,300 2,750
Annual running
cost (b) 8,800 9,900 11,000 13,200 15,400 19,250
Total cost (a + b) 22,000 19,800 17,600 16,500 18,700 22,000

(d) It is assumed that all costs accrue at the end of the year.
(e) The minimum return of 25% on the initial cost of N57,200 is 0.25 x 57,200 =
N14,300.

322
The sum is added to NCF for each year to arrive at minimum annual revenue
for the respective years. These minimum annual revenues are divided by 120
days to arrive at the minimum daily hire rate as follows:

Age (years) 1 2 3 4 5 6
N N N N N N
NCF 22,000 19,800 17,600 16,500 18,700 22,000
Minimum Return 14,300 14,300 14,300 14,300 14,300 14,300
Minimum Revenue 36,300 34,100 31,900 30,800 33,000 36,300
Minimum Daily
Rental 320,50 284,17 265,83 256,67 275,00 302,50

4.0 CONCLUSION

Risk and uncertainly are relevant issues to be considered in investment appraisal with
reference to individual project uncertainty, the decision makers’ attitude to risk and the
diversification effect.

5.0 SUMMARY

Various methods are available for taking care of risk and uncertainly and they include:
sensitivity analysis, simulation, finite horizon, expected value, decision tree, risk
analysis, pay-off matrix, risk premium, adjusted ARR, adjusted payback, asset
replacement decisions, and portfolio theory.

6.0 TUTOR MARKED ASSIGNMENT

1. Risk adjusted discount rates for a firm can be calculated using

A Net present value
B Internal rate of return
C Capital rationing
D Capital asset pricing model
E Accounting rate of returns.

2. In calculating equivalent annual cash flow the formular is

A Present value of revenue
Annuity factor of N years at R%

B Present value of total cost

Present factor for N years at R%

C Present value of costs

Annuity factor for N years at R%

D Present value

323
Present factor

E Present value of costs

Present factor

3. A division within the Wazobia Plc considering whether to undertake a project

that will cost N1 million and will have the following cash inflows:
Year I N600,000
II N400,000
III N1,000,000
The cost of capital is 10%. The net present value is
A + N617,500
B + N637,500
C + N637,320
D + N627,320
E + N647,320

Use data below to answer questions 4 and 5.

Expected value of a product is 7,800 units. The net positive present value is
N10,470. The break-even point is 7,200 units and the cost of capital is 10%,
while the capital outlay is N40,000.

4. Sensitivity to sales volume is

A 7.7%
B 10.7%
C 7.5%
D 8.5%
E 8.4%.

5. Sensitivity of cost of capital is

A 25.5%
B 26.2%
C 25.9%
D 26..5%
E 26.8%

6. What is the formula for standard deviation?

7. A term used to describe any technique whereby decision are tested by their
vulnerability to changes in any variable is known as_____________

8. The standard deviation of project A is N3,500 and its expected value is N6,000
while standard deviation of project B is N4,500 and its expected value is
N12,500, which project should be accepted using coefficient of variation as
decision model.

324
9. Distinguish between risk and uncertainty?

10. The sales demand of a product are as follows:

10,000 units 0.3
20,000 units 0.4
50,000 units 0.2
100,000 units 0.1
Selling price per unit is N20 and variable cost is N6. What is the total
contribution of the product?

7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

UNIT 15 DIVISIONAL PERFORMANCE EVALUATION

CONTENTS

325
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of Decentralisation
3.1.1 Advantages of Decentralisation
3.1.2 Disadvantages of Decentralisation
3.2 Decision Areas Retained by Top Management
3.3 Decision Areas Delegatd to other Levels of Manageme
3.4 Responsibility Accounting
3.5 Cost Centre
3.6 Profit Centre
3.7 Investment Centre
3.8 Characteristics of Cost, Profit and Investment Centres
3.9 Measures of Divisional Performance
3.10 Return on Capital Employed (ROCE)
3.11 Absolute Divisional Profit
3.12 Residual Income (RI)
3.13 Performance Appraisal in Multi-National Organisations
3.14 Performance Appraisal and Measurement in the Public Sector
3.15 Value for Money Audit (VFM)
3.16 Steps in a VFM Audit -
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/ Further Readings

1.0 INTRODUCTION

Many large business organisations have complex structures. These type of set up have
their own advantage and problems. While it may be possible for a single proprietor to
monitor and oversee the detailed operation of a small business outfit, it may be
impossible for the individual to oversee all the operations of a large scale organization
and take all the relevant decisions required.

In view of the above, it becomes necessary to transfer some management functions to

subordinate managers leading to some form of decentralization.

2.0 OBJECTIVES

In this unit, readers would be able to understand:

 The term decentralization and the various decision areas involved and those that
can be delegated, with the attendant benefits/or draw-backs;
 The responsibility accounting and the characteristics of the various centres;
 The various divisional performance evaluation techniques;

326
 The issues involved in appraising multinational and government agencies; and
 The effect value for money audit.

3.0 MAIN CONTENT

3.1 Meaning of Decentralisation

Decentralisation is defined as a system in which the authority for decision making is

delegated to the other levels of management. The lower in the organisation that the
authority for decision making exists, the greater the decentralisation. In practice, it is
impossible to have either a completely centralized organisation, or a completely
decentralised organisation. In effect, decentralisation is a matter of degree along a
continuum. It must be noted that decentralisation is more evident in profit- seeking
organisations than in nonprofit organisations.

3.1.1 Advantages of Decentralisation

The following are the advantages of decentralisation:

(a) Senior management are relieved from mundane or trivial matters leaving them
with more time for overall review and consideration of issues of more strategic
importance.
(b) It speeds up operation decision as the manager at the division swiftly reacts to
changing local circumstances.
(c) It provides better training ground to junior staff who aspires to be at the topmost
level of the organisation.
(d) The more responsibility a manager has for the performance of his unit, the more
he is motivated and the more he will strive to be at his productive best.
(e) It increases flexibility and reduces communication gap.

3.1.2 Disadvantages of Decentralisation

The following are the disadvantages of decentralisation:

(a) It often leads to duplication of services which may be less expensive when
centralised.
(b) Managers tend to take decision improving their own sub-unit's performance at
the expense of the entire organisation, that is, sub-optimal decision.
(c) It leads to frequent rise in the cost of accumulating and processing information.
(d) It may result in friction between divisional managers particularly where the
performance of one division is dependent on another division.
(e) Decentralisation often encourages narrow mindedness in that a divisional
manager only knows what is going on in his division.

Additional problems may arise in the following areas:

(a) Apportionment of overhead cost into individual profit centres.
(b) Introduction of appropriate recording and measuring procedures.

327
(c) Determination of the form, content and effective basis for the preparation
of budget at different level of management.
(d) The extent of decentralisation of the accounting function and the
attendant problems of communication.
(e) Monitoring and evaluation of results.

3.2 DECISION AREAS RETAINED BY TOP MANAGEMENT

Top management retained important decision or some decision while others are
delegated. The following are the ones retained by management:
(a) Appointment of senior staff
(b) Determination of the corporate objectives of the organisation.
(c) Centralised services such as legal services.
(d) Decision relating to sourcing of funds and investment of surplus funds.
(e) Approval for all major capital expenditure proposals.
(f) Product line closure and departmental closure decisions.
(g) Monitoring overall result and settling inter-departmental disputes (for example
on transfer pricing).

3.3 DECISION AREAS DELEGATED TO OTHER LEVELS OF

MANAGEMENT

The following are the main areas of decision usually delegated to other levels of
management, particularly, lower and functional line management:
(a) Divisional planning and control.
(b) Divisional profitability and financial control;
(c) Appointment and dismissal of junior staff;
(d) Transfer pricing decisions;
(e) Short-term financing arrangement;
(f) Granting credit to customers; and
(g) Stock carrying decisions.

3.4 RESPONSIBILITY ACCOUNTING

Responsibility accounting is defined as "a system of accounting that

segregates revenues and costs into areas of personal responsibility in order to assess
the performance attained by persons to whom authority has been assigned" (CIMA).

With responsibility accounting, it is possible to identify or recognise decision centres

within an organisation for the purpose of tracing costs to the individual managers who
are charged with the responsibility of making decision about costs and revenues in an
organisation.

Within the concept of divisional performance evaluation, there are three types of
responsibility centres: cost centre, profit centre and investment centre. Each of the
centres will be considered appropriately with the conditions that need to exist for its

328
adoption.

3.5 COST CENTRE

A cost centre is defined as a location, function, department or section, in

respect of which costs may be ascertained and related to cost units for control purpose
only (CIMA)

To adopt a cost centre:

(i) The cost centre should be relatively easy to establish.
(ii) The cost centres should form the basis for building up cost records for
measurement, budgeting and control.
(iii) Managers of functional departments might be treated as cost centre and made
responsible for their costs.

3.6 PROFIT CENTRE

A profit centre is any sub-unit of any organisation (for instance, a division of a

company) which is responsible for both revenue and cost and profit. In other words, it
is a unit to which both revenue and costs are assigned, such that the profitability of the
sub-unit can be measured. The following conditions must exist before the adoption of
profit centres:
(a) There must be units of the organisation to which both revenues and costs can be
separately attributed.
(b) The revenue might come from external sources through sales of goods or
services or from internal work done for other profit centres for which transfer
price can be charged.
(c) There should be sufficient decentralisation of authority within the
company to permit profit centre managers to make decisions about selling
prices (include transfer prices) and output levels at those prices.

3.7 INVESTMENT CENTRE

This is a unit of an organization where a divisional manager is allowed to exercise

some discretion about the amount of investment undertaken by the division. In
assessing the result of the investment centre, the profit earned must be related to the
amount of capital invested. Performance here is measured by return on capital
employed (ROCE) otherwise referred to as return on investment (ROI).

The following conditions must exist before a centre is adopted as an investment centre:
(a) All the conditions listed under profit centre above.
(b) The centre must make use of assets which can be separately attributed to it.
(c) The centre must make use of assets which the centre manager has
control over in terms of new investment decisions, asset replacement decisions,
etc.

329
3.8 CHARACTERISTICS OF COST, PROFIT AND INVESTMENT
CENTRES

Characteristics
(a) Cost centre manager has control over costs (that is, only controllable cost
items).
(b) Profit centre manager has control over costs; sales prices (including transfer
prices) and over output volumes.
(c) Investment centre manager in addition to the characteristics of the
profit centre has control over investment in fixed and current assets.

3.9 MEASURES OF DIVISIONAL PERFORMANCE

The following are measures of divisional performance:

(a) Return on Capital Employed
(b) Absolute divisional profit
(c) Residual income
(d) Increase in market share
(e) Share of goodwill
(f) Growth of assets
(g) Growth of sales.

The first three are the most common measures and are considered in detail below.

3.10 RETURN ON CAPITAL EMPLOYED (ROCE)

This is otherwise referred to as return on investment (ROI). It measures overall

profitability by relating net income to the level of investment. ROCE can be defined
by using a simple formula:

ROCE = Net Income x 100

Investment 1
The return on investment here is tied to the capital base, hence, it is void of any
dispute. It is the most objective. It gives consideration to the capital base of each
division, thereby considering each division as an autonomous investment unit. It
enables divisions with different sizes to be compared. It equally has a benefit of
facilitating interpretation on the part of the manager because it makes use of data input
contained in the conventional financial report.

However, it suffers some serious setbacks. For example, the variables in its constituent
such as net income, investment or capital employed are subject to many definitions.
Taking net income for instance, should it be income before tax or after tax? Similarly,
different bases are used to value the capital employed in a division. Should the
investment be valued at book value, gross book value or current replacement costs?
Caution must therefore, be exercised to ensure that bias from accounting procedure
does not undermine the level of operational efficiency.

330
Another shortcoming is that managers of those divisions with an existing ROI in
excess of the company's cost of capital incorrectly reject projects with positive net
present value. It is, therefore, an unsatisfactory measure of divisional managers'
performance where a manager can significantly influence the amount which is
invested in working capital.

3.11 ABSOLUTE DIVISIONAL PROFIT

This is profit from divisional operation. The measure of performance by absolute

divisional profit is derived as divisional profit less non-controllable cost. The
divisional profit might then be compared with budgeted profit, past profit or other
divisions' profit dealing in the same line of market. The advantage of this method is
that, it derives the needed profit figure from the normal accounting profit. The
following are the disadvantages:

(a) Difficulty in comparing divisions of unequal sizes.

(b) Determination of controllable overhead costs may not be easy.

3.12 RESIDUAL INCOME (RI)

This is defined as divisional profit less imputed interest charges on the net assets
employed by the division. The word imputed in the definition means that, the charge is
made irrespective of whether the company as a whole, has actually incurred an interest
cost in the ordinary sense of cash disbursement. The rate used represents the minimum
acceptable for investment in that division. This method encourages managers to act in
the interest of both his division and the company. In other words, as a performance
measurement method, it ensures that sub-optimal decisions are reduced to the
minimum while goal congruence is encouraged. However, it suffers from similar
problem with the ROI in terms of what should constitute the division's cost of capital.

ILLUSTRATION 15 – 1

Akinyemi Ltd. has four divisions operating in Ibadan, Sokoto, Calabar and Maiduguri.
The following data are in respect of them.

Ibadan Sokoto Calabar Maiduguri

Total Assets (N) 12m 10m 14m 18m
Total Sales (N) 20m 30m 36m 28m
Total Costs (N) 18m 27m 33.6m 26m
Cost of Capital (%) 14 18 16 1
Required:
(i) Calculate the annual returns on investment
(ii) Calculate the residual income.

SUGGESTED SOLUTION 15 – 1

331
(i) Calculation of Annual Return on Investment (ROI)
Ibadan Sokoto Calabar Maiduguri
Total Sales (N) 20m 30m 36m 28m
Less:
Total Cost (N) (18m) (27m) (33.6m) (26m)
Profit 2m 3m 2.4m 2m

Return on Investment (ROI)

ROI = Net Income x 100

Investment 1

Ibadan Sokoto Calabar Maiduguri

2m x 100 3m x 100 2.4m x 100 2m x 100
12m 1 10m 1 12m 1 18m 1
16.7% 30% 17.1% 11.1%

(ii) Calculation of Residual Income

Ibadan Sokoto Calabar Maiduguri
N N N N
Profit 2m 3m 2.4m 2m
Less: Imputed interest 1.68m 1.8m 2.24m 1.8m
(COC x Total Assets) 0.32m 1.2m 0.16m 0.2m

ILLUSTRATION 15.2

(a) In the context of performance evaluation, distinguish between a profit centre

and an investment centre.
(b) Mention three advantages of divisionalisation.
(c) Standard Ltd currently uses the Return on Investment (ROI) to measure the
performance of its two operating divisions K and B. Summary of the annual
reports from the two divisions for the past year is given below. The company’s
cost of capital is 12%.
Division K Division B
N N
Capital Investment 60,000 100,000
Net Income 12,000 18,000
ROI 20% 18%

Required:
(i) As a Management Accountant, what performance measurement would you
recommend that will show more clearly the relative profitability of the two
divisions and why?

332
(ii) Which division is more profitable? Support your answer with suitable
calculations.
(iii) Assume that the manager of Division K was offered a one-year project that
would increase his investment base (for that year) by N25,000 and shows a net
profit of N3,750, would the manager accept this project if he were re-evaluated
on the basis of his divisional Return on Investment (ROI)?

Note: Both divisions are investment centres.

SUGGESTED SOLUTION 15 – 2

Refer to the text for answers to (a) and (b)

(c) (i) The Return on Investment (ROI) is not a very good measure of
divisional performance in that it results in taking sub-optimal decisions.
The residual income as earlier explained will be more favoured because
it critically evaluates divisional performance. It is defined as divisional
controllable profit less imputed cost of capital on investment (that is,
divisional controllable investment).

(ii) Determination of Profitable Division

Division K Division B
N N
Capital Invested 60,000 100,000
Net Income 12,000 18,000
Less imputed cost of capital
(12% of capital invested) 7,200 12,000
4,800 6,000
ROI 20% 18%

Comment: Going by the ROI given, one will be tempted to say that Division K is
more profitable than Division B. However, with the above calculations it is apparent
that Division B is indeed more profitable than Division K judging from absolute
profits generated by the divisions.

Division K
N
Additional Capital 25,000
Increment in Net Income 3,750
Less imputed cost of capital
(12 x 25,000) 3,000
Residual Income 750
Divisional ROI = 3,750 x 100
25,000 1
= 15%

comment: If the manager is re-evaluated on the basis of ROI, he would likely reject

333
the new project under the pretext that it would reduce his current ROI of 20% to
17.5% [that is, (20% + 15%) 2]. However, going by the computation in (iii) using
residual income approach, the project should be accepted in that it makes an additional
return of N750 to the overall income of the company.

ILLUSTRATION 15 – 3

Didi Company Ltd is a large integrated conglomerate with shipping, metals and
mining operation throughout the country. The General Manager of the shipping
division has been directed by the Board to submit his proposed capital budget for 2003
for inclusion in the company wide budget. The divisional manager is considering the
following projects, all of which require an outlay of capital and have equal risk.

Project Investment required Return

N’000 N’000
1 24,000 5,520
2 9,600 3,072
3 7,000 980
4 4,800 864
5 3,200 640
6 1,400 392

The divisional manager must decide which of the projects to accept. The company has
a cost of capital of 15%. An amount of N60 million is available to the division for
investment purposes.

Required:
Compute the total investment, total return on capital invested and residual income on
each of the following assumptions stating, selected projects:
(a) The company has a rule that all projects promising at least 20% or more should
be accepted.
(b) The divisional manager is evaluated on his ability to maximize his return on
capital invested.
(c) The divisional manager is expected to maximize residual income as computed
by using the 15% cost of capital.

SUGGESTED SOLUTION 15 – 3

Didi Company
Project Investment Returns ROCE/ROI
Required N’000
N’000
1 24,000 5,520 x 100 = 23%
24,000 1
2 9,600 3,072 x 100 = 32%
9,600 1

334
3 7,000 980 x 100 = 14%
7,000 1
4 4,800 864 x 100 = 18%
4,800 1
5 3,200 640 x 100 = 20%
3,200 1
6 1,400 392 x 100 = 28%

(a) Assumption: Assuming that all projects promising at least 20% or more should
be selected.
Accept Projects 1,2,5 and 6 with ROCE greater than 20%
Therefore,
(i) Total Investment will be:
Projects Investments
N
1 24,000,000
2 9,600,000
5 3,200,000
6 1,400,000
38,200,000

(ii) Total Returns will be

Projects Returns
N
1 5,520,000
2 3,072,000
5 640,000
6 392,000
9,624,000

(iii) Return on Capital Invested

= Total Returns x 100
Total investment 1
= N9,624,000 x 100
N38,200,000 1 = 25.5%

(iv) Residual Income

= Total Returns less imputed cost of capital
N
Total Returns 9,624,000
Less Imputed cost
(15% of N38,200,000) 5,730,000
3,894,000

(b) The assumption here is the maximization of ROI. Project 2 should be chosen in
that it provides the highest ROI of 32%.

335
(i) Total Investment = N9,600,000
(ii) Total Return = N3,072,000
(iii) Returns on Capital Invested = N3,072,000 x 100
N9,600,000 1
= 32%
N
(iv) Residual Income = Total Return 3,072,000
Less Imputed Cost
(15% of N9,600,000) 1,440,000
1,632,000

(c) The assumption here is maximization of residual income.

Project 1: RI = 5,520,000 – (15% of 24,000,000) = N1,920,000
Project 2: RI = 3,072,000 – (15% of 9,600,000) = N1,632,000
Project 3: RI = 980,000 – (15% of 7,000,000) = (N70,000)
Project 4: RI = 864,000 – (15% of 4,800,000) = N144,000
Project 5: RI = 640,000 – (15% of 3,200,000) = N160,000
Project 6: RI = 392,000 – (15% of 1,400,000) = N182,000

Decision:
Choose all the projects that have positive RI. Therefore, projects 1, 2, 4, 5, and 6
should be selected.
(c) (i) Total Investment will be:
Projects Investment (N)
1 28,800,000
2 9,600,000
4 4,800,000
5 3,200,000
6 1,400,000
43,000,000

(ii) Total Return will be:

Projects Investment (N)
1 5,520,000
2 3,072,000
4 864,000
5 640,000
6 392,000
10,488,000

(iii) Return on Investment

= N10,488,000 x 100
N43,000,000 1
= 24.4%

336
(iv) Residual Income
N
Returns 10,488,000
Less imputed cost
(15% of 43,000,000) 6,450,000
4,038,000

3.13 PERFORMANCE APPRAISAL IN MULT1-NATIONAL

ORGANISATIONS

Performance appraisal takes place in multi-national concerns and establishments who

operate on cross-border basis with activity or establishments spread all over various
nations. However, control becomes an issue to be taken seriously because of the level
of activities, the variability of circumstance and categories of workers involved as well
as the separation due to gap in areas to be covered. Other short-comings envisaged are:
(a) Inadequacy of information due to communication gap.
(b) Different local taxation and corporate regulations.
(c) Government policies and restrictions in the different countries.
(d) Pricing and tariff regulations established by the governments of a particular
country.
(e) Exchange rate difficulties due to fluctuations.
(f) Transportation delivery problems and transfer pricing difficulties concerned
with trade between divisions.
(g) Accounting standards and policies may not be the same across the borders of
the various countries.
(h) Discouragement may set in where there is disparity in staffing policies as
compared to those of the home country.

3.14 PERFORMANCE APPRAISAL AND MEASUREMENT IN THE

PUBLIC SECTOR

By public sector, it is meant government owned establishments such as ministries,

parastatals, agencies, as well as local, state and federal governments and other related
organisations.

Therefore, performance evaluation is required to ensure probity accountability and

honesty in the discharge of responsibilities to the public from whom taxes are
collected.

Even though performance evaluation is a good thing, the following are considered to
be the areas that call for attention:
(a) Costs are not easily attributable to inputs, thus making output immeasurable.
(b) Objectives may be many, thereby making it difficult to ascertain the
relationships between causes and effects.

3.15 VALUE FOR MONEY AUDIT (VFM)

337
Value for money audit can be defined as "an investigation into whether proper
arrangements have been made for securing economy, efficiency and effectiveness in
the use of resources. (CIMA).
(a) Effectiveness is a measure of ability to attain desired goals.
(b) Efficiency is a measure of the relatedness of inputs and outputs, in order to
measure the extent of usage of resources to realise the set goals of a company.
(c) Economy is getting the desired goals at the least costs without compromising
the quality of input.

VFM audits are usually carried out in the public sector establishments such as local,
state and federal governments and their associated departments, parastatals, agencies,
ministries and related organisations as the case maybe. It can also be of use in the
private sector of an economy.

VFM audits cover wide areas of operation especially where corporate

governance is the order of the day. The following are determined and weighed:
 Staffing policies including selection, training encouragement etc.
 Means of forecasting and gauging expenses.
 Decision matters as they relate to strategic and tactical issues.
 Effective safeguard of all fixed assets such as equipment, motor vehicles etc.
 Organisation depicting the chain of command
 Specific initiatives to improve economy, effectiveness and efficiency
 The manner of monitoring performance and the basis of comparison with goals.

3.16 STEPS IN A VFM AUDIT

VFM audit involves the following six steps:

Step 1. Determine the goals of the public sector establishment or system being
verified.
Step 2. Ascertain the systems and controls utilised to attain the goals. That is how to
determine the procedures for engaging and valuing the success attained.
Step 3. Have a detailed documentation of the system/procedures/ setup being
examined including the ascertainment of the chain control elements.
Step 4. Examine and carry out a test of the system/procedure in existence with a focus
on the economy involved.
Step 5. Verify the adequacy of the system with emphasis on the utilization of
resources involved. (Link with Step 2)
Step 6. Evaluate the effectiveness of the organisation, in order to determine the
applicability of the system to the achievement of set goals. (Link with Step 1)

4.0 CONCLUSIONS

An individual cannot oversee all the operations of a large scale establishment and at
the same time take all the relevant decisions required, thus, the need to delegate some
management functions to subordinate managers leading to some form of

338
decentralisation that will enhance motivation, communication, planning etc.

Decentralisation is not without its short-comings of increase cost of accumulating and

processing information, friction between managers, duplication of services, narrow
mindedness of managers, sub-optimal decision making etc.

Performance appraisal systems should promote goal congruency, provide meaningful

feedback, encourage initiative and longer-term view.

Performances may be appraised by using the ROCE, residual income and absolute
divisional profit methods amongst others.

5.0 SUMMARY

Responsibility accounting ensures that recognition is being given to cost centres, profit
centres and investment centres.

Value for money audits are usually carried out in government establishments with
emphasis on staffing policies, strategies and tactical issues, effective safeguard of
assets, the manner of monitoring performance and the basis of comparison with goals.
It is to ascertain the economy, efficiency and effectiveness in the utilisation of
resources.

6.0 TUTOR MARKED ASSIGNMENT

Use data below to answer questions 1 and 2

Jokotola Limited is considering a project with an initial investment of N50,000. The
project will produce cash inflow of N17,350 per year for 4 years. The cost of capital is
10% and there is nil scrap value.

1. The NPV of the project is

A N4,960
B N4,996
C N4,936
D N4,956
E N4,969.

2. The Residual profit of the project in year 1 using straight-line depreciation is

A N(250)
B N150
C (150)
D N250
E N(170).

3. Which of the following perspectives are encompassed in a balanced scorecard?

i. customer perspective

339
ii. financial perspective
iii. supplier perspective
A i and ii only
B i and iii only
C ii and iii only
D i, ii and iii
E iii only.

Use the data below to answer questions 4 and 5. Blending division of Tom James has
assets of N200,000 operating profit of N600,000.

4. The division’s return on investment is

A 30%
B 35%
C 32%
D 33%
E 36%

5. If the interest is imputed at 14%, the residual income is

A N31,400
B N31,000
C N31,500
D N32,500
E N32,000.

6. State any two objectives of decentralization.

7. Distinguish between profit and investment centres.

8. Enumerate any three short comings of appraising multi-national organizations.

9. What is Value for money audit?

7.0 REFERNCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

MODULE IV: PRICING, RATIO, COST AND CURRENT TREND IN

MANAGEMENT ACCOUNTING

340
Unit 16: Transfer Pricing Systems
Unit 17 Pricing Decisions
Unit 18: Ratio Analysis
Unit 19: Cost Control and Cost Reduction
Unit 20: Current Trends in Management Accounting

UNIT 16 TRANSFER PRICING SYSTEMS

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Objectives of Transfer Pricing
3.2 Broad Categories of Transfer Pricing Methods
3.3 Cost Based Transfer Pricing
3.4 Market Based Transfer Pricing
3.5 Negotiated Transfer Pricing
3.6 Arbitrary Transfer Pricing
3.7 Dual Transfer Pricing System
3.7.1 Demerits of Dual Transfer Pricing
3.8 International Transfer Pricing
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

In this unit, we shall examine the various approaches that can be adopted to arrive at
transfer prices between divisions. Although our focus will be on transfer pricing
between dividThis is the monetary value attached to goods and services exchanged
between divisions of the same organisation. It is peculiar to all divisionalised
organisations where the activities are segmented into autonomous units and a great
deal of authority delegated to the divisional heads.

2.0 OBJECTIVES

In this unit, readers will be able to understand:

341
 The objectives of transfer pricing;
 The different transfer pricing methods;
 Merits and demerits of the transfer methods;
 Factors that must be considered when setting transfer for multinational
transactions.
 The nature and meaning of dual transfer pricing system.

3.0 MAIN CONTENT

3.1 OBJECTIVES OF TRANSFER PRICING

The following are the objectives of transfer pricing to management:

(a) Goal Congruency: We are to select the transfer pricing method that any
optimal decision taken by the division will also be optimal from the corporate
perspective. In other words, any method chosen must reduce sub-optimality to
the barest minimum.
(b) Performance Evaluation: We are to select the transfer method that
management would be in a position to adopt in evaluating the performance of
each divisional manager as effectively as possible. Sequel to this, the
contribution made towards the corporate profit by each division should not be
distorted by the transfer pricing method chosen.

(c) Autonomy: We are to select the method that will preserve the independence of
each division so that the failure of one will not affect the success of the other.

3.2 BROAD CATEGORIES OF TRANSFER PRICING METHODS

A transfer price may be based upon:

(a) Cost
(b) Market
(c) Negotiation
(d) Arbitrary.

3.3 COST BASED TRANSFER PRICING

The selling division sells to the buying division at the cost of production incurred by
the selling division. The following are the various types of cost based transfer pricing
methods:
(i) Full cost, that is, at full cost or at a full cost plus price.
(ii) Marginal cost, that is, at marginal cost or with a gross profit margin on top of
marginal cost.
(iii) Standard cost.
(iv) Cost plus mark up.

Advantages

342
(a) It is very useful in decision making analysis especially with the use of marginal
cost approach.
(b) It assists in measuring production efficiency by comparing actual cost with
budgeted cost.
(c) No unrealised profit is involved in stock computation.
(d) The transfer pricing could be fixed and agreed in advance without being subject
to external function.
(e) It offers the only available opportunity for products that have no market.

Disadvantages
(a) It may lead to unpredictable month by month fluctuations unless standard costs
are used.
(b) The cost of the selling division maybe rejected by the buying division on the
ground that it is inefficient especially when the full cost method is used.
(c) Profitability of the autonomous divisions cannot be effectively measured as
revenues are completely ignored.
(d) When transfers are made at cost plus, the selling division is guaranteed a certain
level of profits which the division may not be capable of earning in an open
market situation.
(e) With the use of cost based method, the incentive required for divisional
planning and motivation is lacking.

3.4 MARKET BASED TRANSFER PRICING

Under this method, the selling division sells to the buying division at the prevailing
market price. In other words, the two divisions will be operating at arm’s length.

Advantages
(a) There is goal congruency
(b) Divisional autonomy is maintained
(c) it is most adequate for measuring performance and motivating managers.
(d) Marketing prices are objective and verifiable.
(e) Top managements' time is not devoted to the bargaining process.
(f) The method can have no influence on the efficiency or inefficiency of the
manufacturing units.

Disadvantages
(a) The element of profit often complicates stock valuation.
(b) Accurate information about the market may not be readily available
(c) The market price for intermediate products is not often determinable since the
market is either non existing, ill-structured or imperfect.
(d) The method may act as a disincentive to the use of any spare capacity in the
division under some peculiar circumstances.

3.5 NEGOTIATED TRANSFER PRICING

343
Under this method, the selling division and the buying division agree in advance to use
a mutually acceptable transfer price.

Advantages
(a) With the use of this method, the motivational impact will be stronger.
(b) There are less disputes on the transfer price fixed because many factors would
have been effectively considered.
(c) Performance evaluation by central management will be devoid of any disputes
on the part of the divisional managers.

Disadvantages
(a) Negotiation may be time consuming.
(b) A negotiated price may be influenced by the negotiating ability; personality and
fluency of the managers involved.
(c) The corporate interest may be subordinated to individual divisional interest.
(d) A negotiated price will not be fixed forever. It may need constant review.

3.6 ARBITRARY TRANSFER PRICING

Under this method, the transfer price is determined centrally based on what top
management conceived to be most beneficial to the company as a whole. Individual
divisional managers may have some say but no control over the price set.

Advantages
(a) The time spent in negotiation is saved.
(b) Uniformity and stability tend to prevail.

Disadvantages
(a) The autonomy granted divisional managers is eroded.
(b) Profit and cost consciousness may suffer where arbitrarily fixed price is not
considered realistic.

ILLUSTRATION 16 – 1

The ORISIRISI Company Limited is a multi divisional company and its managers
have been delegated full profit responsibility and complete autonomy to accept or
reject transfers from other divisions. Division A produces a sub assembly with a ready
competitive market. This sub-assembly is currently used by division B. A charges
division B market price for the sub-assembly which is N700 per unit. Variable costs
are N520 and N600 for divisions A and B respectively. The manager of Division B
feels that Division A should transfer the sub assembly at a lower price than the market
price because at this price, Division B is unable to make a profit.

Required:
(a) Compute Division B’s contribution margin if transfers are made at the, market
prices and also the total contribution to profit for the company.

344
(b) Assume that Division A can sell in the open market only 500 units at N700 per
unit out of the 1000 units that it can produce every month and that a 20% reduction in
price is necessary to sell at full capacity. Should transfers be made?

If so, how many units should it transfer and at what price? Submit a schedule showing
comparisons of contribution margins under four different alternatives to support your
decision.

SUGGESTED SOLUTION 16 – 1

(a) Contribution margin of Division B if transfer price is N700

N N
Selling Price 1,200
Less:
Variable Cost Per Unit 600
Transfer Price 700 1,300
Contribution of Division B (100)
Contribution margin to the company if Division B buys from Division A
N N
Selling Price of Division B 1,200
Less: Variable Cost: Div. A 520
Div. B 600 1,120
Contribution margin of the company N80

Alternatively, the contribution margin of the company, N80 can be arrived at through
another approach as explained below
Div. A Div. B
N N
Transfer Price/Selling Price 700 1,200
Less:
Variable Cost (520) (600)
Transfer Price (700)
Contribution margin 180 (100)

The company’s contribution margin 180 + (100) = N80

(b) In this case, Division A is operating at full capacity. We need to compare the
contribution margin of the company if A transfers to B and when A fails to sell
to B.

As earlier computed, the contribution margin to the company if A transfers to B is

N80.

However, the contribution margin to the company if A does not transfer to B is

calculated below.

345
Div A Div B
N N
Selling Price 700
Less: Variable Cost 520
Contribution margin 180 0

Contribution margin to the company = N180 + N0 = N180

Decision:
Division A should not transfer to Division B because the contribution margin to the
company if there is transfer is only N80 whereas the contribution margin to the whole
organisation if there is no transfer is N180.

If so, the question of “at what price” is not relevant since the decision is that there
should not be any transfer whatsoever.

Alternative strategies:
(i) sell 500 units at N700 per unit and transfer 500 units
(ii) sell 1000 units at N560 and transfer nothing
(iii) sell 500 units at N700 per unit and transfer nothing
(iv) transfer 1000 units.
Calculation of total contribution to the company.

ALTERNATIVE STRATEGIES
I II III IV
N N N N
Total Revenue
Div A 350,000(W1) 560,000 350,000 -
Div B 600,000 - - 1,200,000
950,000 560,000 350,000 1,200,000

Total Variable Cost

Div A 520,000(W2) 520,000(W4) 260,000 520,000
Div B 300,000(W3) - - 600,000
820,000 520,000 260,000 1,120,000
Total Contribution 130,000 40,000 90,000 80,000
(That is, TR – TVC)

The optimal alternative is strategy 1 and it requires 1,000 units to be produced and
distributed as follows:
(i) sell 500 units at N700 per unit
(ii) transfer 500 units to B

Workings

346
1. 500 units @ N1200 per unit = N600,000
2. Note: A produced 1000 units. Hence the total variable cost incurred by A =
N520 x 1000 = N520,000.
3. B obtained 500 units from A. B’s variable cost per unit = N600. Hence, total
variable cost incurred by B is 50 x N600 = N300,000.
4. A produced 1000 units at variable cost per unit of N520.

Therefore, total variable cost = N520 x 1,000 = N520,000.

At what relevant price?

The transfer price should be such that will induce transfer i.e. it should be acceptable
to the two divisions. Consequently, the following should be satisfied.

(i) The minimum transfer price must be greater than the variable cost of Division
A, that is, N520.

(ii) The maximum transfer price must be less than the contribution margin of
Division B before the transfer price is recognized, that is, N600. (N1,200 –
N600). Hence, any price between the range N520 and N600 will be acceptable
the two divisions.

ILLUSTRATION 16 – 2

A transportation-equipment manufacturer, BOSE Limited is heavily decentralized.

Each divisional head has full authority on all decisions regarding sales to internal or
external customers. Division P has always acquired a certain equipment component
from Division S. However, when informed that Division S was increasing its unit
price to N220, Division P’s management decided to purchase the component from
outside suppliers at a price of N200. Division S had recently acquired some
specialized equipment resulting high depreciation charges as the justification for the
price hike. He asked the chairman of the company to instruct Division P to buy from
Division S at the N220 price. He supplied the following:

Division P’s annual purchase of component N2000 units

Division S’s variable cost per unit N190
Division S’s fixed cost per unit N20

Required:
(a) Suppose that there are no alternative uses of the S facilities, will the company
as a whole benefit if P buys from the outside suppliers for N200 per units?
Show computation to support your answer.
(b) Suppose that internal facilities of S would not otherwise be idle, the equipment
and other facilities would be assigned to other production operations that would
otherwise require an additional annual outlay of N29,000. Should P purchase
from outsider at N200 per unit?
(c) Suppose that there are no alternative uses for S’s internal facilities and that

347
selling price drops by N15. Should P purchase from outsiders?
(d) As the chairman, how would you respond to the request of the manager of S?
Would response differ, depending on the specific situation described in
requirements (a) through (c) above? Why?

SUGGESTED SOLUTION 16 – 2

(a) If P buys from outsiders at N200 per unit:

N
Cash Outflow through P (N200 x 2000) 400,000
Cash Savings through S (N190 x 2000) 380,000
Loss to the Group if P buys from outside N20,000

Note 1: If P buys from outside, then no variable cost will be incurred so it is a savings
to the company.
(b)
N N
Cash Outflow through P (N200 x 2000) 400,000
Savings:
S’s Variable Cost 380,000
Initial Outlay 29,000 409,000
Savings to the Group if P buys from outside N9,000

(c)
N
Cash Outflow through P (N185 x 2000) 370,000
Cash Savings through S (N190 x 2000) 380,000
Savings to the Group if P buys from outside N10,000

(d) As the chairman of the organisation, I will not grant the Division S because of
the following reasons:
(i) It will be contrary to the organizational policy which states emphatically
that each division head has full authority on all decisions regarding sales
to internal and external customers.
(ii) It will amount to an erosion of the autonomy of the divisional manager.
This could have negative consequences on morale, productivity and even
profitability of the divisions especially in the long run.
The group will benefit in situations (b) and (c) but the group would lose in situation
(a). The loss in situation (a) perhaps may be the sacrifice that the group may have to
make in order to maintain the present divisionalised structure and to enjoy all the
potential benefits associated with it.

3.7 DUAL TRANSFER PRICING SYSTEM

It is worthwhile to note that no single transfer pricing method is capable of satisfying

the three broad objectives of transfer pricing. In fact, it is just not possible to have a

348
single transfer price. The buying division and the selling division have different
interest in the transfer price.

Of recent, a case has been made for dual transfer hypothetical pricing system. In a dual
pricing situation, the buying division is charged hypothetical market price while the
selling division is given credit for either full cost plus a normal mark-up. The income
for the company as a whole will be less than the total income for the divisions.
However, in preparing financial statements, intra-company eliminations would have to
be made for these differences.

Finally, it has been established that only dual transfer pricing system is capable of
promoting goal congruence, motivation, autonomy and performance evaluation under
all conditions.

3.7.1 Demerits of Dual Transfer Pricing

However, the dual-rate transfer prices are not widely used in practice for several
reasons, which include;
(a) The use of different transfer prices causes confusion, particularly when the
transfers spread outside two divisions;
(b) They are considered to be artificial;
(c) They limit the divisional motivation to compete effectively, thus, reducing their
productivity; and
(d) Top-level executives do not like to double count internal profits because these
can result in misleading information and create a false impression of divisional
profits.

3.8 INTERNATIONAL TRANSFER PRICING

With the advent of multinational corporations and their continued growth, they have
added another more complicated dimension to transfer pricing. In setting an
international transfer price, a company will usually concentrate on satisfying a single
objective i.e. minimize income taxation. The other broad objectives of transfer pricing
are considered secondary. By minimising income taxes through the use of transfer
pricing, the company's profit after tax will increase. It should be noted, however, that
national tax authorities of countries involved (that is, the home country of the multi-
national corporation and the host country) are now taking a very close look at whether
the international transfer price constitutes an "arm's length price", that is, the price the
two parties would have agreed to if they had not been related.

Benke and Edwards (1980) recognised some other issues that merit consideration in
the setting of international transfer prices. These include import duty minimization,
adjusting for currency fluctuations, avoiding economic restrictions and presenting a
favourable financial picture for a foreign affiliate in order to enhance borrowing
opportunity or provide a temporary competitive edge.

349
Lucey (2003) stressed that the level of the transfer price can also affect the amount of
import duties to be paid and is a way of repatriating dividends. Intact, some countries
place restrictions on the amounts of dividends that can be paid from the branches of
multi -national companies in their country. Where this restriction exists, it may be
partially avoided by charging a high transfer price in the particular country.

4.0 CONCLUSION

This is the monetary value attached to goods and services exchanged between
divisions of the same organisation segmented into autonomous units and with a great
deal of authority delegated to the divisional heads.

The objectives of transfer pricing are mainly those of goal congruency, performance
evaluation and ensuring the independence of each division.

The broad categories of basis on which transfer pricing are based include: cost,
market, negotiated and arbitrary

The dual transfer pricing system in to tackle the area of difficulties in the application
of the various bases of pricing a firm's products or services.

5.0 SUMMARY

In this unit, we have discussed the different purpose of transfer pricing. We also
described the methods of transfer pricing and explain that cost plus transfer prices will
not result in the optimum output.

6.0 TUTOR MARKED ASSIGNMENT

1. The main objectivities of transfer prices are stated below except

A Goal Congruence
B Price Determination
C Motivation
D Performance appraisal
E Divisional Autonomy.

2. The following are the methods for determining the transfer price except
A Variable cost
B Skimming cost
C Full cost
D Market price
E Negotiated price.

Use the data below to answer questions 3 and 4

Selected data from Ben Company’s Limited records the following

350
Sales N700,000
Average investment N350,000
Net Income N 50,000
Minimum rate of return 12%.

3. Return on investment is
A N10,900
B N10,500
C N10,000
D N12,000
E N12,500.

4. Residual Income is
A 14.9%
B 14.5%
C 14%
D 15%
E 16%

5. The process of determining the price at which goods are transferred from one
profit centre within same company is
A Market pricing
B Skimming pricing
C Pro-rata pricing
D Arm’s length pricing
E Transfer pricing.

6. State two objectives which transfer pricing should achieve

7. What is the theoretically optimum transfer price?

8. What is negotiated transfer pricing?

9. Explain dual pricing.

10. State two advantages of the Market Based Transfer Pricing.

7.0 REFERNCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.
UNIT 17 PRICING DECISIONS

CONTENTS

351
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of Pricing Decisions
3.1.1 Factors in pricing decisions
3.1.2 Pricing Objectives
3.1.3 Relationship between Price and Output
3.1.4 Relationship between Selling Price and Demand
3.1.5 Other Factors
3.2 Pricing Methods
3.2.1 Full Cost Based or Cost - Plus Method
3.2.2 Marginal Cost Based Pricing Method
3.2.3 Minimum Price Method
3.2.4 Pricing Based on Mark Up/Unit of Limiting Factor
3.3 Demand Analysis (Or Theoretical Pricing Policy)
3.4 Other Pricing Methods
3.5 Price Discrimination
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

In this unit, we shall focus on the role that accounting information plays in
determining the selling price by a price setting firm. Where prices are set by the
market, our emphasis will be on examining the cost information that is required for
product mix decisions.

2.0 OBJECTIVES

In this unit, the reader will be able to understand:

 The factors which affect pricing decisions;
 Objectives of pricing decisions;
 The relationship between selling price, demand and output and price;
 The various pricing methods and their applications;
 The use of differential calculus to find the optimal price; and
 What the different pricing policies are and their description.

3.0 MAIN CONTENT

3.1 MEANING OF PRICING DECISION

352
The issue in pricing is the determination of selling prices. In many profit oriented
organizations, pricing constitutes a major policy decision issue. It may be possible for
the Accountant to make a useful contribution by providing the decision making arm of
the company with costs which are relevant for the pricing decision under view. There
are contrary opinions between the marketers and accountants when it comes to the
issue of pricing in the sense that the former claims that accountants do not understand
the importance of competitive pricing while the latter is strongly of the opinion that
marketers ignore costs when setting prices.

However, management accounting statements for pricing decisions are based on the
adoption of total or full or absorption costing technique which shows product costs
assume a normal level of output or normal mix of products. Nonetheless, the
contribution or marginal costing technique which is another form of approach to
pricing, provides a better basis for pricing decisions than the absorption technique in
that it offers information about cost-volume profit relation which thus makes it
convenient to derive pricing formulae.

There is no direct relationship between selling prices and product costs because of
competition and elasticity of consumer demand. Therefore, profits will be a product of
a good combination of a selected factors which include price, volume and product mix.

3.1.1 Factors In Pricing Decisions

The main factors in pricing decisions are as follows:

(a) Pricing objectives;
(b) Relationship between price and output,
(c) Selling price/demand relationship; and
(d) Other factors.

3.1.2 Pricing Objectives

The pricing objectives of companies fall into three categories. These

are:
(a) To achieve a target return on investment ;
(b) To stabilize price and output; and
(c) To realize a target market share.

3.1.3 Relationship Between Price and Output

The element of price is always instrumental to level of demand. In most cases, the
lower the selling price for an item, the higher is the quantity demanded. Therefore, a
company should consider the relationship between price and demand when deciding
on an efficient or optimal plan of action. However, the level of profit made by a
company is a function of the output levels agreed for the company's products. It is
reasonable to say that changes in output affect both total revenue and total costs, which

353
are the determinants of the profit level to be made at a given point in time.

3.1.4 Relationship Between Selling Price and Demand

The relationship between the selling price for a set of item and the quantity demanded
at that price is influenced by a group of factors among which are:
(a) Variation in quality;
(b) Advertising and other promotional techniques;
(c) Buyers choice and the manner in which they overcome them; and
(d) Pricing and advertising policy decisions of competitors.

3.1.5 Other Factors

The other factors, amongst a host of factors, which interfere in pricing

decisions, and at the same time exercise fundamental effect are:
(a) Overall company goals: These may include target return objectives such as
investment, sales or costs, profit maximization objective, require for the best
possible return on investment and maximum profitability; and non-profit
oriented-objectives which may include increase in firm status or goodwill.
(b) Costs: These play an indirect role in that it secures the profitability of
alternative prices to be determined and also ensure a comparison of the profit
margin at a present price with expected return. However, costs play a direct role
in setting prices in tactical situation, that is, contribution pricing.

(c) Demand: This factor cannot be overlooked in the pricing decisions of a firm. It
is based on two economics principles, that is. the law of demand and supply,
and the price elasticity of demand.
(d) Legal: This is considered from the point of view of Government interfering in
price control, anti-monopoly measures, interest rates, taxation, and so on.
(e) Social Responsibility: The social impact of a firm who sells on national scale
or basis is expected to be felt in the price charged on the goods.

3.2 PRICING METHODS

The various pricing methods encountered in practice are:

(a) Full cost based or cost - plus method;
(b) Marginal cost based method;
(c) Minimum price method;
(d) Pricing based on mark up;
(e) Theoretical pricing policy or demand analysis; and
(f) Others.

3.2.1 Full Cost based or Cost - Plus Method

This is a traditional approach to pricing products whereby the selling price is

354
determined by:
(a) Calculating the full cost of the product; and
(b) Adding a percentage mark-up for profit.

The full cost method vary in its approach to pricing decisions.

(a) It may be a fully absorbed production cost only;
(b) It includes some opportunity costs as well as such as the opportunity cost of
production resources that is in short supply;
(c) It includes some absorbed administration, selling and distribution overheads.

Generally, the percentage profit mark-up does not have to be rigid, but can be varied to
suit the particular circumstances.

Full cost based method has been frequently condemned by a number of authors.
According to John Sizer, full cost appears to be used by many firms as a starting point
in selling pricing decisions while marginal judgement determines the size of the full
cost plus. It is therefore unrealistic to use full cost as a starting point since the size of
the full cost plus is determined subjectively.

Benefits of full Cost Pricing Method

(a) Since the size of the profit margin can be varied at management's discretion, a
price in excess of cost should ensure that a company working at normal
capacity will cover all its fixed cost and subsequently make a profit. Also,
companies may benefit from full cost based method when they:
(i) carry out large contract which must make a sufficient profit margin to
cover a fair share of fixed cost.
(ii) Must justify their prices to potential customers, that is, for government
contracts, and
(iii) Find it difficult to estimate expected quantity at different selling price.
(b) It is a simple, quick and cheap method of pricing.

Problems of Full Cost Pricing Method

(a) There is the need to adjust prices to market conditions.
(b) Budgeting output volume is a very difficult task which is a key factor in
determining the fixed overhead absorption rate and in circumstances where
more than one product is produced.
(c) It fails to allow for competition, that is. a company may need to merge the
prices of rival firms when the competitors take a price cutting or price raising
decision.
(d) Since the selling price is part of the marketing mix of the company's policy,
rigid price setting may be too restrictive for marketing management.

3.2.2 Marginal Cost Based Pricing Method

Under this method, a profit margin is added either to marginal cost of production or to

355
marginal cost of sales. This method is often called mark-up pricing. Generally, typical
mark-up on variable cost will be higher than the typical profit margin on full cost
otherwise selling price may fail to cover fixed cost. Whereas, full cost plus approach to
pricing draws attention to profit margin, a variable cost approach to pricing draws
attention to contribution which is a better pointer of profit.

Advantages of Marginal Cost Based Pricing Method

(a) It draws management's attention to contribution and the effect of higher or
lower sales volume on profit.
(b) It is a simple method to understand and easy to calculate.
(c) The mark-up can be varied to reflect conditions.
(d) In practice, mark-up pricing is more applicable in business where there is
readily identifiable basic variable cost for example, retail industries.

Disadvantages of Marginal Cost Based Pricing Method

(a) The size of the mark-up can be varied.
(b) The method ignores fixed overhead in pricing decision.
The selling price must be sufficiently high to ensure that a profit is made after
recovering fixed cost, thereby leaving most companies in a position of arbitrary charge
on the marginal cost.

ILLUSTRATION 17 – 1

Odunayo Limited produced product A for which the following estimates have been
made:
N
Direct Material 12
Direct Labour (2 hours @ N5) 10
1
Variable production overhead-machine /2 hr @ N6/hr 3
25

Products fixed overhead are budgeted based on 12,000 machine hours at N144,000 per
month and because of the shortage of available machining capacity, the company will
be restricted to 8,000 hours of machine time per month. The fixed absorption rate will
be a direct labour rate. However, budgeted direct labour hour per month is 24,000
hours. It is estimated that the company could obtain a minimum contribution of N14
per machine hour producing another item other than product A. The direct costs
estimate are not certain as to material usage rates and direct labour cost may be subject
to an error of plus or minus 15%. Machine time estimates are similarly subject to an
error of plus or minus 10%. The company wishes to make a profit of 30% on full
production cost from the product.
Required:
What price should be charged using the full cost plus method under the following
circumstances:
(a) Exclude machine time opportunity cost and ignore possible errors.
(b) Include machine time opportunity cost and ignore possible costing

356
errors.
(c) Exclude machine time opportunity cost but make a full provision for
possible under estimation of cost.
(d) Include machine time opportunity cost and make a full allowance for
possible under estimation cost.

SUGGESTED SOLUTION 17 – 1

(a) Excluding Machine time opportunity cost and possible errors.

N
Direct Material 12
Direct Labour 10
Variable Overhead 3
Fixed Overhead 12
37
Add mark up 11.1
48.1

(b) N
Full production cost 37
Opportunity cost
(1/2 @ N14/machine) 7
44
Add mark up 13.2
57.2

(c) Excluding machine time opportunity cost but making a full provision for
possible underestimation of cost.
N N
Direct Materials 12
Direct Labour 10
22
Possible error @ 15% 3.3 25.30
Variable production overhead 3
Possible error 10% 0.3 3.30
Fixed Overhead 12
Possible error @ 15% 1.8 13.80
Full cost 42.40
Markup 12.72
55.12

(d) N
Full cost 43.40
Opportunity cost
(1/2 hr x N14 x 110%) 7.70
51.10

357
15.33
Mark-up 66.43

ILLUSTRATION 17 – 2

Tiger Limited budgets to make 50,000 units of its product time. The variable cost of a
unit is N5 and annual fixed cost are expected to be N150,000.00. The Financial
Director of Tiger Limited has suggested that a profit margin of 25% on full cost should
be charged for every unit sold. The Marketing Director has challenged the wisdom of
this suggestion and has produced the following estimates of sales demand.

Price Per Unit Demand (Units)

N
9 42,000
10 38,000
11 35,000
12 32,000
13 27,000

You are to assume a production sales level of 50,000 units.

Required:
(a) What is be the profit for the year if cost plus price were charged with a 25%
profit mark up?
(b) What would be the profit for the year if a profit maximizing price were
charged?

SUGGESTED SOLUTION 17 – 2

(a) N
Variable cost 5
Fixed cost 3
Full cost 8
Markup 2
10

N N
Total sales (38,000 units @ N10 380,000
Less: Cost of sales:
Opening Stock-Production
(50,000 units @ N8) 400,000
Less: Closing stock
(N8 x 50,000 – 38,000) 96,000 304,000
76,000

(b) Price Unit Contribution Demand Units Total Contributions

358
N
9 4 42,000 168,000
10 5 38,000 190,000
11 6 35,000 210,000
*12 7 32,000 224,000*
13 8 27,000 216,000

The company should sell 32,000 units at a price of N12 since this gives the highest
contribution of N224,000.
N N
Total Sales 384,000
Production 400,000
Closing Stock 144,000 256,000
128,000

3.2.3 Minimum Price Method

A minimum price is the price that would have to be charged so as to cover:

(a) The incremental cost of producing and selling the item
(b) The opportunity cost of the resource consumed in making and selling the item.

A minimum price generally, will leave the business no better or worse off than if it did
not sell the item, that is, no gain no loss. Basically, two essential points about
minimum price should be considered:
(a) It is based on relevant cost, and
(b) It is very much unlikely that a minimum price will actually be charged because
if it is charged, it will not provide the business with any incremental profit.
However, the minimum price of an item would generally show an absolute
minimum below which the price should not be fixed.

The incremental profit is that which would be obtained from any price that is actually
charged in excess of the minimum, for example, the minimum price is N200 and the
actual price charged is N240, then the incremental profit on the sale would be N40.

However, if there are no scarce resources, and a company has spare

capacity, the minimum price of a product would be an amount which
equates the incremental cost of incremental contribution towards profit.

ILLUSTRATION 17 – 3

A firm was required to submit a quotation for a special contract job. Cost estimates
were made as follows:
N
Material – D 75,000 kgs at 20k per kg 15,000
- E 25,000 kgs at 40k per kg 10,000
Labour – 3,000 hours at N2.25 per hour 6,750

359
Variable Overhead 9,750
Total Cost (external opportunity cost) 41,500

Required:
What is the minimum price to be quoted by the firm?

SUGGESTED SOLUTION 17 – 3

1. If the company has no scarce resources, the minimum price will be N41,500,
the total incremental costs to the firm. Any price in excess of N41,500 will be
an incremental contribution towards fixed costs and profit.
2. If there are scarce resources and a company makes more than one product,
minimum price would include an allowance for the opportunity cost of using
the resources to make and sell the product (instead of using the resource on the
next most profitable product.)

ILLUSTRATION 17 – 4

Using the same data in the previous example and assuming that the firm does not have
skilled labour to undertake the special contract job without delaying other production
activities. The contribution expected from other production activities, after charging
labour costs is N5,500. What is the minimum price to be quoted by the firm?

SUGGESTED SOLUTION 17 – 4

The minimum price to be quoted by the firm is as follows:

N
Material – D 75,000 kgs at 20k per kg 15,000
- E 25,000 kgs at 40k per kg 10,000
Labour – 3,000 hours at N2.25 per hour 6,750
Variable Overhead 9,750
Contribution lost on production delay
Internal opportunity cost) 5,500
Total Cost (internal and external opportunity cost) 47,000

Therefore, the minimum price at N47,000 is the sum of both internet and external
opportunity cost. Any price above N47,000 will create an incremental contribution to
fixed costs and profit.

3.2.4 Pricing Based on mark Up/Unit of Limiting Factor

When a business is looking at full capacity and it is restricted by a shortage of

resources from expanding output further, by deciding on what target it will like to
earn. It could, therefore establish a mark up per unit of limiting factor.

360
ILLUSTRATION 17 – 5

Temidire Services Ltd. produces a window cleaning services to offices and factories.
Business is very brisk but the company is restricted from expanding its activities
further by a shortage of window cleaners. The workforce consists of 12 window
cleaners each of whom works 35 hours a week. They are paid N4 per hour. Other
variable expenses are 50kobo per hour and fixed cost is N5,000 per week. The
company wishes to make a contribution of at least N15 per man hour.

Required:
Determine the minimum charge per hour for window cleaning. What is the resulting
profit?

SUGGESTED SOLUTION 17 – 5
N
Direct wages 4.00
Other variable expenses 0.50
Contribution/man hour 15.00
19.50
N
Total Contribution/week (12 x 35 x 15) 6,300
Less fixed cost 5,000
Profit 1,300

3.3 DEMAND ANALYSIS (OR THEORETICAL PRICING POLICY)

Generally, demand analysis theory is based on the idea that a connection can be made
between price, quantity demanded and sold as well as total revenue (TR). In a perfect
competitive market, demand varies with price and so if a realistic estimate can be
made of demand, at different price levels, it should therefore be possible to determine:
(i) a profit maximising price;
(ii) a revenue maximizing price.

However, in practice, business organisations, make pricing decisions on the basis of

demand conditions and competition in the market. On the other hand, most businesses
enjoy a monopoly situation in the market. This is because they develop a unique
marketing mix. The significance of a monopoly situation is that the business does not
have to follow the market price, that is. it is not a price taker and therefore has more
say and flexibility in the prices it sets. In a perfect competitive market, at higher prices,
demand for products or services will be lower. Basically, there will be a selling price
at which the business can maximize its profit. This is the price level at which marginal
cost (MC) is equal to the marginal revenue (MR), that is, the cost of making an extra
unit of output which is equal to the revenue obtained from selling it.

3.4 Other Pricing Methods

361
The other pricing methods that may be adopted by companies are as follows:
(a) Intuitive Pricing: This involves pricing by the "feel of the market" and can
vary from a pure guess to a well-informed attempt to interpret part data and
future trends. It is occasionally used to adjust the cost-plus price according to
the management's perception of likely demand, competition, etc.

(b) Experimental Pricing: This involves the selection of a sample test markets to
create a statistical model which is used to manipulate the price among markets
in order to arrive at a price which maximizes profits. It can be used when there
is a pricing decision concerning a new profit.

(c) Incremental Cost Pricing: It is based on the concept that a price should be
such that incremental cost is less than the incremental
revenue.

(d) Pricing in a Multi-product Situation: From a more objective view,

companies are seen not to be producers of only one but a multiple of products.
However, two issues are of importance in a multi-product environment, namely:
(i) pricing substitute goods, for example, pharmaceuticals where two
methods are in use.
 Uniform margin on the entire range of similar products.
 Varying the size of the margin depending on the cost of each
product in the range.
(ii) Pricing complementary goods such as bread and butter – since the
demand for the product is positively correlated, a decrease in price of
one product increases the demand for its complement.

(e) Demand Oriented Pricing: It is in the attitude of customers influencing

pricing decisions, that is, the price a customer is willing to pay for a product
and it is not simply a consequence of the product itself.

3.5 PRICE DISCRIMINATION

Price discrimination is the 'sales of technically similar products at prices which are not
proportional to their marginal costs'.

This is possible if a firm's management can establish separate market segments for the
same basic product, and prevent contact between ('seal off') the different segments, so
that a different price can be charged for the same product in each segment.

There are several ways, in practice, by which price discrimination may be exercised:
(a) Through negotiation with individual customers. For example, A might buy a
video cassette recorder from firm X for N600 cash, whereas customer B might
buy the same item and negotiate a discount for cash of say 20%;
(b) On the basis of quantities purchased: bulk purchase discounts are a well-

362
established form of price discrimination which offers favourable prices to large
customers.

4.0 CONCLUSION

Pricing is to ensure the determination of selling prices with the objective of achieving
a target return on investment; stabilize output and realization of a target market share.
The factors that influence pricing decisions include the pricing objectives,
relationships between price and output, selling price/demand relationships, costs,
government interference and overall company goals.

5.0 SUMMARY

The unit also covers the main pricing methods, which include full cost based or cost
plus; marginal cost based, minimum price, pricing based in mark-up and demand
analysis.
Other pricing methods are: Intuitive, experimental, incremental, multi-products,
demand oriented.
Price discrimination is the sales of technically similar products at prices which are not
proportional to their marginal costs. It could be practiced through negotiation, quality
purchased, product type, location or area.

6.0 TUTOR MARKED ASSIGNMENT

1. What is marginal pricing?

2. State three factors which may need to be considered in a pricing decision.

3. What are the short comings of using cost-plus-system pricing?

4. Explain full-cost-pricing.

5. Define price discrimination.

6. Explain demand oriented pricing.

7. A price which exactly covers incremental costs of making the items sold, the
opportunity costs of the resources consumed in making the item is
called………….

8. A product or service sold at lower than normal margins in order to attract

customers who might then buy other items at normal prices is known as……….

7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

363
Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

UNIT 18 RATIO ANALYSIS

CONTENT

364
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Nature of Ratio Analysis
3.2 Classes of Ratios
3.2.1 Profitability Ratios
3.2.2 Solvency Ratios
3.2.3 Investment Ratios
3.2.4 Activity Ratios
3.2.5 Value Added Ratios
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

A ratio is expressed as the measure of the relationship between two mathematically

inclined items or objects. (That is. the relationship between two or more variables). A
financial ratio is that which measures the mathematical relationship between two or
more accounting items, such that qualitative opinion about a company's financial
results can be expressed at a point in time.

The various users of financial statements (that is, management, shareholders,

employees, trade unions, government and government agencies, lenders, auditors,
suppliers, public/customers, competitors, financial analysts, and researchers) have
different reasons for analyzing the results as a basis to form their opinions on how well
the operations of a firm had been run as well as its financial position as at a given date.
It would assist in determining the strengths and weaknesses of a firm and also be able
to predict the future. A good knowledge of the interpretation of the ratios is therefore,
desirable for management in taking decisions.

2.0 OBJECTIVES

In this unit, readers will be able to understand:

 Ratio analysis as a concept.
 The basis for comparing ratios and the associated analysis that are involved.
 The benefit and limitations of ratio analysis.
 The computation of the various ratios.
 And identify the main value-added ratios and the manner of computation.

3.0 MAIN CONTENT

3.1 NATURE OF RATIO ANALYSIS

365
Ratio analysis forms the basis for assessing the financial results and performance of a
company using accounting data or figures that make the measure of financial
relationship possible. For example, current ratio can be determined by the relationship
between current assets and current liabilities. Hence, the nature of ratio analysis is
such that, the quantitative expression is used to arrive at qualitative opinion.

A single financial ratio is not itself enough to determine a good or bad situation, hence
the need to compare with some other ratios using some standards which may include:

(a) Historical ratios: These are those computed from the past records of the same
company;
(b) Industry ratios: These are, those that were computed on the average of all the
firms in the same sector of the economy. It is the industrial average ratio;
(c) Projected ratios: These are, those that were derived based on the
budgeted financial statements of the same company; and
(d) Competitors' ratios: These are, those of chosen competitor companies, most
importantly the ones adjudged adequate in the same period. The ratios are
computed based on the financial statements of the competitor company for the
same period.

The ability to properly evaluate a company's performance is also a function of the

following analysis which are off-shots of ratio analysis:

Trend Analysis (Time Series)

This has to do with the comparism of financial ratio over a given period of time. This
helps to ascertain the mode of change and the determination of the company's financial
results in terms of being constant, diminished or increased over a given period of time.
Nonetheless, focus should also be on the reason for the change and not just the change
itself.

Industry Analysis
The comparison of a company's financial ratios with that of the industry average ratios
which it belongs to is referred to as industry analysis. The latter provides a basis for
assessing the financial position and performance of the company when weighed
alongside those of other companies within the same industry. Nevertheless this basis is
not without its shortcomings:
(a) Difficulties in obtaining information for deriving the industry average ratios,
(that is, financial statement of similar companies may not be readily available).
(b) The averages so derived are those of both the viable and less viable companies
within the industry
(c) Accounting policies and mode of operation may not be the same for all the
companies within the industry
(d) Differences in parameter of the variables (that is, of the numerator and
denominator).

366
Cross-Sectional Analysis
Where the ratios relating to the same period and of particular company is compared
with that of some companies within the same industry relating to the same time, we
have what can be referred to as cross-sectional analysis. This is usually done by
picking out the ratios of the relevant competitors to the company especially where they
operate on a similar basis. Thus, what is being measured here, is the relative financial
standing and operational results of the company under consideration.

Budgeted Analysis
It is possible for future ratios to be used as basis for comparing two or more companies
and where this is the case, we have what is referred to as budgeted analysis. What is
actually involved here, is the comparism of the current/ past ratios with the future
ratios in order to determine the company's relative strength and inadequacy before,
now and in the future. The effect of this, is to show the deficiency of the financial
situation so that remedial actions can be put in place.

From the foregoing, ratio analysis can focus on different issues as they relate to the
measurement of a company's performance which include:

 The financial results of the company as they have to do with the generation of
revenue.
 The company's ability to meet up with her obligations in both the long and short
run.
 The evaluation of the company 's results relative to the benefits to be derived by
the owners of the business (existing or potential).

3.2 CLASSES OF RATIOS

Based on the needs of the different users of financial statements, ratios have been
classified as follows:
 Profitability ratios
 Solvency ratios
 Investment ratios
 Activity ratios
 Value-added ratios.

3.2.1 Profitability Ratios

The profitability ratios are determined in order to ascertain or evaluate the operating
adequacy of a company over time. Apart from the management of the company, the
other interested parties in the profits made by the company are the creditors and the
shareholders.

The debenture holders are conscious of their principal and the accrued interest while
the shareholders await the return on their investments in terms of dividend.
367
In order to give room for effective analysis, the ratios under this category are:
(a) Return on capital employed
(b) Asset turnover ratios
(c) Profitability margin ratios
(d) Other margin ratios.

Return on Capital Employed (ROCE)

This is an important ratio in that it measures the relationship between the Net Profit
and the Capital Employed or the Total Net Assets. The ROCE shows the effects of
sales, different assets, and various costs on the total company's results or position.

The ROCE can be defined in different ways depending on the objective to be achieved
and the comparisms to be made. The following can be adopted for the purpose of
defining 'capital employed':
(a) Total capital which is a function of share capital, retained profits, reserves,
long-term liabilities and current liabilities.
(b) Long term capital which is made up of total capital less current liabilities.

Of importance is the numerator, which is the profit and it can be defined as net profit
before tax, loan interest and bank interest or net profit before tax and loan interest.

Therefore, ROCE can be expressed as:

Net Profit Before Interest and Tax x 100

Total Capital

Asset Turnover Ratio

This ratio shows the extent to which the assets have been utilised and is used to predict
the degree of future profits.

Profitability Margin Ratios

These ratios are used to measure the total relationship of the margin on sales and asset
turnover as well as those of operating costs. These ratios are used to determine
managerial capability.

ILLUSTRATION 18 – 1

The following is the final accounts of Prospect Plc:

Prospect Plc
Profit and Loss Account for the period ended 31 December 2005.

N’000 N’000
Sales 9,800

368
less Manufacturing cost of sales
Materials 3,915
Labour 1,710
Factory Overheads 1,088 6,713
GROSS PROFIT 3,087
less Administrative Expenses 1,010
Selling & Distribution Expenses 640
Bank Interest 100
Loan Interest 450 2,200
NET PROFIT BEFORE TAX 887
less Tax 174
PROFIT AFTER TAX 713

less Dividends
15% Preference 113
Ordinary – Interim (paid) 270
Ordinary – Final (proposed) 270 653
TRANSFERRED TO RESERVES 60

Prospect Plc
Balance Sheet as at 31 December 2005
N’000 N’000 N’000
FIXED ASSETS
Premises 3,750
Plants and Equipments 5,625
Motor Vehicle 893
Goodwill 263
Patent Right 75 10,606

CURRENT ASSETS
Stock: Finished Goods 300
Raw Materials 292
Consumables 480
Trade Debtors 1,537
Cash Bank 240 2,849

Less CURRENT LIABILITIES

Bank overdraft 1,275
Trade Creditors 1,236
Taxation payable 174
Proposed dividend 270 2,955 (106)
10,500

Represented by

369
SHARE CAPITAL
Ordinary Shares N1 each 4,125
15% Preference Shares N1 each 750
RETAINED PROFIT 2,625
7,500

DEBENTURES
15% loan stock 3,000
CAPITAL EMPLOYED 10,500

Required: Calculate the profitability ratios of Prospect Plc.

SUGGESTED SOLUTION 18 – 1

Profitability Ratios:
(a) ROCE = Net Profit before Interest and Tax x 100
Total Capital
= N1,437,000 x 100
13,455,000
= 10.68%
Total Capital = N10,606,000 + 2,849,000 = N13,455,000
Net Profit, that is PBIT = N887,000 + 100,000 + 450,000
= N1,437,000

(b) The various asset turnover ratios can be computed thus:

Sales = 9,800,000
Total Assets 13,455,000 = 0.73:1

Sales = 9,800,000
Fixed Assets 10,606,000 = 0.92:1

Sales = 9,800,000
Stock 1,072,000 = 9.14:1

Sales = 9,800,000
Current Assets 2,849,000 = 3.44:1

Profit margin ratios

PBIT x 100 = 1,437,000 x 100 = 14.7%

Sales 1 9,800,000 1

Manufacturing Costs x 100 = 6,713,000 x 100 = 68.5%

Sales 1 9,800,000 1

370
Selling and Distribution Exp. x 100 = 640,000 x 100 = 6.5%
Sales 1 9,800,000 1

Administrative Overheads x 100 = 1,010,000 x 100 = 10.31%

Sales 1 9,800,000 1

Material Costs x 100 = 3,915,000 x 100 = 40.0%

Sales 1 9,800,000 1

Labour Costs x 100 = 1,710,000 x 100 = 17.45%

Sales 1 9,800,000 1

Factory Overheads x 100 = 1,088,000 x 100 = 11.1%

Sales 1 9,800,000 1

In addition to computing the above ratios, past years’ ratios, time analysis and issues
advanced for draw backs need be compared in order to address laxities in operations.

3.2.2 Solvency Ratios

These ratios can be categorised into two:

(a) Short-term solvency or liquidity ratios
(b) Long-term solvency or leverage ratios.

Liquidity or Short-Term Solvency Ratios

The liquidity ratios are used to determine the ability of the company to meet its current
obligations or liabilities. Illiquidity will lead to loss of goodwill, poor credit ratings
and undue legal tussles which may eventually lead to the winding up of a company.
Excess liquidity could also lead to under utilisation of assets.

The liquid ratio can be classified as:

(a) Current ratio;
(b) Quick or add test ratio;
(c) Cash ratio;
(d) Interval measure; and
(e) Net working capital ratio.
(a) The Current ratio is a measure of the relationship between
the current assets and current liabilities. The current assets are made up of cash,
debtors, bank and those assets that can be easily turned into cash within a
period of one year, these include stock, marketable securities and prepayments.
The liabilities payable within one year are referred to as current liabilities such
as trade creditors, bills payable, bank overdraft, tax liability, proposed dividend
and portion of long-term debt due within a year. A ratio greater than one shows
that the company has more of current assets than current liabilities. The ratio
ideally, is expected to be 2:1.

371
Current ratio = Current assets
Current liabilities

(b) The quick or acid test ratio shows the relationship between
liquid assets and current liabilities. The stock and prepayment items are not
always included in the current assets because stock items are not usually the
same in the different companies while prepayments may not be easily
recoverable, for example, advance payment for electricity or telephone.

The quick ratio is calculated as:

Current assets - stock - prepayments

Current liabilities

A general quick ratio of 1:1 is considered reasonable for financial purposes.

(c) Cash ratio

Since cash is an important element of the current assets, it is considered
important to measure it along with trade investments which are cash equivalents
against current liabilities especially where the value of the former is significant.
This ratio is used to determine the degree of responsiveness of cash and cash
equivalents to take care of current liabilities and ascertain the ability of the
company to hold enough cash and cash equivalents per time. It can be
expressed as:

Cash + marketable securities/trade investments

Current liabilities

(d) The interval measure ratio is that which is used to evaluate the company's
ability to take care of its constant cash expenditures, that is, it is used to measure
the relationship of liquid assets to average daily operating cash outflows. It may
also be expressed as a measure of additional operating expenditures such as
discharging of interest, acquisition of assets and repayment of debts. It is also
used to determine the number of days that there will be sufficient liquid asset to
finance operation without having any cash intake.

Interval measure = Current Assets - Inventory/Stocks

Average daily operating expenditures

(e) Net Working Capital ratio is that which measures the difference between the
current assets and current liabilities which is an expression of the company's
potential funds reserved. Therefore, it can be measured as the relationship with
net assets.

Net Working Capital = Net Current Assets

372
Net Assets (Capital Employed)

Leverage or Long-Term Solvency Ratios

These are ratios that are used to ascertain the long-term financial performance of a
company, hence, the usage of the terms financial leverage or capital structure.
Therefore, they are used to determine the manner in which funds provided by
shareholders (owners) and debenture holders (lenders) are mixed up in order to finance
the assets of the company. In general, the leverage ratios are determined in order to
compute the financial risks and the company's competence to engage debts tote
shareholders' benefits.

The usage of external funds in relation to the internal funds is a function of the
following issues:
(a) External funds (debts) are riskier from the company's view point, because of the
need to pay interest not minding the amount of profits or losses made,
(b) Shareholders can benefit from the arrangement in terms of sustaining control
with minimum risk and their earning could be improved upon when the rate of
return on capital is greater than rate of interest paid on borrowed funds.
However, the reverse could be the case if the latter is greater than the former,
and
(c) The company may not be able to secure funds from external sources if the
equity provided is small compared to the funds being borrowed.

The ratios that can be computed under leverage ratio include:

(a) Gearing ratio = Fixed Interest Capital x 100

Capital Employed (Net Total Assets)

Where the fixed interest capital is made up of the long-term loans from the financial
institutions as well as the debentures or bonds raised from the capital markets and any
other interest-bearing loan, whereas capital employed is the totality of net fixed and
current assets.

(b) Debt ratio = Total debts x 100

Capital employed

Where the total debts is a function of the fixed interest capital and short-term
funds, deferred charges and various deposits. This ratio is to measure the extent
to which the external providers of funds have contributed to the financing of the
company.

(c) Equity to Assets ratio

= Shareholders Funds (Capital and reserves) x 100
Total Assets

This is to measure the degree of contribution of owners of business in financing

373
the total assets put to use at a point in time.

(d) Coverage ratios

These are used to assess the debt-servicing capacity of a company in terms of
meeting the payment of interest on loan and other charges that are fixed in
nature.

The various ratios that can be calculated under the heading include:
(a) Interest coverage ratio
(b) Fixed charges coverage ratio.

Interest coverage ratio = Net Profit Before Interest and Taxes

Interest

This reflects the number of times the charges for interest are paid for in the ordinary
course of doing business. However, a variation of this could be computed.
The interest coverage ratio can be calculated as:

Interest coverage ratio = Net profit before depredation, interest and taxes
Interest

This ratio is however, computed in order to determine the degree to which profits may
diminish without indicating any decline in the ability of the company to meet up with
her obligation in paying interest expenses.

Fixed charges coverage ratio =

Net profit before depredation, interest and taxes
Interest + (Loan repayment/1 - tax rate)

As a result of interest coverage ratios inability to consider the repayment of loan, the
above ratio is computed in order to provide coverage measure in terms of cash flow
rather than profits earned.

Nonetheless, other fixed charges like lease rental fees and dividend
paid to preference shareholders can be recognised in the computation
of the fixed charges coverage ratio and can be recomputed as follows:

Net profit before depreciation, interest and taxes plus rentals lease
Interest + lease rentals + (Preq. dividend + loan repayment)/1-tax rate

ILLUSTRATION 18 – 2

Using the data from illustration 18 – 1, compute the short term, leverage and coverage
ratios of Prospect Plc. You may assume that average stock is the same as stock figure
given in the balance sheet.

374
SUGGESTED SOLUTION 18 – 2

Current ratio = Current assets = 2,849,000

Current liabilities 2,595,000 = 0.96:1

Since the above is not in conformity with the norm of 2:1, it could be said that the
above ratio is not acceptable.

Acid or Quick Test Ratio = Current assets – stock – repayments

Current liabilities

= 2,849,000 – 1,072,000 = 1,777,000

2,595,000 2,955,000

= 0.60:1
Cash ratio = Cash + trade investments = 240,000
Current liabilities 2,955,000 = 0.08:1

This goes to indicate that the cash position of the company is so tiny that the company
may require a lot of cash to meet up her immediate obligations.

Interval measure
= Current assets - Stocks/inventory = 2,849,000 - 1,072,000 x 365
Average daily operating expenditure 8,913,000 1

= 72.77  73 days

Net-working capital ratio = Net Current Assets = (106,000) = (0.008):1

Capital Employed 13,455,000

This is a bad picture as the company is not in any position to take care of her
immediate obligations and contributions of net assets to capital employed being
negative is too good.

Leverage ratios
Gearing ratio = Fixed Interest Capital x 100 = 3,000,000 x 100
Capital employed 10,500,000

The company is not highly geared.

Debt ratio = Total debts x 100 = 5,955,000 x 100
Capital employed 10, 500,000
= 56.71%

This is relatively on the high side and calls for caution if the company is not to be seen
as over-trading and the need to manage current assets very well.

375
Equity to Asset ratio = Shareholders Funds x 100 = 7,500,000 x 100
Total Assets 13,455,000
= 55.74%

Interest Coverage ratio Net Profit before Interest and Taxes

Interest
= 1,437,000
550,000 = 2.61 times
3.2.3 Investment Ratios

As an off-shoot of the profitability ratios, the investment ratios are calculated in order
to determine the ability of the company as it relates to consistency in sustaining
investment potentials and stability.
The various ratios that can be calculated include:
(a) Earnings per share (EPS)
(b) Dividends per share (DPS)
(b) Dividends pay-out ratio
(c) Earnings yields
(d) Dividends yields
(e) Price - earnings ratio (PER)
(f) Market value - to- book value ratio.

Earnings Per Share

This is a ratio that indicates the relationship of the distribution of profits
to every shareholding in a company, even though, there is no reflection
of the amount paid as dividend or retained by the business. It is calculated thus,

EPS = Net Profit After Tax - Preference Dividend (Gross)

Number of ordinary share on issue

Dividends Per Share (DPS)

Since dividend is the return on investments made by the shareholders
after taxes might have been considered, then, it is this dividend that is expressed as a
function of the number of ordinary shareholdings in the company. It is calculated as:

DPS = Ordinary Dividend (Interim and Final)

Number of Ordinary share in issue

Dividend Cover /Pay-Out Ratio

This is a ratio that shows the relationship between the DPS and EPS,
that is, it shows the proportion of earnings or profit after tax that is required to pay the
current dividends due to each ordinary shareholder. It is calculated as:

Dividend - Payout Ratios = Dividend Per Share x 100

Earnings Per Share 1

376
Dividend Yield
This is a ratio that is used to determine the percentage of return on investment made
and it is calculated as:

Dividend yield = DPS x 100

MVS where mvs is market value per share.

Earning yields/E/P Ratio

This is a ratio used to measure the degree of responsiveness of net
profit after tax per share to market value per share. The latter can be
sourced from the stock exchange official daily listing made available through the
financial periodicals or the stock exchange itself. It is calculated as:

Earnings yield = EPS x 100

MVS

P/E Ratio
The inverse of the earnings yield is referred to as the price-earnings
(P/E) ratio and is determined as:
Price-earnings ratio = MVS
EPS

This is a ratio that shows the shareholder's future outlook about the increase in the
company's profit after tax. The security market operators also use it to evaluate the
company's financial position as required by the shareholders.

Market Value -to-Book Value Ratio

This is a ratio that measures the relationship between the ruling share
price of a security and the book value of the security. The ratio is calculated thus:
Market value per share
Book Value per share.

ILLUSTRATION 18 – 3

Using the data given in illustration 18.1, determine the various investment ratios for
Prospect Plc, assuming that the market value for ordinary share is N3.00 per share,
preference shares N1, and debentures are listed at 98.

SUGGESTED SOLUTIONS 18 – 3

Earnings Per Share (EPS)

= Net Profit after tax less preference dividend (gross)
Number of ordinary shares on issue
= N600,000 = 14.56k
N4,125,000

377
Dividends Per Share (DPS) = Ordinary Dividend
Number of Ordinary Shares On Issue
= N540,000
N4,125,000 = 13.09k

Dividends Cover/Payout Ratio = DPS x 100 = 0.131 x 100

EPS 0.146
= 89.73%
Dividend Yields = DPS x 100 = 0.131 x 100
MVS 3.00
= 4.37%

Earnings yield = EPS x 100 = 0.146 x 100

MVS 3.00
= 4.87%

Price-Earnings Ratio = MVS = 3.00 = 20 times

EPS 0.15

Market Value-to-Book Value = MVS = 3.00 = 1.18:1

BVS 2.55

Capital Gearing = Market value of preference shares + debentures x 100

Market value of equity
= 750,000 + 2,940,000 x 100
12,375,000 = 29,82%

3.2.4 Activity Ratios

These are ratios used by companies to assess the degree of effectiveness achieved with
the utilization of their assets. They also show the rate at which assets are turned over
into sales. Therefore, they are used to measure the relationship between sales and
assets. The ratios that can be calculated include:
(a) Stock turnover
(b) Debtors turnover
(c) Average collection period
(d) Assets turnover
(e) Working capital turnover.

Stock Turnover Ratio

This ratio shows the ability of a company in manufacturing and marketing of its
product and is computed by dividing the cost of sales by the average stock, that is.
Stock turnover = Cost of Sales
Average Stock

378
where the average stock (is the opening and closing balances of stock divided by 2).

However, the stock turnover can be given on percentage basis by having its reciprocal
which is referred to as the stock holding period and this is calculated thus:
Stock holding period = Average stock x 365 days
Cost of sales Or
= 365 days
Stock turnover

However, where the cost of sales is not available, the stock turnover can be calculated
thus:
Stock turnover = Sales and
Stock

Stock holding period = Stock x 365 days

Sales

It is to be noted that the first basis for calculating stock turnover is preferable because
costs are related to costs unlike the second basis whereby value is related to costs.

Of importance is the fact that, it may also be required to look at the efficiency in
turning raw materials to work in progress and the latter to finished goods, therefore,
the calculation can be as follows:

Raw material stock turnover = Raw materials consumed

Average raw material stock
And,
Work-in-progress stock turnover = Cost of production
Average work-in-progress

Note that where the data for raw materials consumed and cost of production are not
accessible, raw material consumed and work in progress can be associated with the
sales figure.

Debtors Turnover Ratios

These are the ratios that are calculated to determine the degree of responsiveness of
debtors to credit sales activities. Hence, the following ratios are calculated: (a) debtors
turnover and (b) debtors average collection period.

Debtors Turnover
This ratio is used to show the number of times that debtors are turned over-in a year.
The management is adjudged reliable and effective if the ratio of debtors turnover is
high.
The ratio is determined thus:
Debtors turnover = Credit Sales
Average debtors

379
However, where the credit sales and the opening and closing debtors balances are not
available, then, the calculation can be determined as:

Debtors turnover = Sales

Debtors

Debtors Average Collection Period

This is the ratio that is used to determine the average number of days for which
amounts due from debtors remain uncollected and it is also used to determine a
company's ability to sustain its credit policy compared with those of its competitors. It
can be calculated as follows:
Average collection period = 365 days or Debtors x 365 days
Debtors turnover sales

It is also to be noted that sales are assumed to be consistent throughout the year.

Assets Turnover Ratios

Sales are generated by putting assets to work. It is therefore, necessary for the assets to
be fully utilised so that sales can be increased. These ratios are to measure the
relationship between sales and assets. Some of the ratios that can be calculated are:

(a) Net Asset Turnover = Sales

Net Assets

(b) Total Asset Turnover = Sales

Total Assets

(a) Fixed Asset Turnover = Sales

Net fixed Assets and

(a) Current Asset Turnover = Sales

Current Assets

Working Capital Turnover Ratios

This is the ratio that compares the net current assets (net working capital) to sales
which is indicative of determining every naira of net current assets required for every
naira of sales. It can be calculated by dividing sales by net working capital.
Working capital turnover = Sales
Net Current Assets
ILLUSTRATION 18 – 4

Using the data provided in illustration 18 – 1, calculate the various activity ratios for
Prospect Plc assuming that the stock values given in the Balance Sheet is the same as
the average stocks during the year.

380
SUGGESTED SOLUTION 18 – 4

Stock turnover = Cost of sales = 6,713,000 = 6.26 times

Average Stock 1,072,000

Stock holding period = Average stock x 365 days

Cost of sales
= 1,072,000 x 365 days
6,713,000 = 58.29 days

Debtors turnover = Sales = 9,800,000 = 6.38 times

Average debtors 1,537,000

Average Collection period = Debtors x 365 days

Sales
= 1,537,000 x 365 days
9,800,000 = 57.24 days

Total Assets turnover = Sales = 9,800,000

Total Assets 13,455,000 = 0.73 times

Fixed asset turnover = Sales = 9,800,000

Net Fixed Assets 10,268,000
= 0.95 times

Working capital turnover = Sales = 9,800,000

Net Current Assets (106,000)
= (92.45) times

3.2.5 Value Added Ratios

Value added is defined by CIMA as 'sales value less the cost of purchased materials
and services. This represents the worth of an alteration in form, location or availability
of a product or service'.

The value added is usually applied in paying employees, providers of capital

(shareholders, debentures and long term loan), the government, as well as provisions
made for maintenance and increasing the value of assets (depreciation and retained
earnings).

Value Added ratios are therefore, those calculated to measure the degree of
responsiveness of value added to the various beneficiaries of the wealth created. The
typical ratios include:
(a) Value added to fixed assets.
(b) Value added to current assets.
(c) Value added per employee.

381
4.0 CONCLUSION

The common ratios are profitability solvency, investment, activity and value added.

The profitability ratios include ROCE, asset turnover ratios etc. The activity ratios
include debtors turnover, stock turnover, asset turnover etc.

The solvency ratios are of two types viz: short-term and long-term. The short-term
include: current ratios and the add test ratio; while the long-term ratios are concerned
with the financial stability and structure of the company e.g. gearing ratios.

The investment ratios include earnings per share, dividend per share etc.

Value added is the wealth created by a company through its own activities and
expressed in a statement (Value Added Statement) to reflect the effective performance
of a firm.

The value added ratios include value added per employee etc.

5.0 SUMMARY

In this unit, we have discussed that Ratio Analysis uses financial reports and data and
explains key relationships (for example, gross profit to sales) in order to assess
financial performance. Its importance becomes greatly enhanced when trends are
determined, comparative ratios are available and inter-related ratios are made
available.

6.0 TUTOR MARKED ASSIGNMENT

1. Define the term ratio analysis.

2. What are the formula for current ratio and quick or acid test ratio?

3. Explain how to calculate interest coverage ratio.

4. State two long-term solvency ratio.

5. What is the formula for earnings per share?

6. The difference between sales income and bought in goods and services is
known as__________

7. A method of comparing one company’s financial ratio with that of another

within the industry average is referred to as_______

382
7.0 REFERNCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

UNIT 19 COST CONTROL AND COST REDUCTION

CONTENTS

383
1.0 Introduction
2.0 Objectives
3.0 Main Content
19.1 Cost Control
19.2 Cost Reduction
19.3 Similarities and Differences between Cost Control and Cost Reduction
19.4 The Scope of Cost Reduction
19.5 Factors to be considered for Reducing Costs
19.6 Cost Reduction Techniques
19.7 Standardization and Variety Reduction
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

Cost control is the regulation of the costs of operating a business and it is concerned
with keeping expenditure within acceptable limits whereas cost reduction is a planned,
positive approach at reducing expenditure where it is in excess. It entails focus on
material costs, labour costs, finance costs and rationalization measures.

2.0 OBJECTIVES

In this unit, readers will be able to understand:

 The concepts of cost control and cost reduction;
 The main differences between cost control and cost reduction;
 The similarities between cost control and cost reduction;
 The factors considered for cost reduction purposes;
 The various cost reduction techniques.

3.0 MAIN CONTENT

3.1 COST CONTROL

Cost control involves all methods of controlling costs within a pre-

determined target. Examples of cost control techniques are budgetary control and
standard costing.

Cost control actions lead to a reduction in excessive spending, for example, when
material wastage is higher than budgeted or productivity level is below the agreed
standard. Both budgets and standards reflect current costs and conditions, and not
necessarily the cost and conditions which would minimize costs. Therefore:
(a) Standard costing and variance analysis is often an inadequate means of

384
controlling costs (although it is an effective means of control.)
(b) Standards set may be generous and incorporate low standards of efficiency.
This can be referred to as introduction of budget slack variable unto the system.
(c) Budgets may include contingency allowances.

Cost control process involves setting targets, receiving feedback information in order
to ensure that actual performance are in line with target set, and if not, to take
corrective actions.

3.2 COST REDUCTION

This is an active, dynamic concept, which attempts to extract more from the factors of
production without loss of effectiveness.

Cost reduction activities are planned efforts to reduce expenditure; they should
preferably be continuous, long term efforts, so that short term cost reductions are not
soon reversed and forgotten. The major difficulties with cost reduction programmes
are:
(a) Resistance by employees to pressure, to reduce costs, usually because the
nature and purpose of the campaign has not been properly explained to them,
and they feel threatened by the change.
(b) Application may be limited to a small area of the business (e.g.. to one
department) with the result that costs are reduced in one cost centre only to re-
appear as an extra cost in another cost centre.
(c) Efforts to cut materials or labour costs may erode confidence in the established
systems for estimating material usage and labour efficiency standards.
(d) Cost reduction campaigns are often introduced as a rushed, desperate measure
instead of a carefully organized, well thought out exercise.

3.3 SIMILARITIES AND DIFFERENCES BETWEEN COST CONTROL AND

COST REDUCTION

They are similar as they both:

1. Ensure the efficient utilisation of resources.
2. Involve the pre-setting of a target after an initial cost analysis.

The differences include the following:

(i) Cost control is static with the basic objectives of containing cost within pre-set
target while cost reduction aims to reduce costs from some predetermined target
without reducing the benefits derived from the product made or service
rendered.
(ii) Cost control is an on-going process while cost reduction is on ad-hoc basis.
(iii) They both have quite distinct objectives and different techniques are used to
achieve their goals.

3.4 THE SCOPE OF COST REDUCTION

385
The scope of cost reduction embraces activities of the entire company, from
production to marketing and at all levels within the organization from the operative to
top levels.

Costs reduction efforts may include the following:

(a) Material costs:
(i) Quantity discounts or cash discounts for early payment to suppliers may
be negotiated at favourable discount rates;
(ii) Inventory control policy might need improvement;
(iii) Value analysis may be carried out;
(iv) Procedures for reducing material wastage in production should be
instituted.

(b) Labour costs:

(i) Labour efficiency may be improved by work study
(ii) Unit labour costs and unit overhead costs may be reduced by having
production efficiency rewarding plan with the employees.
(iii) Total costs may be reduced by replacing labour intensive jobs with
automated machines related jobs.

(c) Finance costs:

(i) Where there is the desire to allow for discount, it should be done on a
regular basis.
(ii) Bank overdraft expenses may be better reduced by effective cash
monitoring efforts.

(d) Rationalization Measures:

As a company expands in activities, there may be duplication of efforts in the
different facets of its operations. However, this duplication can be removed by
ensuring that resources are concentrated in the firm and this is referred to
rationalisation efforts, which is aimed at cost reduction that brings about
efficiency at the workplace.

3.5 FACTORS TO BE CONSIDERED FOR REDUCING COSTS

The following factors are to be considered if cost reduction is to be meaningful:

(a) Efficient business may not be able to avoid undue expenses;
(b) Inconsistency of management may add to costs;
(c) Employees may want to resist change;
(d) Faultless system may be costly;
(e) Avoidance of elaborate procedures;
(f) Cost reduction efforts can be enhanced by allowing for creative ideas;
(g) The sources of costs must be given adequate and prompt attention;
(h) Short-term action should be related to long-term objectives;
(i) Cost reduction should be maintained; and

386
(j) Communication of company policy and objectives in the context of cost
reduction.

The following explanatory notes have been provided to clarify some key terms
necessary for the understanding of the cost reduction factors.
(i) Undue Expenses
Undue expenses can be removed without having to compromise the quality of
the items of production or units of service provided.

Consumers can only appreciate buying goods of better quality.

Nonetheless, a lowering of the standard may ensure the reduction of costs but at
the expense of the quality of goods.

(ii) Management Inconsistency

Cost reduction programme requires the support and commitment of the top
management and this has to be on a regular and consistent basis in order to
avoid complacency not minding whether the business climate is harsh or
friendly.

(iii) Resistance To Change By Employee

Employees may want to react to change negatively as a result of past beliefs or
norms. This can be addressed by ensuring that existing systems or work
environment situations are constantly reviewed and friendly employees are
involved at every stage in order to gain their confidence and support. With this,
negative efforts will be eliminated and costs reduced.

(iv) Faultless System

A faultless system may be a desired one, but efforts should be made to ensure
that it is not over blown so that unnecessary controls are removed.

(v) Avoidance of Elaborate Procedures

Elaborate procedures if allowed in a company, may bring about costly
operations at the expense of ensuring that employee capabilities are recognised
which could lower costs.

(vi) Creative Ideas

Since issues can be approached from different ways, ideas and contribution
from everyone involved in cost reduction programme must be allowed for in
order to eliminate wastes. Creative ideas can be enhanced by ensuring that
employees are given good incentives to work and the work environment must
be friendly so that any scheme put in place can be successful.

(vii) Areas of Cost Reduction

For cost reduction activities to be meaningful, the sources for incurring these
costs such as finance, marketing, production, human resources, engineering,
maintenance, etc. need be considered in terms of the material, labour and

387
overhead costs involved in the areas mentioned. There is a need for using an
integrated approach whereby costs are not considered in isolation, but their
inter-relatedness is given some consideration. The managers are, therefore,
expected to exchange ideas that will allow for goal congruence to be attained.

(viii) Maintaining Cost reduction

Cost reduction can be sustained or maintained by ensuring that there is
consistent control of costs in place with the aid of budgetary control technique.

(ix) Short Term Action should be related to Long Term Objectives A cost
reduction campaign should have a long term aim as well as short term
objectives.
 In the short term, only variable costs, for the most part, are susceptible to
cost reduction efforts. Many fixed costs (for example, depreciation, rent)
are unavoidable.
 Some fixed costs are avoidable, in the short term (e.g. advertising or
sales promotion expenditure). These are called 'discretionary fixed costs'.
 In the long term, most costs can either be reduced or avoided. This
includes fixed costs as well as variable cost expenditure items.

(x) Communication
Information to employees must be such that they are timely, relevant, focused
and less costly. Information will be valued, where employees are convinced that
their future is guaranteed and prospects can be ascertained at the same time.
Good and equitable personnel manual must also be in place.

3.6 COST REDUCTION TECHNIQUES

The cost reduction techniques include:

(i) Value Analysis: Value analysis or value engineering is an assessment process
carried out by a team during the design stages of a product, with the aim of
designing a product or methods of rendering a service which meets the essential
design objectives at minimum cost.
Four aspects of value analysis that should be considered are:
(a) Cost Value- that is. its cost of sale
(b) Exchange Value-that is, its market value
(c) Use Value- that is, what the article does, the purposes it fulfils. Value analysis
attempts to provide the same (or a better) utilisation value at the lowest cost.
(d) Esteem Value- that is, the prestige the customer attaches to the product. Value
analysis attempts to 'maintain or enhance the prestige of a product at the lowest
cost.
Value Analysis was a formal system developed after the second world war, when
shortages of materials forced manufacturers to look for cheaper methods of
production. It was found that cheaper production could be achieved with no loss in
quality or value. From this, value analysis, the systematic investigation of every source

388
of cost and technique of production with the aim of getting rid of all unnecessary costs.
An unnecessary cost is an additional cost incurred without adding use, exchange or
esteem value to a product.

Value analysis (value engineering) embraces the investigation of specification, design,

planning, buying, manufacture, testing, sales and distribution. Its methods include:
(a) Organization and methods study;
(b) A study of comparative costs; and
(c) A study of new available materials.

Three areas of special importance are:

(a) Product design; The designer should be cost-conscious and avoid unnecessary
complications;
(b) Components and materials cost: The purchasing department should beware of
lapsing into the habit of routine buying decisions. Buyers ought to be fully
aware of technological changes, and significant changes in material prices that
new technology creates;
(c) Production methods; These ought to be reviewed continually, on a product-by-
product basis.

The origins of value analysis were in engineering industry, but its principles and
applications spread wider. Value analysis can be applied to services, or aspects of
office work, or to management information systems (for example, the value of
information, reports. etc.)

The stages in value analysis

A value analysis study should be carried out by a team of experts, preferably with
varying backgrounds, which blends experience, skill and imagination.

The stages in value analysis are:

(a) Select a product or service for study: The product selected should be one which
accounts for a high proportion of the organizations' cost. since the greatest cost
savings should be obtained from high cost areas. The choice should also have
regard to the expected future life of the product and the stage of its "life cycle"
that it has reached.
(b) Obtain and record information: The question to be asked include what is the
product or service supposed to do? Would it succeed? What are the costs of the
product or service? Are there alternative ways of making or providing it? What
do these alternatives cost?

(ii) Work Study:

This involves the determination of the most efficient means of using input
resources such as labour, materials and machinery. It is a technique for
improving efficiency and rendering waste in factories and can be applied in
many areas including factory layout, and work flow, material handling, tool
design, scheduling, workplace methods and layout. Work study comprises

389
method study and measurement.

a. Method Study: This is that part of work study which is aimed at improving
methods, or establishing a correct method for a job or process to economise its
human effort and make more efficient use of men, materials and machines. The
procedure normally includes the selection of work to be studied, relevant facts
or method used, examining the facts logically, developing a more effective
method and installing and maintaining this method as a standard practice.

b. Work Measurement: This is the application of techniques designed to

establish the time for a qualified work to carry out a specified job at a defined
level of performance. Although, method study can also examine the more
effective use of manpower, measurement is distinct in that it aims to make
improvements in the labour planning and control, and through incentive
schemes the managing of organization. Thus, it is complementary to and can
assist the former by examining the times that alternative methods of carrying
out a work assignment would take. Thus, it can help to ascertain a balanced
allocation of manpower resources between the various stages in the production
of a product or service, In work measurement, time study may be used to
examine performance, after considering time allowances for such things as
relaxation. Frequently, statistical sampling techniques will be used in the
analysis especially with the large production units where otherwise it would be
impossible to consider each person and operation on an individual basis.

3.7 STANDARDISATION AND VARIETY REDUCTION

An examination of product components and final products can be carried out with the
objectives of optimising the range of these. In this case, special consideration will be
given to unprofitable products bearing in mind that such unprofitable products may be
necessary to ensure that the organisation has a complete product range to offer to its
customers. The intention as far as components of a product are concerned is to
simplify and standardise them as much as possible. This may all appear to be a subset
of value analysis. However, although the two techniques are inter- linked, there is the
distinction that rationalisation is relevant in the consideration of standardisation of
products and variety reduction.

4.0 CONCLUSION

We have discussed that Cost reduction techniques are value engineering analysis and
work study.

Value engineering or analysis embraces the investigation of specification, design,

buying, manufacture testing, sales and distribution.

Work study is a technique of management which is applied to existing procedures and

problem areas to eliminate wastes and improve efficiency It incorporates both method

390
study and work measurement in order to achieve the most efficient and economic
utilization of resources.

5.0 SUMMARY

This unit has treated the concepts of cost control and cost reduction; the main
differences between cost control and cost reduction; similarities between cost control
and cost reduction; factors considered for cost reduction purposes; various cost
reduction techniques.

6.0 TUTOR MARKED ASSIGNMENT

1 The process of regulating costs of operation of a business and keeping the

expenditure within acceptable limits is____________

2 A planned positive approach to reducing expenditure because of its

excessiveness is__________

3 State three main objectives of method study.

4 A cost reduction technique which is concerned with new products at the design
stage before production commences is known as_______

5 A cost reduction technique which attempts to reduce the manufacturing cost of

a product without reducing its quantity, performance or value to the customer is
called_________

6 A technique of management which is applied to existing procedures and

problems areas to eliminate waste and improve efficiency is known
as__________

7 State the stages in work measurement.

7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

391
UNIT 20 CURRENT TRENDS IN MANAGEMENT ACCOUNTING

CONTENTS

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 What is Advanced Manufacturing Technology? (AMT)
3.2 Benefits of AMT
3.3 Computer-Aided Design (CAD)
3.4 Computer-Aided Manufacturing Efforts (CAM)
3.5 Flexible Manufacturing System (FMS)
3.6 Total Quality Control (TQC)
3.7 Total Quality Management (TQM)
3.8 Management Accounting and AMT
3.9 Throughput Accounting
3.10 Back flush Accounting
3.11 Advantages of Back flush Accounting
3.12 Target Costing
3.13 Performance Evaluation in an AMT Environment
3.14 Life-Cycle Costing
3.15 Kaizen Costing
3.16 Benchmarking
3.17 Environmental Cost Management
3.18 Strategic Management Accounting
3.19 The Balanced Scorecard
3.19.1 Advantages and Drawbacks of the Balanced ScorecardTechniques
4.0 Conclusion
5.0 Summary
6.0 Tutor Marked Assignment
7.0 References/Further Readings

1.0 INTRODUCTION

The traditional management accounting when compared with the current

trends management is deficient in the areas of absorption costing methods; cost
behaviour analysis; standard costing and the pre-occupation with short-term financial
measures. This unit will throw light on what is obtainable in this modern era.

2.0 OBJECTIVES

In this unit, readers will be able to understand:

 The principal issues in Advanced Manufacturing Technology (AMT) and
relationship with management accounting;

392
 The concept of total quality management (TQM);
 The relevance of AMT to activity-based costing (ABC);
 The principal principles as they relate to throughout accounting;
 The usage of back flush accounting;
 The principles of target costing;
 How performance evaluation can be carried out with the use of physical
measures;
 Life-cycle costing and the stages involved in a product’s life cycle (PLC);
 The tear-down analysis, value engineering and functional analysis;
 The aim of kaizen costing;
 The different types of environmental cost;
 The various elements of strategic management accounting;
 The balanced scorecard and the associated benefits thereof.

3.1 WHAT IS ADVANCED MANUFACTURING TECHNOLOGY (AMT)?

Advanced Manufacturing Technology (AMT) is an umbrella word used to capture

automated production technology, computer assisted design and manufacturing
systems (CAD/CAM), flexible manufacturing systems (FMS), robotics, total quality
control (TQC), advances in production management including materials requirement
and manufacturing resources planning systems (MRP), just-in-time (JIT) systems etc.,
which are considered to be the new developments in the area of management
accounting due to technological advancement.

Based on the above, the traditional management accounting systems have

been found to be inadequate as basis for evaluating performance in
companies that have adopted the AMT. This view is supported by Kaplan
(1996) when he said that "traditional management accounting produces' , simply the
wrong measures. They move me company in the wrong direction, reward managers for
damaging the business and provide no incentive for improvement The best we can do
is to switch them off, just stop doing them!"

3.2 BENEFITS OF AMT

The benefits of AMT include:

(a) It assists companies to function effectively in the technologically and fast
growing economies and global markets.
(b) It ensures that consumers derive better satisfaction from super-quality goods
that are made available at cheap rates.
(c) Encourages companies to cope with short product life cycles which are
enhanced by flexibility and innovation in production activities.
(d) Abilities to sustain cost reduction programme and ensure that variety of goods
are supplied.
(e) The desire to minimise set-up times and costs as well as stock usage which are
required for sustaining flexibility in production activities is achieved.

393
3.3 COMPUTER-AIDED DESIGN (CAD)

This is a good part/component design and testing using a computer terminals. The
designer, the computer and the database engineers come together so that more choice
and designs can be looked at as a way of having activities carried out at the least cost
The basic function involved here is putting the CAD database to test in order to
ascertain standard parts and systems that ensure the minimisation of production parts,
stock and simplifies product design.

3.4 COMPUTER-AIDED MANUFACTURING EFFORTS (CAM)

This is an umbrella word depicting the application of computers for the programming
and control of production equipments which includes robots, machines operated
numerically and those machines that operate numerically by computers. The benefits
of CAM include:
(a) Enhances efforts carrying out series of operation and production of various
components;
(b) Effective monitoring of production efforts;
(c) Minimises set-up times and costs;
(d) Ensures quality on constant basis;
(f) Low defective units are involved; and
(g) Jobs are machine intensive/highly automated.

3.5 FLEXIBLE MANUFACTURING SYSTEM (FMS)

This is a system that ensures a linkage of computer controlled machines to ensure

effective handling and transfer of parts from one location to another location,
principally to give effect to the production of similar parts in a more flexible manner.

Even where the ultimate is to integrate manufacturing efforts by the use of computers,
the human element is still of paramount importance.

3.6 TOTAL QUALITY CONTROL (TQC)

Under the conventional management accounting practice, functions and costs

associated with bad quality units addressed are by factoring into standard costs and
process costs 'normal' allowances in percentages for scrap, waste and defects. In effect
if the normal loss is kept within the set limits no matter the output involved, no
problem is reported.

However, in based on modern trends, quality is a function of the design and not the
inspection. Therefore, TQC is a matter to be considered at every point of activity,
especially commencing with when the idea for the product was muted.
TQC is seen to be functional with the following activities: place; product design,
production engineering, control charts, Just in time systems, goods inwards and output

394
inspection.

With the effective installation of TQC, the following among others happen: decrease
in defects, scrapping, reworking, warranty and service expenses. Higher quality means
lower costs.

3.7 TOTAL QUALITY MANAGEMENT (TQM)

Total quality management has to do with ensuring that there is a spirit of defined
culture of quality improvement in quality maintenance in every aspect of an
organisation whether in terms of function and units. Of relevance is the recognition of
three key elements of customers, products and employees.

In Nigeria, organisations can be recognised under Nigerian Standard Organistion

(SON), if they comply with the required quality standards throughout the companies.
SON's recognition applies to service organisations as well as production companies
and there are various businesses that have received the recognition. These include:
government, agencies, accountants, shipping companies, paints and food and
beverages, etc.

3.8 MANAGEMENT ACCOUNTING AND AMT

Under 20.1 above, it was asserted that the traditional management accounting is
deficient and the issues involved are been discussed here.

The main problem areas as identified by Lucey (2003) are:

(a) Absorption costing

In the AMT environment, the application of overhead absorption basis of direct
labour hours or machine hours in determining product costs is considered
inadequate because of time lag or inconsistency in decision making efforts.

(b) Cost behaviour

The classification of costs as fixed or variable does not make for the effective
recognition of overheads especially where costs are related to production
volume, even though labour costs are not significant in view of relation to total
costs.

(c) Standard costing

The traditional control techniques of standard costing and variance analysis
have been considered inadequate in the AMT and JIT environments because
they are not at par with the consistent improvement belief, in the AMT situation
and that the variances lose their significance under the latter situation, for
example, material usage variance is not relevant where quantity is involved
because JIT does not allow for excess material as what is required is what is
purchased.

395
(d ) Short-term financial measures
Much traditional management accounting focuses on short-term financial issues
which are related to industrial events or costs, whereas AMT addresses readily
available non-cash issues such as those concerning machine failures, defective
items etc.

(e) Cost accounting methods

Cost accounting is basically concerned with the determination of production
processes, by methodically focusing at the movement of stocks of raw materials
to the final stage of having the finished products and this also entails a lot of
journal entries in order to give effect to all the transactions that were involved.
However, with the advent of JIT, all the cumbersome processes are no longer
required because activities are such that stocks are at almost nil level and
production processes are carried out at small batch lots, even though on a
continuous basis. Furthermore, casual labour system is now a thing of the past.
Therefore, the cost accounting procedures and methods are now by no small
means made simple to operate and results more effectively achieved.

3.9 THROUGHPUT ACCOUNTING

Throughput accounting is a management accounting system of determining the rate at

which capacity is achieved especially when costs are related to the throughput time,
that is, the rate at which products and/or services can be made available to meet
consumer's demand.

Throughput accounting is defined as:

'A management accounting system which focuses on ways by which the maximum
return per unit of bottleneck activity can be achieved.' Throughput Accounting (TA)
can be viewed from the following assumptions:
(a) All factory costs, except material costs are assumed to be fixed costs, especially
in the short run. All of these costs inclusive of the indirect labour costs are
categorised as total factory costs (TFC).

(b) One of the principles on which J1T is based is that if there are no orders there
should be no production since the stock level is almost nil. The whole essence
of this, is to ensure that there is no idle capacity except for the activity with
bottleneck at present. Therefore, production will be meaningless, if stock-piling
will not result in profits.

(c) Efforts are to be geared towards the rate of producing to meet consumers'
demand, if profits are to be realised or increased, of importance too, is the fact
that key resources or capacity factors must be recognised, if contribution is to
be effectively measured.

396
Using TA, product returns can be determined thus:

Return per factory hour = Sales Price - Material Cost

Time on key resource (i.e, the bottleneck)

Product costs are calculated thus:

Cost per factory hour = Total factory costs (TFC)

Total time available on the key resource

Therefore, the TA ratio can be calculated thus:

TA ratio = Return factory hours (or Minute)
Cost per factory Hour (or Minute)

A ratio of 1 and above is better but anything short of this would bring about loss of
funds and the decision will be that of rejecting the product and non inclusion for
marketing purposes.
The TA ratio can be computed by comparing the total return with the total fixed costs.
This is a total concept.

TA ratio = Return from total throughput (that is, Sales – Material Cost
TFC (that is, all costs other than materials)

It should be noted that since a bottleneck is; key factor that limits the
production function or activity, then the issue of how to treat overheads involved at a
point in time should be related to the actual period involved in
terms of the key resource and not the period related to the utilised portion of the key
resources which may be caused by factors not related to key resource, for example,
poor quality production inputs.

The computation can be made thus:

Standard minute throughput x Budgeted TFC cost per minute

(Usage of key resource) Key resources

From the foregoing, an efficiency percentage can be determined thus:

Efficiency % = Throughput cost x 100
Actual TFC

Labour efficiency can be measured as:

Labour Efficiency % = Throughput cost x 100
Actual total labour cost

ILLUSTRATION 20 – 1

A key resource (bottleneck) of facility Z is available for 15,650 minutes per period.

397
Budgeted factory costs and data for two products, A and B, are shown as below:
Product Selling Material Time in facility
Price/unit Cost/unit Z
N N Mins
A 14 9 2
B 14 8 4

Budgeted factory costs per week:

N
Direct labour 10,000
Indirect labour 5,000
Lighting 700
Depreciation 9,000
Space costs 3,200
Maintenance 1,400
Administration 2,000

Calculate:
 Total Factory Costs (TFC)
 Cost per Factory Minute
 Return per Factory Minute for both products
 Throughput activity ratios for both products

SUGGESTED SOLUTION 20 – 1

Total Factory Costs = Total of all costs except materials

= 10,000 + 5,000 + 700 + 9,000 + 3,200 + 1,400 + 2,000
= N31,300
Cost per factory minute = TFC
Minutes available in bottleneck

= 31,300
15,650
= N2

Return per bottleneck minute for Product A =

= N14 – 9
2
= N2.5

Return per bottleneck minute for Product B = N14 – 8

4
= N1.50

Throughput Accounting (TA) Ratio for Product A =

398
= 2.5
2.0
= 1.25
TA Ratio for Product B = 1.50
2.0 = 0.75
The TA ratios shows that if we only make Product B we would make a loss as its TA
ratio is less than 1; when we make Product A we make a gain.

ILLUSTRATION 20 – 2

Based on the data in illustration 20 – 1 above, during a week actual production was
6,000 units of Product A and 700 units of Products B. Actual factory costs were
N31,300

Calculate:
(a) Throughput cost for the week
(b) Efficiency percentage
(c) State the possible reason(s) for the efficiency percentage calculated.

SUGGESTED SOLUTION 20 – 2

Workings
Standard minutes of throughput for the week
= (6,000 x 2) + (700 x 4)
= 14,800 mins.

Throughput cost for week =

= 14,800 x N2 per min (from illustration 1)
= N29,600

Efficiency % = Throughput cost x 100

Actual TFC
= 29,600 x 100 = 94.57%
N31,300

The bottleneck resource of facility A is available for 15,650 minutes per week but
produced 14,800 standard minutes. Thus could be due to:
(a) The presence of a ‘wandering’ bottleneck causing facility Z to be under-
utilised; or
(b) Inefficiency in facility Z.

Even though the TA has some similarity with the conventional contribution method in
that it focuses on limiting key resources, the following constitute the difference.

In TA, return is defined as sales minus material costs unlike contribution which is

399
sales minus variable costs (material, labour and variable overheads). Furthermore, it is
assumed under TA, that all costs, except materials, are fixed in relation to throughput
in the short run.

Despite the criticism of TA on being a short-run concept, it has the following

advantages:
(a) It is useful in a J1T environment.
(b) It enhances management's ability to focus on key resources that are required for
profit making, for example, reduction of stock piled up as well as time required
to attend to customers' request.

3.10 BACKFLUSH ACCOUNTING

This is defined as
'A method of costing, associated with J1T production systems, which applies cost to
the output of a process. Costs do not mirror the flow of products through the
production process, but are attached to output produced (finished goods stock and cost
of sales), on the assumption that such back flushed costs are a realistic measure of the
actual costs incurred'. (CIMA)

In effect, a single account is maintained for both the raw materials and work-in-
progress item whereby the standard cost of the raw material in the finished goods
would be credited to the single account already created. Furthermore, the processing
costs would not be applied to the work-in-progress.
ILLUSTRATION 20 – 3

The following shows the transactions of Bisi Ltd. in a given period:

N
Purchases of raw materials 510,000
Processing costs 411,600

Qty.
Production 9,800
Sales 9,700

There were no opening stocks of raw materials, WIP or finished goods. The standard
cost per unit is N93 (N51 materials + N42 processing cost). There was no closing
WIP at the end of the period.

Journalise the entries for a backflush accounting system using a Raw Materials In
Progress (RIP) account.

SUGGESTED SOLUTION 20 – 3
N N
RIP account 510,000
Creditors 510,000

400
Being the cost of raw materials
Bought in credit
Finished Goods Stock 911,400
RIP a/c 499,800
Processing cost control a/c 411,600
Being the cost of production (9,800 units)
Cost of sales 902,100
Finished Goods Stock 902,100
Being the cost of sales (9,700 units)

At the end of the period there will be two separate stock balances:

N
RIP account (510,000 – 499,800) 10,200
Finished Goods (100 @ N93) 9,300

3.11 ADVANTAGES OF BACKFLUSH ACCOUNTING

(a) It is very simple to operate. Work-in-progress is not accounted for separately.

(b) The accounting entries are very few and documentation is not vigorous.
(c) It does not allow for the piling-up of inventory, since doing so may not really be
of great importance to the managers.

3.12 TARGET COSTING

Target costing is a customer-focused management tool that is used to determine the

market value share for a new product using the market research as basis for measuring
performance needs and setting target selling price. However, the target cost is
determined by deducting the target profit margin from the target selling price.
Therefore, target costing as a tool is a function of the following phases:
(a) Ascertain the target selling price at which demand are likely to be made.
(b) The target cost is derived by subtracting the target profit margin from the target
selling price.
(c) Forecast the likely actual cost for the product
(d) Make efforts at ensuring that the estimated cost is equal to the target cost.

Target costing entails the adoption of team spirit which ensures that the
designers, engineers, purchasers, production, selling and distribution as well as the
management accounting staffs are involved in order to attain the quality level required
for realising the target cost. If the target cost cannot be attained, then the new item or
goods should not be considered.

This technique is adopted at the design and planning stage, with the designers
especially using the tear-down analysis, value engineering and functional analysis in
order to attain the target cost.

401
The tear-down analysis has to do with the determination of openings for increasing the
value of products and/or reducing cost by putting to test a competitor's product, in
order to get at the area of competitive hedge that can be introduced into the product.

Whereas, value engineering is used to determine the elements that could have effects
on the costs of a product such that measures can be taken to enhance product design
and reduce unwanted activities that add to product costs which consumers would not
appreciate.

Functional analysis is a variation of the value engineering which is used to determine

product activities, the associated costs and value added to the consumers. In the CIMA
terminology, it is an analysis of the relationships between product function, their
perceived value to the customer and the cost of provision'.

3.13 PERFORMANCE EVALUATION IN AN AMT ENVIRONMENT

The conventional performance evaluation basis such as variances (material, labour,

overhead cost) can no longer meet up with the requirements of the technological
advancement in global world because of the following issues which include; inability
to assess important elements of performance; inadequate use of standard costing;
delays in reporting mechanism etc. Therefore, to overcome these short comings, some
physical and non-financial measures have been put in place in order to enhance
improvement and not just to monitor.

As an example, Lacey (2003) asserted that I a Miller carried out an international

survey on the measures being used to monitor and control production in Europe, USA
and Japan. The key results are summarised in Figure 20.4.

Europe United States Japan

1. Outgoing quality Incoming quality Manufacturing lead times
2. Unit manufacturing costs Inventory accuracy Direct labour productivity
3. Unit material cost Direct labour productivity WIP turnover
4. Overhead costs Manufacturing lead times Incoming quality
5. On-time deliveries Vendor lead times Vendor lead times
6. Incoming quality Set-up times Indirect productivity
7. Direct labour productivity WIP turnover Material yield

Figure 20.4: Performance measures listed in order of importance

Examples of non-financial measures:

Manufacturing cycle efficiency

Ideally the above ratio should be 1. Progress in moving towards this should be
402
monitored. This is a useful summary ratio for a JIT factory or line as it relates value
added time to non-value added time.

Machine availability =

Useful in monitoring machine availability, usage and efficiency

In-coming quality =

This could be used to monitor the quality of existing and new suppliers. Customer
satisfaction is the ultimate measure of product/service quality This can be measured in
a variety of ways including:

Customer rejects/returns
Total sales

and/or percentage of sales which are repeat sales to existing customers.

Delivery performance = Delivery late

Deliveries on Schedule

Applied to sales, this provides a measure of the efficiency of production and

production scheduling. Applied to purchasing it monitors supplier reliability.

In addition to ratios, many AMT performance measures are expressed in real terms;
such as hours, minutes, quantities, weights and so on. The trends in these can be
followed easily and have real and immediate meaning for everybody associated with
production.
Examples include:
 Process times
 Set-up times
 Distance parts/materials travel
 Number of on time deliveries
 Number of lost machine time

Source: Lucey, T(2003) Management Accounting 5th Edition. London: Book Power.
pp 594 - 595

3.14 LIFE - CYCLE COSTING

Life cycle costing or terotechnology can be defined as: 'The maintenance of physical
asset cost records over the entire asset lines, so that decision concerning the
acquisition, use or disposal of the assets can be made in a way that achieves the
optimum asset usage at the lowest possible cost to the entity. This term may be applied
to the profiting of cost over a product's life, including the pre-production stage
403
(terotechnology), and to both company and industry life cycle' (CIMA).

Even though the above definition is applicable to assets that are physical, there is a
need to reflect the concept in relation to manufactured goods and services rendered.

The prevalent costs associated with product life-cycle of an asset, product or service
may include the following:

(a) Acquisition costs - Such as set-up costs, research and development costs,
production etc., if they are produced by the company. However, where they are
bought, the costs will include purchase costs, freight charges, installation costs
etc.

(b) Operating costs - Such as maintenance costs, lighting costs, spare components,
storage costs, staff costs, safety regulation costs etc.

(c) Disposal costs - Such as scrap costs.

The product life cycles are as depicted in figure 20.5 below. Thus, one can talk about
the stages as being planning/design stage, production stage and the service and
abandonment stage. This goes to show that more costs are incurred at the first stage as
well as the last stage of abandonment where activities are considered to be heavy.

If life cycle costs are to be minimised, then, the issues of utilisation, maintenance and
disposal should be properly addressed in terms of technical, engineering and
production viability and exposure.

100% -

80% -
Cost committed

60% -

40% - Product manufacturing Post sales

and sales phase service and
abandonment
20% - phase

Product Planning
and design phase

Cost incurred

0
Product life-cycle phases

404
Figure 20.5 Product life-cycle phases: relationship between costs committed and costs
incurred

Source: Drury C. (2004) Management and Cost accounting 6th edition. London: Book
Power p 945.

ILLUSTRATION 20 – 4

Kogbodoku Nigeria Limited, with a 10% cost of capital, is considering the purchase of
two fertilizer machines: Lexure machine and deluxe machine. Both can produce the
same component at identical rates per working hour and the relevant data on the
machines, are as follows:

Lexure machine Deluxe machine

(i) Capital cost N380,000 N480,000
(ii) Operating cost per
working hours
Energy N9 N15
Consumables N18 N24
Variable overheads N18 21
(iii) Maintenance costs
Service intervals 36 p.a 30 p.a
Cost of services N3,000 N2,400
Random breakdowns 9 p.a 9 p.a
Cost of breakdowns N6,000 N9,000
(iv) Expected Availability
(working hours per annum) 4,500 6,000
(v) Contribution from production
per hour N150 N150
(vi) Expected life 5 years 5 years
(vii) Net salvage value at the
end of year 5 N30,000 N75,000

Required:
Determine the machine to be bought with reasons.

SUGGESTED SOLUTION 20 – 4

Lexure machine Deluxe machine

N N
Gross contribution 150 150
Less: operating costs 45 60
Contribution per hour 105 90
Hours available 4,500 6,000

405
N N
Total contribution per annum 472,500 540,000
Less: Maintenance cost:
Service (108,000) (72,000)
Breakdowns (54,000) (81,000)
Net contribution per annum 310,000 387,000

Lexure machine Deluxe machine

Yr Cash flow DCF PV Yr Cash flow DCF PV
N N N N
0 (300,000) 1,000 (3,000,000) 0 (480,000) 1,000 (480,000)
1-5 310,000 3.791 + 1,175,210 1-5 + 387,000 3.791 +
1,467,117
5 30,000 0.621 + 18,630 5 75,000 0.621 +
46,575
NPV + 893,840 NPV +
1,033,692

Decision: Deluxe machine would be preferred for the following reasons:

i. Although having a greater capital cost, it is available for more hours per year
for production.
ii. It has lower servicing costs and greater resale value.
iii. Over the whole life cycle, it is more cost effective.

3.15 KAIZEN COSTING

This is a costing method adopted whenever the issues of cost reduction and
management are to be addressed by a company. it involves the enhancement of
production activities by little increases in costs rather than substantial increases.

Basically, Kaizen costing is to minimize the cost of parts and goods at a pre-
determined rate, whereby each factory is allocated target cost reduction rate which is
used in relation to past year's actual costs to ascertain the target cost reduction.

Kaizen costing is workers’ friendly because their understanding of the enhancement of

production processes and customer welfare are condition for the reduction of costs.

Therefore, significant characteristic of Kaizen costing is that employees have the duty
of enhancing processes and reduce costs.

3.16 BENCHMARKING

Benchmarking is defined as:

406
'The establishment, through data gathering, of targets and comparators, through whose
use relative levels of performance (and particularly areas of underperformance) can be
identified. By the adoption of identified best practices it is hoped that performance will
improve'. (CIMA)

Therefore, benchmarking has to do with the comparison of a company with other

companies, especially where they are leaders by making use of certain indicators that
are financial and non-financial.

CIMA suggests that there are various types of benchmarking:

(a) Internal benchmarking - a method of comparing one operating unit or function
with another within the same industry;
(b) Functional benchmarking, in which internal functions are compared with those
of the best external practitioners of those functions, regardless of the industry
they are in (also known as operational benchmarking or generic benchmarking):

(c) Competitive benchmarking, in which information is gathered about direct

competitors, through techniques such as reverse engineering; and
(d) Strategic benchmarking - a type of competitive benchmarking aimed at strategic
action and organizational change.

3.17 ENVIRONMENTAL COST MANAGEMENT

Environmental cost management has evolved as a result of the need for companies to
adopt different methods of assessing, summarizing and ascertaining environmental
costs. All of these are important because environmental costs can be enormous for
some industrial organisations; legal condition may involve substantial times for
inability to conform to the rules and regulations in the past years; the public requires
that organisations work towards being environmentally compliant especially if the
issues of social responsibility and high volume of sales of goods are to be enhanced.

Epstein and Roy (1997) stated that 'companies cannot identify their total
environmental costs, and do not recognize that they can be controlled and reduced'.
Therefore, the required association between environmental costs and the respective
activities, processes and products can be determined.

From the foregoing, environmental costs should be gathered by using different cost
pools and effect given based on the classifications used to find out the products or
processes that caused the costs using the Activity Based Costing principles. The issue
here is to ensure that the pollution of the environment can be managed more easily by
redesigning the process especially where the causes and the types of environmental
costs are made available to the managers.

In order to address the issue of costs incurred as a result of the existence of bad
environmental quality procedures, Hansen and Mendoga (1999) have advocated that

407
an 'environmental cost report should be produced at regular intervals, based on the
concepts of a cost of quality report to indicate the total environmental costs to the
organisation associated with the creation, detection, remedy and prevention of
environmental degradation'. They have also classified the environmental costs into
four as follows:

(a) Environmental prevention costs- Being the costs of processes involved to avoid
the wastes in production which could bring about pollution of the environment.
The costs that may be involved included certification for meeting international
and national standards, staff training, design and plan to minimise pollution,
product recycling etc.

(b) Environmental evaluation costs- Which are the costs associated with ensuring
that companies production functions and goods comply with legal laws and
local regulations and procedures. The associated costs include verification of
goods and production functions to determine compliance with rules,
environmental audits and carrying out of pollution tests.

(c) Environmental Internal failure costs- Which are the costs of carrying out
production functions that have been finalised but are yet to be released to the
environment especially those that involve the elimination or reduction of wastes
to the extent of meeting up with legal standards. Good examples include the
costs of having scraps reworked and disposal of acidic items that are injurious
to human health.

(d) Environmental external failure costs - Which are cost of functions carried out
after polluting the environment with wastes. Examples include the costs of
reducing degradation of the soil, ensuring the reduction of the spread of oil-
spillages, fumigation to reduce bacteria effects etc.

With the effective classification of the costs, the environmental cost report should be
framed in such a manner that each class of costs is denoted as a function of turnover
(or operation costs) in order to ensure that comparisons with past periods, other
companies and subsidiaries of the same company are made possible.

Nonetheless, the Environmental Cost Management Report is more meaningful than the
conventional accounting reporting system for various reasons which include:
(a) It ensures the division of costs and ascertain that they are not of
significance which calls for the minimisation of those costs elements.
(b) It enhances the basis for determining the healthy position of the company.
(c) The classification of costs as above helps in enhancing the outlook of the
company towards the management of costs.
(c) It ensures effective assessment of the environment and allows everyone
involved to be more informed about the activities that are carried out.
(d) It allows for progress to be evaluated in real terms because the focus is the same
within the company.

408
The main drawback of the environmental cost reports is that they only show or relay
the costs that were basically incurred by the company alone without giving effect to
those created by the company, However, the society is made to bear the burden of
reducing the life span of creatures within the ecosystems as a result of releasing solid
wastes to the environment.

The above issues can be addressed by carrying out the environmental effects of goods
and this can be done by adopting the life cycle costing technique earlier explained in
this chapter and this can be nipped in the board at the planning and design phase where
the great percentage of the environmental costs would have been incurred rather than
at the production phase.

3.18 STRATEGIC MANAGEMENT ACCOUNTING

What is strategic management accounting?

Innes (1998) defines strategic management accounting as the provision of information
to support the strategic decisions in organizations. Strategic decisions usually involve
the longer-term, having a significant effect on the organization and, although they may
have an internal element, they also have an external element'. This definition affirms
that strategic management accounting can be used to provide information on mixing of
products, initiation and abandonment issues. Cooper and Kaplan (1988) are also of the
view that 'strategic accounting techniques are designed to support the overall
competitive strategy of the organization principally-by the power of using information
technology to develop more refined products and Service costs.
Of relevance here is the fact that target costing, life cycle costing techniques and
activity based costing are all related to strategic management accounting when current
trends of management are involved.

The provision and analysis of financial information on the firm 's product markets and
competitors' costs and cost structures and the monitoring of the enterprises’ strategies
and those of its competitors in these markets over a number of periods

The Chartered Institute of Management Accountants (CIMA) defines strategic

management accounting as:

A form of management accounting in which emphasis is placed on information which

relates to factors external to the firm, as well as nonfinancial information and
internally generated information (CIMA Official Terminology 2000: 50)

The lack of consensus on what constitutes strategic management accounting

motivated, Lord (1996) to review the literature and he identified several strands that
have been used to characterize strategic management accounting. They include:
(a) The extension of traditional management accounting's internal focus to include
external information about competitors.
(b) The relationship between the strategic position chosen by a firm and the
expected emphasis on management accounting (batis, accounting in relation to

409
strategic positioning).
(c) Gaining competitive advantage by analysing ways to decrease costs and/or
enhance the differentiation of a firm's products, through exploiting linkages in
the value chain and optimizing cost driver.

Based on the survey carried out by Guiding (2000), the following represent the twelve
(12) areas of strategic management accounting practices:
(a) Quality costing which entails the adoption of quality reports.
(b) Life cycle costing which has to do with the forecasting and accumulation of
costs over a product's life cycle with respect to the various stages involved and
effects of profits earned on every stage concerned.
(c) Target costing which focuses on the product and cost reduction
strategies especially at the planning and design stage.
(d) Monitoring of competitors strategic marketing position in the industry in terms
of sales volume, share of the market, unit costs and sales turnover.
(e) Pricing strategy as it relates to price elasticity, exposure, reaction to competitors
price, growth in the market etc.
(f) Evaluation of competitors result in order to determine the strength in terms of
the competitors key resources which can be ascertained by having a look at the
published financial statements.
(g) Determination of competitors basis for costing such as evaluation of facilities,
technological advancement, economies of scale through ex-staff, dealers,
inspection, substantive buyers etc.
(h) Strategic costing procedures evolved in order to ensure competitive advantages
as a result of adopting strategic and selling information put in place by the
management.
(i) Value-chain costing which ensures that costs are directly related to function
needed to design, buy, manufacture, sell, and make service and goods available
at the right time, place and cost.
(j) Brand value assessment which entails the valuation of brand power elements
which includes; leadership; consistency; market trend; support; and guide
related to past brand profits.

(k) Brand value forecasting - whereby managerial efforts in relation to the direct
utilization of resources to promote brand position is based on brand value for
which management is seen to be responsible.
(1) Attribute costing with emphasis on the relatedness of the various
characteristics of relevance, timeliness, cost effectiveness etc. to the processes,
products and services which are required to enhance cost reduction
opportunities throughout the entire production functions.

In a nutshell, it was discovered that the three competitors' strategies (d, f and g above)
and pricing strategy are rated as being easily adopted. Furthermore, it was also
asserted that the term is not popular in organizations and practising accountants have
not really valued it as a concept.

410
3.19 THE BALANCED SCORECARD

In the words of Drury (2004), 'The need to integrate financial and nonfinancial
measures of performance and Identity key performance measures that link
measurements to strategy led to the emergence of the balanced score card - an
integrated Set of performance measures derived from the company's strategy that
gives top management a fast but comprehensive view of the organizational unit (that
is, a division/strategic business unit).

The balanced scorecard was devised by Kaplan and Norton (1992) and refined in later
publications by Kaplan and Norton, (1993; 1996; and 2001).

Therefore, the following discussion is a summary of Kaplan and Norton's writings on

this topic.

The balanced scorecard philosophy assumes that an organisation' s vision and

strategy is best achieved when the organization is viewed from the following four
perspectives:
(a) customer perspective (How do customers see us?)
(b) internal business process perspective (What must we excel at?)
(c) learning and growth perspective (Can we continue to improve and create
value?)
(d) financial perspective (How do we look to shareholders?)

The balanced scorecard is a strategic management technique for measuring and

disseminating the attainment of the mission and strategy of a company. In order to
give effect to the balanced score card, the main reasons for the basis should be put
together so that they can be transformed into particular evaluation system whereby one
or more reasons can be advanced with various evaluation bases associated with each
reason. However, there is a need to reduce the number of basis in order to avoid excess
information content.

The balanced scorecard could be measured from two angles, thus;

(a) Lagging measures which are financial results based on past financial action
detailing the financial effects on decisions as they occur which are usually after
the decisions might have been made.
(b) Leading measures are those that are related to future financial results which are
non-financial in nature especially as they relate to process within an enterprise
as well as the learning perception.

Kaplan and Norton (1996) describe how innovative companies are using the
measurement focus of the scorecard to accomplish the following critical management
processes:
(a) clarifying and translating vision and strategy into specific strategic objectives
and identifying the critical drivers of the strategic objectives;
(b) Communicating and linking strategic objectives and measures Ideally once all

411
the employees understand the high level objectives and measures, they should
establish local objectives that support the business unit's global strategy;
(c) Plan, set-targets and align strategic initiatives. Such targets should be over a 3-
5 year period broken down on a yearly basis so that progression targets can be
set for assessing the progress that is being made towards achieving the longer-
term targets;
(d) Enhancing strategic feedback and learning so that managers can monitor and
adjust the implementation of their strategy, and, if necessary make fundamental
changes to the strategy itself.

3.19.1 Advantages and Drawbacks of the Balanced Scorecard Technique

The advantages of the balanced scorecard techniques are

(a) It ensures that the various competitive objectives of a company which include
reduction of lead time, enhancement of quality, promotion of team spirit,
consumer consciousness etc are reflected in a single report such that the various
perceptions of company results are reflected.
(b) It is used to transform the form's strategic objectives into understandable means
of evaluation systems used to develop the main objectives for the perspective
and ensuring that these objectives are turned to particular evaluation systems,
(c) It assists managers to determine whether enhancement in one perspective is at
the detriment of another one.
(d) It enhances the ability to link performance measures with strategic business
units through effective communication as well as formulation and
implementation of corporate strategy.

The drawbacks include the cause and effect relationships which are assumed despite
their being empirically or theoretically deficient and not clear in meaning. The
empirical studies that have been undertaken have failed to provide evidence on the
underlying linkage between non-financial data and future financial performance
(American Accounting Association Financial Accounting standards Committee, 2002).

Another short coming is that the perspectives in which it is based may not be all that
can be used to assess its impact especially where the staff perspective and public
perspective are not recognised.

It should, nevertheless, be realised that perspectives must be limited, even though there
is a need to meet various demands.

4.0 CONCLUSION

Advanced Manufacturing Technology (AMT) is altering the way manufacturing takes

place and the manner it is organised. It consists of Computer Aided Design and
Manufacture, Flexible Manufacturing Systems and also included: Material
Requirement Planning (MRP) and Just-In-Time (JIT) systems.
Of relevance here also are Total Quality Control (TQC); Activity Based Costing;

412
Target Costing; Life-Cycle or Tetrotechnology Costing; Kaizen Costing; Backflush
Costing; Throughput Costing, Strategic Management Accounting and Balanced
Scorecard techniques of managing processes, products and manufacturing efforts in
the modern day era.

5.0 SUMMARY

This unit has delved into modern way of treatment of account using the Advanced
Manufacturing Technology (AMT) as an umbrella word used to capture automated
production technology, computer assisted design and manufacturing systems
(CAD/CAM), flexible manufacturing systems (FMS), robotics, total quality control
(TQC), advances in production management including materials requirement and
manufacturing resources planning systems (MRP), just-in-time (JIT) systems etc.,
which are considered to be the new developments in the area of management
accounting due to technological advancement.

6.0 TUTOR MARKED ASSIGNMENT

1. What is a Manufacturing Cycle Efficiency?

2. Explain the differences between lag measures and lead measures.

3. State two benefits attributed to the balanced scorecard approach.

4. Evaluate the various types of environmental costs.

5. A term used to describe a situation where all business functions are involved in
a process of continuous quality improvement is known as____________

6. Distinguish between Target costing and Kaizen costing.

7. The examination of competitor’s product in order to identify opportunities for

product improvement and/or cost reduction is called___________

8. “A management accounting system which focuses on ways by which the

maximum return per unit of bottleneck activity can be achieved” is known
as___________

9. Define Advance Manufacturing Technology (AMT).

7.0 REFERENCES/FURTHER READINGS

ICAN Pack, (2006) Management Accounting, Lagos: VI Publishing Ltd.

Faruonbi K. (2006) Management Accounting, Lagos: EL-Toda Ventures Ltd.
Aborode R. (2006) A Practical Approach to Advanced Financial Accounting, Lagos:
El-Toda Ventures Ltd.

413
414