MANAGEMENT ACCOUNTING

BY

LUGEMWA JOHN BAPTIST

Tel: 0779428107/ 0702432603

EMAIL: [email protected]

Course Title: Management Accounting (4 CU)

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Course Code: BBA 3102

Course Level: III (Semester I)

Credit Units: 4

Contact Hours: 60

Brief course description

The course focuses on the way management accounting information is

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

Learning outcomes

By the end of the course students should be able to;

 Use cost information to make informed short and long- term decisions
 Use standard costs for planning and control purposes
 Prepare budgets for organisations
 Monitor budget performance
 Prepare organisational performance and evaluation reports.
Indicative Course Content

Introduction to Management Accounting:

(2hrs)

 Differences between cost accounting and management accounting;

 The functions of management accounting information;
 Emerging themes in management accounting,
 Evaluate performance of various units of an organization.
Cost concepts (review) (4
hrs)

 Cost and revenue behaviour in relation to the level of activity

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 Cost classification for control
 Costs in manufacturing and service organisations
 Using cost behaviour patterns to predict costs
Costs-Volume Profit Relationships and Decision Making:
(10hrs)

 Break-even analysis: Assumptions and its importance in short term

decision-making;
 Break-even and tax
 Margin of safety
 Multi-product break-even
Short-term decisions (8hrs)

 Relevant costing and decision making;

 Make or buy
 Special offers
 Shut-down
 Pricing decisions, calculating optimum prices;
 Limiting factor situations
Budget and Budgetary Control Procedures: (10
hrs)

 Stages in budgeting process;

 The role of budgeting in organisational control;
 Approaches in budgeting (incremental, zero-base budgeting, activity
based budgeting, etc.).
 Preparation of operating and master budgets,
 Fixed and flexible budgeting; budgetary control procedures.

Standard Costing: (10

hrs)

 Preparation of standard costs,

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 Analysis of variance including, material cost variances, labour cost
variances, overheads cost variances, mix and yield variances, total
cost variances; sales variances;

Divisionalised Performance Measurements and Transfer

Pricing(6hrs)

 Functional and divisionalisedorganisational structure,

 Advantages and disadvantages of divisionalisation;
 Measuring divisional profitability;
 Objectives of transfer pricing;

Contemporary issues in management accounting (10 hours)

 Cost management
 Target costing
 Business process engineering
 Balanced scorecard
 Just-in-time production process
 Total Quality Management
 Continuous improvement

Total Contact Hours 60

Delivery methodology

Lectures and tutorials

Assessment

Coursework 40%

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End of semester Exam 60%

Reading List

1. Atrill, P (2012) Management accounting for decision makers,

Harlow, England: Pearson.
2. Groot, T. (2013) Advanced management accounting Harlow,
England; New York: Pearson.
3. Macintosh, N B (2010) Management accounting and control
systems: an organizational and sociological approach, Hoboken,
NJ : John Wiley & Sons.
4. Drury Colin (2010) Cost and Management accounting, 5th Ed.
Thompson Business Press, London

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TOPIC 1

Introduction to Management Accounting

Management Accounting (Definition)

Management Accounting is the application of accounting techniques for providing

information designed to help all levels of management in planning and controlling the
activities of a business enterprise and in decision making.

CIMA defines Management Accounting as an integral part of management concerned

with identifying, presenting and interpreting information used for, formulation of
strategy, planning and controlling activities of the organization, decision making
optimizing the use of resources and safeguarding the company’s assets.

Differences between management accounting and financial accounting

1. Primary users of information: Information generated under management

accounting system is used by members of management at different levels while the users
of financial accounting statements are mainly external to the business enterprise such as
creditors, financial institutions, potential investors, government authorities, etc.
2. Unit of measurement: Management accounting addresses financial and non
financial performance measures (issues that cannot be quantified) as decision making
cannot be enhanced by using quantitative information only while financial accounting
addresses financial performance measures i.e. matters than can be expressed in monetary
terms.
3. Auditing requirement: Financial accounts must be subjected to an external
audit since they are used by external parties but it is not a requirement to audit cost and
management accounts.
4. Reporting frequency: Financial accounts are usually prepared annually or semi
annually while management reports are more routine (frequently prepared).
5. Legal requirement: It is a statutory requirement for all public limited companies
to produce annual accounts at the end of every financial year while management
accounting is optional.

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6. Time dimension/span: Financial accounting reports on the past events or
occurrences while management accounting focuses on the future by providing pre-
determined information that can enhance or promote management functions.
7. Accounting system: Financial accounting is based on the double entry system
while management accounting is not based on double entry system.
8. Scope: Management accounting covers a wider scope in that its scope extends
beyond the traditional measures of costs and revenue, satisfaction of employees,
customer services etc while financial accounting covers a narrow scope.
9. Level of standardization: Financial accounting is highly standardized because
they are specific report formats that have to be followed whereas there is no
standardization when it comes to management accounting reports.
10. Reporting requirements: Financial accounts must be prepared and presented in
conformity with GAAP while management accounting is not based on any accounting
rules and regulations and not bound to use generally accepted accounting principles.

Cost and Management Accounting

Cost Accounting cannot be separated from management accounting. The two accounting
systems are closely linked as they use common basic data and reports to a significant
degree.
Much of the information used to prepare accounting statements and reports in cost
accounting is also used in management accounting reports for example management
accounting utilizes the same data to prepare budgets, performance reports, control
reports, etc.
Like cost accounting, management accounting involves reporting at frequent intervals
rather than at the end of the year. Thus management accounting may be regarded as an
extension of the managerial aspect of cost accounting.
Distinction between the cost accounting and management accounting
1. Decision making Vs Control: Management accounting aids management in
decision making while cost accounting focuses on cost control ie keeping costs within the
budgeted and standard limits.

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2. Use of financial accounting: Management accounting uses financial accounting
techniques such as ratio analysis and funds flow analysis but cost accounting does not use
financial accounts much as it supplies data to financial accounting.
3. Wider scope: Management accounting employs many quantitative models from
statistics operations research and computers while cost accounting is less sophisticated
and use of the above techniques is very limited.
Management accounting also looks at both financial and non financial performance
measures but cost accounting mainly looks at financial performance measures.
The role of management and cost accountant in managerial process
The cost and management Accountant provides information which is expected to assist
managers in undertaking various management functions as explained below:
1. Planning: A cost and management Accountant assembles the various plans of
various sections into one overall plan which is quantified in monetary terms.
2. Budget formulation: Information provided by management accountant can be
based on by Managers to prepare different types of budgets.
3. Decision making: The information provided by the Management Accountant
enables managers to take the right direction since it is well researched.
4. Controlling: The information provided assists in the controlling process by
producing performance reports that compare actual outcome with planned
outcome.

The Management Accountant is part of management but not just a service arm to
management. He acts as a Manager and decision maker and exercises managerial
influence and of course is responsible for the management of the entire cost and
management accounting system.

Financial accountants and book keepers have the task of maintaining the ledger system of
accounting records, from which the financial statements will be prepared. The financial
accounts can be a source of management information. In general, however, they are
insufficient for management’s requirements.

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Illustration;
BPL Company
Trading and Profit and loss Account for period X
£ £
Sales 2000000
Cost of sales
Materials consumed 800000
Wages 400000
Production expenses 150000
1350000
Gross profit 650000
Marketing expenses 150000
General administrative expenses 100000
Financing costs 40000
290000
Net profit 360000

This profit statement above may be adequate to give shareholders a superficial picture of
the trading results of the whole business. However, it doesn’t give managers enough
information about the business performance. Managers need much more detail to answer
questions such as:
 Which of our products sell best? How much sales revenue do we earn from each
product or product line?
 How much profit do we earn from each product?
 Do we make a loss with any of our products?
 How does the cost per unit sold compare with the cost per unit of last year?
 Are costs higher than expected, and if so, in which areas?
 How much more would we have needed to sell to make a profit of £500000 for
the year?

Managers want to know about costs of individual products and

services and the profits they make. Detailed financial information,
about costs, revenues, profits and returns, is needed for each cost
centre, revenue centre and investment centre.

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The basic financial accounting system is not capable of providing this information. Cost
accounting and management accounting systems, which can vary in practice between a
simple budgeting system and a large and complex information system, provide the
detailed information that managers require.

AN ACCOUNTING SYSTEM
An Accounting system aims at providing accounting information which could be in form
of cost information, financial and qualitative information; Typical of accounting systems
are three subsystems:
 Financial Accounting system
 Cost Accounting System
 Management Accounting System.

Financial accounting system: Deals with the maintaining of accounting records and
preparation of final accounts/or financial statements; the main purpose of which is to
provide financial information which is channeled through financial reports which include
the balance sheet, income statement, and cash flow statements.

Management Accounting: Encompasses the two accounting systems i.e. cost and
financial accounting and it aims at providing information needed for:
 Planning
 Controlling
 Decision making
 Formulation of strategy
 Control of company resources (assets)

Management accounting system considers complete information that covers cost

information, financial information, and information regarding qualitative aspects in the
environment the firm is likely to operate from.

Cost Accounting: The accounting system which deals/ or aims at the ascertainment of
costs of the product/ or services to be provided by the organization.

CIMA defines Cost Accounting as the establishment of budgets, standard costs and
actual costs of operations, processes, activities or products; and the analysis of variances,
profitability or social use of funds.

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Cost Accounting involves the application of principles, methods and techniques to
determine and analyze costs for use within an organization. It is concerned with a careful
evaluation of the resources used within an undertaking.
A cost accounting system is concerned with the provision of information that is required
to relate costs incurred to products, operations and services.

DISTINCTION BETWEEN COST AND FINANCIAL ACCOUNTING

COST ACCOUNTING FINANCIAL ACCOUNTING
1. Main purpose is to provide cost 1. Main purpose is to provide financial
information to Management. information to interested parties-
2. Cost information is more detailed and mgt, gov’t
limited in scope. 2. Not so detailed and covers a wider
3. Cost system does not provide historical scope.
(past) information, instead it provides 3. Concerned not only with historical
predetermined information. costs but also predetermined costs.
4. Cost accounting addresses the needs of 4. Addresses the needs of both internal
internal management by providing them management and external parties.
with information used for decision making. 5. Financial reports are prepared
5. Cost reporting is a continuous process periodically usually on annual
which may be on daily, weekly, monthly basis.
basis. 6. The statements are prepared
6. No legal requirements are followed or according to legal requirements of
based on when preparing cost accounts. the companies Act, GAAP &
income tax.

COST ACCOUNTING AND MANAGEMENT ACCOUNTING

These two appear to be the same but differ greatly in scope and purpose;
a. Scope: the scope of management accounting is broader than cost accounting.
Cost accounting only provides cost information for managerial uses while
management accounting provides all types of information (financial, cost) and the
information regarding qualitative factors gathered from the environment.
b. In cost accounting, the main emphasis is on cost ascertainment and cost control
while management accounting’s main emphasis is on decision making.

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TOPIC 2: TARGET & LIFE CYCLE COSTING
TARGET COSTING
This involves setting a target cost by subtracting a desired profit margin from a
competitive market price. Organizations to compete effectively must continually re-
design their products or services in order to shorten life cycles. The planning,
development and design stage of a product is therefore critical to an organization’s cost
management process and reducing costs at this stage of the product life cycle rather than
during the production process is the one of the most important issues facing management
accountants today.

Examples of decisions made at the design stage which impact on the cost of the product
include:
 The number of different components
 Whether the components are standard or not
 The case of changing over tools.
Most Japanese companies have developed target costing as a response to the problem of
controlling and reducing costs over the product life cycle.

Steps in implementing target costing

Step I Determine a product specification of which an adequate sales volume is
estimated.
Step II Set a selling price at which an organization will be able to achieve a desired
market share.
Step III Estimate the required profit based on return on sales or return on investment.
Step IV Calculate the target cost = Estimated selling price – Target profit.
Step V Compile the estimated cost for the product based on the anticipated design
specification and current cost levels.
Step VI Calculate the target cost gap = Estimated cost – Target cost.

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Step VII Make efforts to close the gap. This is more likely to be successful if efforts
are made to “design out” costs prior to production rather than to “control out” costs
during the production phase.
Step VIII Negotiate with the customer before making the decision about whether to go
ahead with the project.

How do we derive a target cost?

The target cost is calculated by starting with a market-based price and subtracting a
desired profit margin.
The target cost is simply the price minus the profit.

Example:
A car manufacturer wants to calculate a target cost for the new car, the price of which
will be set at $17950; the company requires an 8% profit margin.
Calculate the target cost.

Target costing and target cost gap

Sports betting a manufacturer of betting games, is in the process of introducing a new
game to the market & has undertaken a market research to find out about customers
views on the value of the product and also obtain a comparison with competitor’s
products.
The results of this research have been used to establish a target selling price $60.
Cost estimates have been prepared based on the proposed product specification.
Manufacturing cost $
Direct material 3.21
Direct labor 24.03
Direct machinery costs 1.12
Ordering $ receiving 0.23
Quality assurance 4.60

Non manufacturing costs

Marketing 8.15
Distribution 3.25
After sales service 1.3

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The target profit margin for the game is 30% of the proposed selling price.
Required;
Calculate the target cost of the new game and the target cost gap.

Closing the target cost gap

The target cost gap is the estimated cost less the target cost. When the product is first
manufactured, its target cost may well be much lower than its current attainable cost
which is determined by current technology & process.

Management can therefore set benchmarks for improvement towards target costs by
improving technologies and process, techniques which can be employed include.
 Reducing on the number of components.
 Using standards wherever possible.
 Training staff in more efficient techniques.
 Using different materials.
 Using cheaper staff.
 Acquiring new, more efficient technology.
 Cutting out non value added activities (using activity analysis).

Target costing should be applied throughout the entire life cycle and cost savings should
actively be sought and made continuously over the life of the product.
Target costing is difficult to use in service industries due to the characteristics and
information requirements of service businesses.

Characteristics of services
(1) Intangibility: refers to the lack of substance which is involved with service
delivery. There is no substantial material or physical aspects to a service, no taste
no feel visible presence etc. For example, if you go to the theatre you cannot take a
play with you.

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(2) Perishability. Services are perishable. The services of a beautician are purchased
for a period of time.
(3) No transfer of ownership. Services do not result in transfer of property. The
purchase of a service only confers on the customer access to use a facility.
(4) Inseparability. Many services are created at the same time as they are consumed.
For example dental treatment. No service exists until it is actually being
experienced/ consumed by the person who has bought it.
(5) Variability or heterogeneity. Many services face the problem of maintaining
consistency in the standard of output. It may be hard to attain precise
standardization of the service offered, but customers expect it (such as with fast
food).

Information requirements of services

Service business need the same aggregate information as manufacturing firms, but also
need performance data as to their cost and the volume drivers.
Operational information is likely to be more qualitative. A service business needs a
mixture of quantitative and non quantitative information to price its services properly, to
optimize capacity utilization and to monitor performance
 They need to control the total cost of providing the service operation.
 They need positive cash flow to finance activities.
 They need operating information to identify how costs are incurred and on what
services.
Service industries rely on their staff. Front line staffs are those who convey the service
and the experience of the brand to the consumer. They convey the moment of truth with
the customer. For service business management accounting information should
incorporate the key drivers of service costs i.e.;
 Repeat business
 Customer satisfaction surveys, complaints
 Opportunity costs of not providing the service
 Avoidable/ un avoidable costs.

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LIFE CYCLE COSTING
Life cycle costing tracks and accumulates costs and revenues attributable to each product
over the entire product life cycle. Product life cycle costs are incurred from its design
stage through development to market launch, production and sales and finally to its
eventual withdraw from the market. The component elements of a products cost over its
life cycle may include the following:
Design
 Research and development Testing
Production process and equipment
 The cost of purchasing any technical data required
 Training costs
 Production costs
 Marketing costs that is; customer service, field maintenance, brand promotion.
 Distribution costs
 Retirement and disposal costs. Costs occurring at the end of a products life
 Inventory costs
Life cycle costing can apply to services, customers and projects as well as to physical
products.
The product life cycle
The product life cycle is divided into five phases:
(1) Development phase: Costs are incurred but no revenue is generated.
(2) Introduction
(3) Growth Phase
(4) Maturity Phase
(5) Decline Phase

Illustration 1

A company specializes in the manufacture of solar panels. It is planning to introduce a

new slim line solar panel specially designed for small houses. Development of the new
panel is to begin shortly and the company is in the process of determining the price of the
panel. It expects the new product to have the following costs:
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Year 1 Year 2 Year 3 Year 4

Units manufactured and sold 2000 15,000 20,000 5,000

$ $ $ $

R & D costs 1.900.000 100.000 - -

Marketing costs 100.000 75.000 50.000 10.000

Production cost per unit 500 450 400 950

Customer service costs per unit 50 40 40 40

Disposal of specialist equipment 300,000

The Marketing Director believes that customers will be prepared to pay $500 for a solar
panel but the Finance Director believes this will not cover all of the costs throughout the
life cycle.

Required

Calculate the cost per unit looking at the whole life cycle and comment on the
suggested price.

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Illustration 2

A company manufactures MP3 players. It is planning to introduce a new model and

development will begin soon. It expects the new product to have a life cycle of 3 years
and the following costs have been estimated.

Year 0 1 2 3

Units manufactured and sold - 25,000 100,000 75,000

Price per unit - $ 90 $ 80 $ 70

R & D costs $ 850,000 $ 90,000 - -

Productions costs

Variable cost per unit - $ 30 $ 25 $ 25

Fixed costs - $500.000 $500.000 $500.000

Marketing costs

Variable cost per unit - $5 $4 $3

Fixed costs - $300.000 $200.000 $200.000

Distribution costs

Variable cost per unit - $1 $1 $1

Fixed costs 190.000 190.000 190.000

Customer serviced costs per unit - $3 $2 $2

(a) Explain life cycle costing and state what distinguishes it from more
traditional management accounting techniques.

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(b) Calculate the cost per unit looking at the whole life cycle and comment on the
price to be charged.

Maximizing return over the product life cycle

(1) Design costs out of products: Between 70% to 90% of a products life cycle are
determined by decisions made early in the life cycle, at the design or development stage.
Careful design of the product and manufacturing and other process will keep cost to a
minimum over the life cycle.
(2) Minimize the time to market: This is the time from conception of the product to
its launch. Competitors watch each other very carefully to determine what types of
product their rivals are developing. If the organization is launching a new product it is
vital to get it to the market place as soon as possible as this will increase its market share.
(3) Minimize the break even time (BET). A short BET is very important in
keeping an organization liquid the sooner the product is launched the quicker the research
and development costs will be repaid providing an organization with funds to develop
further products.
(4) Maximize the length of the life span: product life cycles are not predetermined
They are set by the actions of management and competitors. Once developed some
products lend themselves to a number of different uses this is especially true of materials
such as plastic, nylon and other synthetic materials. The life cycle of the material is then
a series of individual product curves nesting on top of each other as shown below.

Sales
Revenue

Time
By using different national or regional markets one after another an organization may be
able to maximize revenue. This allows resources to be better applied and sales in each
market to be maximized.

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On the other hand in today’s fast moving world, an organization could lose out to a
competitor if it failed to establish an early presence in a particular market.

5. Minimize product proliferation: if products are updated or superseded too

quickly, the life cycle is cut short and the product may just cover its R&D cost before its
successor is launched.

6. Manage the product cash flows.

Customer life cycles

Customers also have life cycles, and an organization will wish to maximize the return
from a customer over their life cycle. The aim is to extend the life cycle of a particular
customer or decrease the churn rate, as the Americans say. This means encouraging
customer loyalty e.g. supermarkets and other retail outlets issue loyalty cards that offer
discounts to loyal customers who return to the shop and spend a certain amount with the
organization existing customers tend to be more profitable than new ones. They also
become more profitable over their life cycle approx.4-20 years.

Read about the benefits of life cycle costing.

Through put Accounting and Theory of Constraints

Through put Accounting: is a product management system which aims to maximize

through put and therefore cash generation from sales, rather than profit.

Theory of constraints TOC: is an approach to production management which aims to

maximize sales revenue less material and variable overhead cost. It focuses on factors
such as bottlenecks which act as constraints to this maximization.

Bottleneck resource or binding constraint: an activity which has a lower capacity than
preceding or subsequent activities, thereby limiting through put.

5 step approach to summarize the key stages of TOC

1. Identify the constraint.

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2. Decide how to exploit the constraint.
3. Subordinate and synchronize everything else to the decisions made in step 2.
4. Elevate the performance of the constraint.
5. If the constraint has shifted during any of the above steps go back to step 1. Do
not allow inertia to cause a new constraint.

The overall aim of TOC is to maximize through put contribution (Sales Revenue –
Material cost) while keeping conversion cost (all operating costs except materials costs)
and investment costs (inventory, equipment etc) to a minimum.

Limitations of Through Put Accounting

1. It is seen as too short term as all costs other than direct material are regarded as
fixed. It concentrates on direct material costs and does nothing for the control of other
costs such as overheads.
2. An organization could be producing in excess of the profit maximizing output as
through put accounting attempts to maximize through put.
Advantage
 Through put accounting helps to direct attention to bottlenecks and focus
management on key elements in making profits, inventory reduction and reducing
the response time to customer demand.
Environmental Accounting
Read about: - Environmental Accounting
- Managing Environmental costs
- Various types of environmental cost i.e.
 Conventional costs
 Potentially hidden costs
 Contingent costs
 Image and relationship costs
- Accounting for environmental costs
 Input/output analysis
 Flow cost accounting

TOPIC 3:
ACTIVITY BASED COSTING (ABC)
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The traditional methods of overhead allocation are based on direct material and labour
which used to dominate the total cost of production. In addition, companies used to
produce small range of products, the overheads were relatively small and any distortions
in the cost information resulting from inappropriate allocation system was insignificant.
Information processing costs used to be high that sophisticated overhead allocation
methods were unjustifiable.

Currently companies produce a wide range of products and direct labour forming a small
percentage of the total costs. At the same time overheads are increasingly high with
intense global competition decision errors based on poor cost information can be highly
regretted.
Limitations of Traditional Costing System
(i) Allocation of organization resources/costs those are unrelated to physical volume.
These costs result from non-volume related activities of material handling,
procurement, set up activities, inspection activities, etc.
(ii) Traditional costing systems assume that all resources are consumed in relation to
their production volumes. This distorts production cost, serious distortions of
costs are more pronounced in organizations producing a wide range of products
that differ in volume and complexity. Traditional volume based costing systems
tend to over-cost high volume products and under-cost low volume products.
(iii) All fixed costs are clustered in one cost pool and one cost driver is employed to
charge costs to products.
(iv) They pay no consideration to non-volume factors that may cause costs, e.g.
management time, setup activities.

Benefits derived by using ABC

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a) It assumes that activities cause costs & that products create the demand for the
activities. Costs are assigned to production based on their consumption for each
activity.
b) The complexity of manufacturing has increased with wider product, shorter product
life cycles and more complex production processes. ABC recognizes this complexity
with its multiple cost drivers.
c) In a more competitive environment Co’s must be able to assess product profitability
realistically. ABC facilitates a good understanding of what drives overhead costs.
d) In modern manufacturing systems overhead functions include a lot of non factory
floor activities such as product design, quality control, production planning and
customer services. ABC is concerned with all overhead costs and so it takes
management accounting beyond its traditional factory floor boundaries.
e) Provides accurate and reliable cost information.
f) Establishes a long run product cost
g) Provides data which can be used to evaluate different ways of delivering business
Note: Costs are influenced by many activities of the organisation rather than overheads,
therefore several costs drivers are necessary to each activity.

Criticism of Activity Based Costing

 The cost of implementing and maintaining an ABC system can exceed the benefits of
improved accuracy.
 Some measure of cost apportionment may still be required at the cost pooling stage for
items like rent rates and building depreciation.
 Implementing ABC is often problematic.
 Unless costs are caused by an activity that in measurable in quantitative terms and
which can be related to production output, cost drivers will not be useable.
 ABC is sometimes introduced because it is fashionable, not because it will be used by
management to provide meaningful product costs or extra information. If management
is not going to use ABC information an absorption costing may be simpler to operate.

Operations (stages) of ABC

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The following steps are taken when applying ABC:
1. Identification of activities performed by the organisation; ABC divides the
organisation into various activities. These are:
 Unit level activities; activities that are performed each time a unit is produced. These
activities consume resources in relation to volume of output.
 Batch level activities (production run activities); activities that are performed each
time a batch is produced. Batch level activities assume that inputs are consumed in
direct proportions to the number of batches of each product produced regardless of the
size of the batch such as processing purchase orders, lecturing to a class i.e costs of
products change with a number of batches of output.
 Production sustenance/facility level activities; activities concerned with maintaining
the machinery which produces products e.g. cost of upgrading software, machine
upgrading. Such costs are not identifiable with a particular product line or product.
These costs are either allocated on arbitrary basis or not allocated at all.
 Product level activities; activities concerned with sustaining a product line in the
market e.g. beer promotional activities or activities performed to support the
production of each type of product. Product level activities assume that inputs are
consumed to develop or permit production of individual products
These activities manifest themselves in certain costs as indicated below;
Unit Level Cost
These are basically short-term and may include items like direct materials, direct labour,
consumables like oil, petrol, etc. The most appropriate cost driver will be overhead or
volume.
Batch Level Costs
These include set up costs that are incurred only when there is a new run. The
appropriate driver is the set up or production runs.
Production Sustenance Costs
For example, management time; these costs are not attributed to any particular produce.
The appropriate cost driver may be number of hours.
2. Identification of cost drivers: a cost driver is an activity or factor which generates
costs or a quantity measure of output of an activity. The appropriate cost driver should

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always be selected in order to have an appropriate apportionment or distribution of
overheads; examples of cost drivers include: ordering of materials, setting up of
machines, inspections made etc. all these can be used as basis of apportioning or
distributing overheads. This step also involves the identification of those costs that are
specific to each activity that is, those costs which the activity actually causes.
Types of cost drivers:
 Transactional cost drivers- these consider or count the number of times an activity is
performed. Assume that same amount of resources are consumed or required whenever
an activity is performed. These include such matters as number of setups, number of
receipts, number of purchase orders, etc. These can be used when all outputs make
essentially the same demands on the activity.
 Duration cost drivers- these represent the amount of time required to perform an
activity. They are used when significant variation exists in the amount of activity
require for different outputs.
 Intensity cost drivers- these consider the resources used each time an activity is
performed.
3. Ascertain the cost driver rate: divide the value of the cost pool for the period by
volume of cost driver in that period to calculate the cost per unit of cost driver or cost
driver rate;
Activity Overhead Expense
Cost Driver Rate 
Volume of the activity cos t driver
3. Assigning activity costs to cost centres or product- this involves allocating or
apportioning overhead costs to cost units using the selected cost drivers.

Exercise 1:
Asingya Ltd manufactures four products W, X, Y, & Z. Output and cost data for the
period just ended are as follows:
Management Accounting Page 25
Product Outpu No. of No. of Material Direct Machine
t production material cost per labour hour per
(Units) runs in a period orders made unit( $) hours per unit
unit
W 10 2 2 20 1 1
X 10 2 2 80 3 3
Y 100 5 5 20 1 1
Z 100 5 5 80 3 3

Direct labour cost per hour is $5.00

Overhead costs (common costs) $(000)
Overhead variable costs 3080
Set-up costs 10920
Scheduling costs 9100
Material handling costs 7700

30800
a) Use both traditional (conventional) cost system and ABC system to determine the
cost of each product. Compare the results got using the two systems and comment
according.
b)

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REVIEW QUESTIONS
Review Question 1
A company manufactures 2 products L and M using the same equipment and similar
processes. An extract of the production data for these products in one period is shown
below.
Quantity produced (units) L M
5000 7000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set ups in the period 10 40
Orders handled in the period 15 60

Overhead costs $
Relating to machine activity 220,000
Relating to production run set ups 20,000
Relating to handling of orders 45,000
285,000
Required:
Calculate the production overheads to be absorbed by one unit of each of the products
using the following costing methods.
(a) A traditional costing approach using a direct labour hour to absorb overheads

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(b) An Activity based costing approach using suitable cost drivers to trace overheads to
products.

Review Question 2
JK (U) KLtd manufactures and sells three products ie Doughnuts, Ice-cream & Yoghurt.
The company’s production department consists of processing & Packaging.
The management Accountant of JK (U) Ltd has provided you with the following
budgeted information for the six month period ending 31st Dec 2016

Product Production Unit Direct Direct Machine Direct

(Units) selling material labor cost hrs per labour
price cost per per unit unit hours per
(ushs) unit (ushs) Ugx unit
Doughnut 100,000 45 16 14 4 14
Ice-cream 80,000 95 50 30 10 6
Yoghurt 60,000 70 30 30 8 4

In bid to embrace modern business techniques, the Management Accountant intends to

adopt ABC method of cost allocation and has identified the following activities as the
main cost drivers for the overhead costs.

Overhead costs Cost driver Projected

overhead costs
(ugx)
Processing services Machine hours 714,000/=
Packaging services Direct labor hours 636,000/=
Quality control No of inspections 52,000/=

Material handling & dispatch No of internal 156,000/=

requisitions
Selling & administration No of customer orders 168,000/=
Machine setups Number of production 156,000/=
runs
Total 1,882,000/=

Additional information
i) All units produced will be sold in the six month period
ii) Production takes in batches of 1,000 units
iii) The following estimates have also been provided for the period

Product Number of Number of internal Number of customer

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inspections requisitions orders
Doughnut 240 8,000 3,000
Ice-cream 400 8,000 4,000
Yoghurt 400 16,000 4,200

Required
a) Prepare budgeted statement of profit/loss( income statement) for the period
ending 31st December 2016 based on activity based costing
b) Explain the short falls of ABC method over the conventional cost allocation
methods.

Review Question 3
XYZ ltd plans to produce Sausages which have to be processed through three cost centres
A,B & C. the following budgeted data have been obtained from the books of XYZ Ltd.
Cost Centres

A B C
Material cost per 2,000 4,000 3,000
unit (ugx)
Direct labour hrs per 2 5 1
unit
Rate per direct 1,500 2,000 3,000
labour hr (ugx)
No of inspections to 5 3 2
be made
No of machine 7 8 10
setups
No of orders made 12 20 8
No of requisitions to 7 5 8
be made

XYZ has budgeted to produce 5,000 units of Sausages and also plans incur the following
overhead costs

Inspection costs 4,000,000

Setup costs 8,000,000
Management Accounting Page 31
Ordering costs 10,000,000
Material storage costs 12,000,000
Total 34,000,000

Required
Using ABC with appropriate/suitable cost drivers determine
i) The total cost of producing sausages
ii) The unit cost of each sausage
iii) The selling price of sausages assuming the company targets to get 25% profit
on selling price
iv) Determine the total number of hours that will be required by the company to
realise its budgeted output.
Review question 4
a) Explain the reasons behind the development of ABC
b) Clearly point out ways in which ABC will assist management in discharging their
role of cost control
c) Explain the limitations of ABC
d) Point out the steps in applying ABC in a manufacturing company

TOPIC 4

MARGINAL / VARIABLE & ABSORPTION/FULL COSTING TECHNIQUES

Marginal costing together with absorption costing are costing techniques that try to
explain what constitutes the unit cost of the product or the composition of costs in the
unit cost of the product or service. The two that is, marginal/variable costing and
absorption (full costing) are two extremes of product costing in inventory valuation and
their application is influenced by what organizations intend to achieve. However, it is
crucial of recognize that none of the two techniques is superior to the other.

MARGINAL COSTING (VARIABLE COSTING) TECHNIQUE

This represents a costing system that treats only those costs of production that varies with
output as product costs. Under this system, only variable manufacturing costs are
assigned to the products and are included in the inventory valuation. The system

Management Accounting Page 32

categorizes costs according to their cost behaviour and divides them into variable and
fixed costs.

All fixed costs are regarded as time based and are linked to accounting periods rather
than units of output.

Ordinarily, direct materials, direct labour and variable manufacturing overhead costs are
included in production costs under this method. Fixed manufacturing overhead costs are
not included and they are treated as period costs and charged against profit in the period
in which these goods are sold or in the period to which they relate.

Marginal costing is the accounting system in which variable costs are charged to cost
units and the fixed costs of the period are written off in full against the aggregate
contribution. The technique allocates only variable/marginal costs to the product/service
and treats fixed manufacturing and non-manufacturing costs as period costs.

Therefore, the two main features of marginal costing are:

i) Separation of all costs into fixed and variable elements.

ii) Exclusion of the fixed costs from unit cost calculations.

A key concept in marginal costing is “contribution”. Contribution = sales revenue minus

marginal (variable) costs. Profit is measured by subtracting period costs (fixed costs)
from contribution.

Contribution = sales – variable cost of sales

INCOME STATEMENT (PROFIT STATEMENT) UNDER

MARGINAL/VARIABLE COSTING

Under this technique, variable costs represent the cost of sales or cost of production
which are deducted from total sales generated in a period to get total contribution (i.e
total sales –total variable costs).

All other costs including fixed manufacturing cost and non-manufacturing costs are
treated as operating costs and hence offset from the registered total contribution to get net
income of profit/loss.

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The fact that fixed manufacturing costs are not charged to products under this technique
there can be no volume (capacity) variance.

Format of the income statement – Under Marginal Variable costing

UGX
Sales xxx
Less: Marginal Cost of sales
Opening stock (quantity x unit variable cost) xx
Add: Production cost (Quantity produced x unit variable cost) xx
Cost of goods available for sale xx
Less: Closing stock (units x unit variable cost) (xx)
Marginal Cost of sales (xxx)
Total contribution xxx
Less operating expenses (costs)
Variable selling and distribution cost (xx)
Net contribution xxx
Less: Fixed manufacturing overhead costs xx
Fixed administration overhead costs xx xxx
Net income or profit/loss xxx/(xxx)

EXAMPLE 1
KK LTD produces a single product and has the following budget:
Company budget per unit
UGX
Selling price 10
Direct materials 3
Direct wages 2
Variable overheads 1

Fixed production overhead is UGX 10,000 per month and production volume is
5,000 units per month.
Required
Calculate the cost per unit to be used for stock valuation under marginal costing.

Example 11

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Tukolerewamu enterprises produces a single product and has the following budget:
Company Budget per unit:
UGX
Selling price 10
Direct materials 3
Direct wages 2
Variable overheads 1
Fixed production overhead is UXG 10,000 per month; production volume is 5000 units
per month.

Required
Derive the profit statement under marginal costing for the month if sales are 4,800 units.

REVIEW QUESTIONS - MARGINAL/VARIABLE COSTING

Review Question 1
Kwagalana Ltd, the producer of a single product has provided the following data to you.
His cost and management accountant has prepared the following cost structure based on
the normal or budgeted level of output of 60,000 litres.

Cost per unit (UGX)

Material cost 8
Direct labour 6
Variable overheads 10
Selling and distribution cost per unit 4
Fixed manufacturing overhead 8
Total 36
st
At the beginning of the 1 quarter, Kwagalana Ltd had opening stock amounting to
20,000 litres whose value is based on the above cost structure. The budgeted selling and
administration overheads amount to UGX 200,000 per quarter. The company sells the
produce at UGX 50 per unit. The production and sales for each quarter were:
QUARTER
I II III IV
Production (litres) 45,000 60,000 40,000 70,000
Sale (litres) 50,000 55,000 60,000 70,000

Required
Prepare in a columnar form profit statement based on marginal costing technique

REVIEW QUESTION 2

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A & S Ltd provided the following data to you and sought your services to prepare a profit
statement based on marginal costing technique
Opening stock is 2000 units valued at UGX 70,000
Including variable cost of 25 UGX per unit
Fixed manufacturing costs are UGX 120,000
Variable cost per unit is 30 UGX.
Normal output is 15,000 units
Actual production is 20,000 units
Sales are 14,000 units at UGX 100 per unit.
Selling and distribution costs are ugx 200,000.
Fixed administrative costs are ugx 400,000
Stock is valued on the basis of FIFO method.

Review Question 3

The following are the production cost of BB and sons Enterprises Ltd.

Level of Activity
60% 70% 80%
Output (in units) 1,200 1,400 1,600
Cost (in UGX)
Direct materials 24,000 28,000 32,000
Direct labour 7,200 8,400 9,600
Factory overheads 12,800 13,600 14,400
Total cost 44,000 56,000 56,000

The management has a proposal of increasing production to 90% level of activity

and it is not expected to involve any increase in fixed factory overheads.
Required:
Prepare a statement showing the prime cost, total marginal cost and total factory
cost at 90% level of activity.
Management Accounting Page 36
ADVANTAGES OF MARGINAL COSTING (ARGUMENTS IN FAVOUR OF
MARGINAL COSTING SYSTEM)
i) It helps in providing relevant information about costs to enhance the process of
decision making since it makes a distinction between fixed costs and variable costs. This
implies that the information provided by the system is relevant for production decisions.

ii) The profit of the period calculated using marginal costing is more easily related to
sales than it is in absorption costing. This means that contribution increases with every
unit sold and this has a direct impact on the profit or loss recorded by an enterprise. This
clearly indicates that managers can easily anticipate income and take viable decisions
accordingly.

iii) It avoids fixed manufacturing overheads being capitalized in un-saleable stocks. Stock
is valued on the basis of unit variable costs which is always lower than absorption costing
stock figure. Failure of marginal costing to capitalize fixed manufacturing costs in
inventory, profits are not always exaggerated.

iv) Profit statement (internal reports) produced on the basis of marginal costing may be
used as a basis for measuring managerial performance since most of the costs involved
are controllable.

v) Advocates of marginal costing argue that fixed manufacturing costs are incurred in
order to have the capacity to produce. Moreover, they will be incurred regardless of
whether anything is actually produced. Since these costs are not caused by any particular
unit of product and are incurred to provide capacity for a particular period, the matching
principle would dictate that fixed manufacturing overheads cost must be expensed in the
current period.

Arguments against Marginal costing system

i) If marginal costing is used to set the selling price for an organisation’s products and
services, then the price set may well result in a contribution being received for every
unit sold but may fail to cover the fixed costs of the enterprise. This means that it is
likely that the selling prices set basing on marginal costs may not cover all operating
costs.

ii) Though the system is based on the principle that fixed costs can be easily separated
from variable costs, it is not always the case. Costs are made of different categories
including semi-fixed costs which have both attributes of fixed and variable costs.
The existences of semi-fixed and semi-variable costs posses a lot of challenge to
separate the fixed and variable costs. This implies that the premise of separating the
two costs where marginal costing is based is highly questionable.

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iii) Marginal costing technique is not acceptable for external reporting or as a basis for
preparation of financial reports because of violating accounting standards (IAS2) in
valuation of inventories. In the same wave length, tax understatement of profits and
hence tax liability.

iv) The opponents of marginal costing system argued that it is and appropriate to
exclude fixed manufacturing overhead costs from the production costs. They are not
borrowing the view that fixed costs are incurred to maintain productive capacity
which is not at all affected by the levels of volume in the short run.
v) Marginal costing system is only useful as information provides for short run profit
planning and decision making technique. In long run planning and decision, one
needs more information on the variability of costs. The danger of using variable
costs is that it can be generated into a short sighted approach to decision making.

ABSORPTION COSTING (FULL COSTING)

It is a costing technique that tries to explain what constitutes the unit cost of a product or
a service.
Absorption costing is an extreme of product activity and inventory valuation techniques
whose application is influenced by what the organization intends to achieve.
In absorption costing, the cost of a product or a service is established by adding a share of
overheads to direct costs like direct labor, direct wages. It is consistent with the
requirements for stock valuation in financial reporting (IAS2).

Absorption costing includes variable overheads and fixed overheads where variable
overheads are those manufacturing costs that vary in relation to changes in production
output, for example production supplies, equipment utilities like water and material
handling wages.

Fixed overheads are a set of costs that do not vary as a result of changes in activity, for
example rent, insurance, office expenses, administrative salaries, depreciation etc.

Format of absorption costing

Absorption Cost per unit
Direct Costs e.g. Direct Labor xx
Direct Materials xx
Add Variable overheads xx
Absorbed fixed overheads xx
Absorption Cost per unit xxx

INCOME STATEMENT UNDER ABSORPTION COSTING

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Under the technique, all the costs are grouped into the categories, manufacturing or
production costs, selling and distribution costs and administration costs. In the income
statement, all manufacturing costs (cost of sales) are offset from total sales generated in a
period to arrive at gross profit or loss.

The registered gross profit may be adjusted accordingly. (i.e. upwards or downwards)
because of over or under absorbed fixed manufacturing overheads. All non-
manufacturing costs are subtracted from the gross margin to get net profit for the year.

It should be clearly understood that fixed manufacturing overhead costs are charged to
units of output produced on the basis of per unit fixed manufacturing overhead rate
obtained by dividing the standard fixed manufacturing overhead by the normal output or
budgeted output level as follows:

Unit fixed cost= Standard/budgeted manufacturing overhead costs

Normal or budgeted output

The computed unit fixed cost implies that for every unit of output produced, the amount
of unit fixed cost will be recovered by the firm. This means that level of actual output
determines the amount of overheads recovered. If the actual output is greater than the
normal level of output. It means more manufacturing overheads than incurred/budgeted
will be absorbed into the production costs. This therefore, indicates that there is over
absorption of fixed manufacturing overheads. The over absorbed (excess) amount is a
credit to the income statement as a gain. This indicates favourable volume or capacity
variance.

However if the actual output is below the normal level of output, it means that some of
the fixed manufacturing overhead costs have not been absorbed into production costs.
This represents under- recovery or under absorption of fixed manufacturing costs, which
are charged against profits in the income statement.

Income Statement under absorption costing is illustrated below:

Income statement (based on absorption costing principles)
UGX UGX
Sales xxxx

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Less: Cost of Sales
Opening Stock (Qty x Full Unit Cost) xxx
Add: Production Costs (Qty x Full Unit Cost) xxx
Cost of goods available for sale xxx
Less: Closing Stock (xxx) (xxxx)
Gross Profit xxxx
Add/Subtract Over/under absorption xxx
Net Gross Profit xxx
Less: Operating variable costs xxx
Fixed administrative overhead costs xxx
(xxx)
Net income or Profit/Loss xxxx

Example 1: James and Jolly Limited produces a single product and has the following
budget:-
Company budget per unit
$
Selling Price 20
Direct Materials 6
Direct Wages 4
Variable overheads 2

Fixed production overhead is $20,000 per month, production volume is 10,000 units per
month.
Required
i) Calculate the cost per unit to be used for stock valuation in absorption costing.
ii) Calculate the profit per unit for James & Jolly Ltd using absorption/full
costing.

Example 11:

Management Accounting Page 40

A & S Ltd provided the following data to you and sought your services to prepare a profit
statement based on Absorption costing technique
Opening stock is 2000 units valued at UGX 70,000
Including variable cost of 25 UGX per unit
Fixed manufacturing costs are UGX 120,000
Variable cost per unit is 30 UGX.
Normal output is 15,000 units
Actual production is 20,000 units
Sales are 14,000 units at UGX 100 per unit.
Selling and distribution costs are ugx 200,000.
Fixed administrative costs are ugx 400,000
Stock is valued on the basis of FIFO method.

Review Questions on Absorption/Full Costing

Review Question 1
ABC limited the producer of a single product has provided the following data to you. His
management accountant has prepared the following cost structure based on the normal or
budgeted level of output of 60,000 litres.
Cost per unit (UGX)
Material Cost 8
Direct Labour 6
Variable overheads 10
Selling and distribution cost per unit 4
Fixed manufacturing overheads 8
Total 36
At the beginning of the 1st quarter, ABC limited had opening stock accounting to 20,000
litres whose value is based on the above cost structure. The budgeted selling and
administrative overheads amount to UGX.200, 000 per quarter. The company sells the
product at UGX.50 per unit.The production and sales for each quarter (QR) were as

Management Accounting Page 41

follows:
QR1 QR2 QR3 QR4
Production (litres) 45,000 60,000 40,000 70,000

Sales (litres) 50,000 55,000 60,000 70,000

Required:
Produce in a columnar form profit statement based on absorption costing technique
principles

Advantages of using Absorption costing technique

 Fixed costs are incurred within the production function, and without those
facilities, production would not be possible. Consequently such costs can be
related to production and should be included in stock valuation.
 Absorption costing follows the matching concept by carrying forward a
proportion of production cost in the stock valuation to be matched against the
sales value when items are sold.
 It is necessary to include fixed overhead in stock values for financial statements,
routine cost accounting using absorption costing produces stock values which
include a share of fixed overheads.
 Overhead allotment is the only practicable way of obtaining job costs for
estimating prices and profit analysis.
 Analysis of under-/over absorbed overheads is useful to identify inefficient
utilization of production resources.
 It is quite common to price jobs or contracts by adding a profit margin to the
estimate fully absorbed cost of the work.
Disadvantages of using the absorption costing technique.
 Profit per unit with absorption costing can be a misleading figure, this is because
profitability might be distorted by increases or reductions in stock levels in the
period, which has no relevance for sales.
 Comparison between products can be misleading because of the effect of arbitrary
apportionment of fixed costs. Where two or more products are manufactured in a
factory and share all production facilities, the fixed overheads can only be
apportioned on an arbitrary basis.

RECONCILIATION OF PROFITS
Reconciliation of profits can EITHER be started with marginal costing profits, add the
difference in closing stock and then deduct the difference in opening stock (of marginal
and absorption costing) so as to arrive at net profit figures as per absorption costing.
OR
Start with absorption costing profits, add the difference in opening stock and less the
difference in closing stock so as to arrive at net profit figures of marginal costing system.
Management Accounting Page 42
ILLUSTRATION
UGX
Marginal costing profit xx
Add difference in closing stock xx
Less difference in opening stock (xx)
Add/subtract over/under absorption xx
Net profit as per absorption xxx

Practice Exercise 1
A company produces a single unit of product for which the variable production cost is £6
per unit. Fixed production overhead is £10,000 per month and budgeted production and
sales volume is 5,000 units each month. The selling price is £10 per unit. Suppose that
in a particular month, production was in fact 6,000 units with 4,800 units sold and 1,200
units left as closing stock
Assume all costs were as budgeted.
a) Prepare the profit statement for the month under absorption costing
b) Prepare the profit statement for the month under marginal costing
c) Prepare a statement to reconcile the two reported profit figures.

Practice Exercise 11

MK Ltd produces a single product and has the following budget:

Company Budget per unit
£
Selling price 10
Direct materials 3
Direct wages 2
Variable overheads 1

Fixed production overhead is £10,000 per month; production volume is 5,000 units per
month.
Show profit statements for the month if sales are 4,800 units under:
a) Total Absorption costing
b) Marginal costing

Practice Exercise 111

Rayners Plc manufactures and sells blankets. The selling price is £12. Each blanket has
unit cost set out below.
Administration costs are incurred at the rate of £20,000 per annum.
The company achieved the production and sales of blankets set out below.
The following information is also relevant.

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i) the overhead costs of £2 and £3 per unit have been calculated on the basis of a
budgeted production volume of 90,000 units
ii) there was no inflation
iii) there was no opening stock

Unit Cost
£
Direct material 2
Direct labour 1
Variable production overhead 2
Fixed production overhead 3
8
Production and Sales
Year 1 2 3
Production (in 000s units) 100 110 90
Sales (in 000s units) 90 110 95
Required:
a) Prepare in a columnar form an operating statement using (i) marginal costing and (ii)
absorption costing.
b) Explain why the profit figures reported under the two techniques disagree
c) Reconcile the profits obtained under the two techniques

Practice Exercise iv
Lugazi sugar works produces sugar packed in 50kg bags and sells each bag for shs
60,000. For the financial year 2016, it’s budgeted to produce and sell 180,000 bags with
annual fixed production cost of shs 720,000,000/=

During the month of November 2016, the following results were observed.
Stock movement in units:
Opening stock 3,000
Production 16,000
Closing stock 4,000

The cost for each bag produced and sold were constant throughout the year as under;
Direct materials shs 24,000/=
Direct labour shs 12,000/=
Variable production overheads shs 3,000/=

During the month, fixed selling & administration costs amounted to 30,000,000/=
Required

a) Prepare the profit statement using absorption costing

Management Accounting Page 44

b) Prepare the profit statement using marginal costing
c) Prepare a statement to reconcile the two reported profit figures in a & b above.

TOPIC 5
DECISION MAKING TECHNIQUES- use of C-V-P Analysis
Introduction
Cost-volume-profit (CVP) analysis is a technique which uses cost behavior theory to
identify the activity level at which there is neither a profit nor a loss (the breakeven
activity level). This is important management information because management needs to
know the minimum activity level that must be achieved in order for the business not to
incur losses.

CVP analysis may also be used to predict profit levels at different volumes of activity
based upon the assumption that costs and revenues exhibit a linear relationship with the
level of activity.

COST-VOLUME PROFIT ANALYSIS/ BREAK EVEN ANALYSIS

Management Accounting Page 45

This is a technique used for planning short-term run profits by finding the relationship
between profits and factors that influence profits. The following factors are taken to be
influencing profits.

 Selling price
 Variable cost of production
 Fixed costs
 Activity level (production and sales units).,

CVP Analysis is an analytical technique or tool used to study the behavior of profit in
response to the changes in volume, costs and prices. Analysis of such factors on profits is
an essential step in the financial planning and decision making.

The main objective of CVP Analysis is to establish what will happen to the financial
results if a specified level of activity or volume fluctuates. This technique helps in
providing information to managers which is based on establishing;

 The minimum level of sales required to avoid losses

 The sales level required to earn a target or desired profit
 Effect on profit levels when sales mix is changed
 The effect of changes in prices, costs and volume on profits
With the help of CVP Analysis, the Accountant is able to present facts and figures in
accurate reports and intelligible charts to management for action

Profit planning is based on break-even analysis and can be worked out using either;

(a) Algebraic method

(b) Contribution method
(c) Break-even chart

Accountants Model: Assumptions of Break-even Analysis

(a) The selling price will remain constant at all levels of sales units
(b) The fixed costs will not change at whatever level of activity
(c) The variable costs of production will remain constant for each unit.
(d) Costs and revenues will follow a linear trend.

Management Accounting Page 46

(e) Organizations produce only one type of product of various products at a
constant mix.’
(f) The only factor that affects costs and revenue is the production (volume).
(g) Technology and efficiency methods do not change.
(h) Production level is equal to sales level i.e. all that is produced is sold hence no
opening & closing stocks.
(i) Single product is assumed to be produced
Limitations of Break- Even Analysis (Criticisms)

The limitations arise from the shortcoming of the assumptions given above.

(a) It is not true that the selling price will always remain constant at all levels of
sales because to induce sales the company may lower the price.
(b) The costs of production per unit does not remain constant as at a certain stage,
the costs fall per unit due to the learning curve effect and the economies of scale
and may raise again later at diseconomies of scale.
(c) The economies today are dynamic leading to changes in technology of
production and yet it has been assumed constant.
(d) There are fluctuations in production and leading to changes in stock levels that
are assumed to be constant
(e) It’s not easy to separate costs to variable and fixed elements
(f) Difficult to apply in a multi-product firm.
Advantages of CVP Analysis

a) Graphical representation of cost and revenue data (Breakeven charts) can be more
easily understood by non financial managers.
b) Highlighting the breakeven point and margin of safety gives managers some
indication of the level of risk involved
c) A break even model enables profit or loss at any level of activity within the range
for which the model is valid to be determined, and the C/S ratio can indicate the
relative profitability of different products.
BREAK-EVEN CHART.

Management Accounting Page 47

This is a graph on the Cartesian plane showing costs and revenue on the Y-axis and
activity level (output) on the X-axis. The Breakeven chart shows how total cost, fixed
cost, variable cost and revenue change as the level of output alters.
Accountants’ model

Cost
Revenue TR
Profits TC

BEP
Angle of incidence = where TR line cuts the
TC line

FC
Losses MOS

BEQ Actual qty Activity level

The accountants approach to CVP analysis cannot work out or is not applicable unless
certain assumptions are in place. The assumptions are; i) single product being produced
ii) there are no stocks ie all what is produced is sold iii) selling price,vc per unit, and Fc
do not change as output increases or decreases iv)constant efficiency & production levels
v) the only factor that influences TC and TR is volume of output vi) assumes separation
of costs into vc & fc

The accountant’s model introduces the concept of angle of incidence which represents the
angle at which total revenue line cuts the total cost line. If the angle is large it indicates
that profits are being made at a high rate and if the angle of incidence is small it shows
that whereas profits are being made, they are being made under less favorable conditions.

According to the accountant’s model, the output level that maximizes profit is the
maximum practical capacity. But a relevant range is always observed in determining the
maximum level capacity. Relevant range refers to the output range that is planned at
which a firm expects to operate usually in one year or short run. The accountant’s model
is not applicable in the long run but only in the short run

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Compared to the economist model, the accountant’s model is not realistic in the long run
because if it’s unrealistic assumptions i.e. sales revenue will keep on increasing up to
infinity. But the accountants defend their model by saying that it’s not meant to provide
accurate representation of the relationship between output, costs and revenues throughout
all ranges of output but only over the relevant range.

Revenue
Cost Economist model
TC
Losses
BEP 2 TR

Profits

FC
BEP 1

Losses

Out put
MC=MR MR=MC
The economist’s explanation is that the relationship between output and total cost or total
revenue is curve linear (no clear relationship). The TR line is curve linear indicating that
more units of output can be sold if the selling price is reduced. Thus the TR line does not
increase proportionate without price reduction. The economists argue that more units can
be sold if the selling price is reduced.

The economists recommend firms to operate at the point where the gap between MR is
exactly equal to MC. At this point the gap between TR curve and TC curve is so wide.
The economist’s model helps management in addressing both short and long term plans
and decisions.

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The Break-even point (BEP) is that point at which sales revenue (SR) equal total cost
(TC) leading to no profits (No losses, No gains).
The left of the BEP, the organization makes losses and to the right of BEP, profits are
realized. This seems to suggest that organization makes losses simply because of
operating below BEP and improve on their profits by operating above BEP

Margin of safety (MOS): Is the difference between current operating activity level and
the Break even activity (BEP). It’s preferable to express this as a percentage and can be
measured using units or shillings. I.e

. MOS = Current Activity - Break-even activity x 100 (in relative terms)

Current Activity

MOS= Current Activity-Break Even Quantity (in absolute terms)

It measures the extent to which the sales should fall before the organization starts making
losses. The higher the MOS, the safer the organization in times of a depression and the
lower the MOS, the higher the risk the organization faces during depression.

ANGLE OF INCIDENCE:

Angle of Incidence: Is the angle between the total revenue (TR) curve and the total cost
(TC) curve and the higher the angle, the higher the risk of the company and vice versa.

Risk is a measure of fluctuations in profits or cash flows.

During a boom, a company with a large angle of incidence will be at a better position
because its profits will increase faster but during a recession, it suffers heavily because
the profits decrease faster.

BREAK-EVEN POINT COMPUTATIONS- Algebraic or mathematical approach

Contribution per unit = selling Price – Variable cost per order

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Contribution / sales(C/S) ratio = Contribution x 100 or Contribution per unit x 100

Sales Selling price

The break-even point can be measured in units and in shillings, hence

BEQ = Fixed costs FC

Contribution per unit C/U

Break-even shilling = FC x price = FC

C/U Contribution sales ratio(c/s)

OR Break even shillings = BEQ* Price

If the organization’s target is to realize a certain profit, then the quantity to be produced is
given by planned quantity for planned profit is

Q @ target π = Fixed costs + profit targeted

Contribution per unit

Planned sales (Shs) = Fixed costs + targeted profits

Contribution sales ratio

Algebraically: Profit = Sales- FC-VC

But at BEP, profits = 0 Sales = PQ

Sales – FC-VC =0 VC =VQ

Sales – FC –VC

PQ –FC –VQ

FC = Q (p-v) Dividing by p-v

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FC = Q

P-V

Q = FC = FC

P-V Contribution per unit

For planned profits. Profits = ∏

∏ = Sales – FC – VC

∏ = PQ-FQ-VQ

FC + ∏ = Q (P-V) Divide by P-V

FC + ∏ = Q

P-v

Q = FC + ∏ = FC + ∏ if profits are not taxable or

P-v Contribution per unit

Q = FC + ∏/(1-t) if profits are taxable

Contribution per unit
Where “t” is the tax rate

Sales =FC + ∏ x P or = FC + ∏

P-V PV ratio, PV ratio = C/S ratio

%MOS = Expected sales – BEP sales x 100

Expected sales

MARGIN OF SAFETY.

MOS = profits in units

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Contribution per unit

MOS = Current Activity – Break-Even Activity

Current Activity

FC + ∏ - FC = FC + ∏ - FC =∏

C/u c/u c/u c/u

MOS = ∏ / c/u (in absolute terms).

MOS as a ratio = ∏/c/u = ∏ x c/u

FC +∏ c/u FC +∏

MOS as ratio = ∏
FC + ∏
Illustration 1

The following standard cost statement relates to a product which sells for 100,000/=, per
tonne.
Details Amount(shs)
Direct materials 30,000
Direct wages 20,000
Variable overheads 10,000
+ 60,000
Fixed overheads 20,000
Total cost 80,000
The fixed overheads were based on output of 3,000 tonnes.

Required:

(a) Calculate the break-even point (graph not required)

(b) Calculate contribution to sales ratio
(c) Calculate margin of safety
(d) Calculate percentage increase in profit if sales volume increased by 10%
(e) Calculate extra tones to be sold in order to maintain the existing ∏ level if
selling price is reduced by 10%

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Review Questions – Single Product environment

QUESTION 1

a) MBA students at UMU came up with the idea of producing and selling a single
product in the next financial year after their programme. They managed to come
up with the following data relating to their planned level of operations.

The product will be sold at 2000/= per unit and price will remain constant for
some time. The unit costs to be incurred in producing and marketing the product
will include the following:

Variable costs Unit costs

Production 800
Selling & distribution 400
1,200
Total fixed costs will amount to 2,400,000/= in a period and the students have budgeted
to produce 2,800 units in the same period. Jim one of the MBA students was
uncomfortable with the whole plan especially the budgeted level of output. He wondered
whether it will be viable to operate at that level of activity. Using Cost-Volume-Profit
(CVP) analysis answers the following questions below;

i) Following Jim’s argument, will it be viable to operate at the budgeted level of

output? Your advice must be supported by the figures.

ii) Assuming the students are planning to earn a profit of 400,000/=. How many units
can be produced so as to realize their plan?

iii) Basing on the answers got in (ii) above, what will be the margin of safety in units.

iv) Calculate the contribution sales ratio

QUESTION 2

Uganda clays Ltd manufactures and sells tiles. The tiles are homogeneous and the
customers like the long lasting product so much that all that is produced is sold. The
company uses marginal costing technique and below is a projected marginal costing
profit statement for the next accounting year.
Sales (2,000 tiles)---------------------------------------------------- shs 50,000,000/=
Less variable costs……………………………………………shs 30,000,000/=
Contribution…………………………………………………..shs 20,000,000/=
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Less Fixed costs
Fixed office & Administration………. 2,400,000/=
Fixed selling & Distribution………… 2,600,000/=
Fixed Production Overhead…………. 2,200,000/= shs 7,200,000/=
Net profit 12,800,000/=
Production is uniform throughout the year. Likewise costs are incurred and revenue
generated uniformly throughout the year. You are the newly appointed Management
accountant of the company and you are supposed to do profit planning basing on the
forecast statement above.
Required
i) Calculate the monthly breakeven point (in Units and Sales)
ii) Calculate the number of tiles that can be sold per year to earn a profit of Shs
20,000,000/=
iii) Calculate the Contribution sales ratio
iv) Calculate the margin of safety in units

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

Question 4
A company plans to earn an after tax profit of ugx 1,200,000/= and that the income tax
rate is 30%. The unit selling price and variable cost amount to ugx 10,000 and ugx 6,000
respectively. The fixed costs will amount to ugx 20,000,000. You are to determine the
amount of units and sales value to enable the firm earn the desired profit.

MULTI PRODUCTS CPV ANALYSIS

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A company can produce and sell more than one product but the sales mix is assumed to
remain unchanged i.e. we have to assume that whenever X units of product A are sold, Y
units of product B and Z units of product C are sold. Such an assumption allows us to
calculate a weighted average contribution per mix, the weighting being on the basis of the
quantities of each product in the constant mix. This means that the unit contribution of
the product that makes up the largest proportion of the mix has the greatest impact on the
average contribution per mix.

The only situation when the mix of products does not affect the analysis is when all
the products have the same ratio of contribution to sales (C/S ratio)

Under Multi Product environment the BEQ = Fixed costs

Expected or average contribution

Expected contribution = px1 xcx2 + px2 x cx2……. + pxn x cxn

Where: p→ is the proportion of the product x1 in the total product mix

X1→ is the product in the company product mix

Cx1→ is the unit contribution of product x1

The quantity of each product then is obtained by multiplying BEQ by p

Example 1

KK ltd manufacturers and sell 3 products milk, ice cream and yogurt in the following
quantities
Milk 500 liters
Ice cream 200 liters
Yoghurt 300 liters
1,000 litres

The selling prices and variable production and distribution cost for each product are
as follows milk, ice cream yogurt
Selling price 800 1000 600
Variable production cost 300 600 400

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Variable distribution cost 100 50 50
Operating fixed monthly costs are; production 20,000,000, administration cost for
each product 9,998,000
Required

 The breakeven quantities by product

 The quantities if each product to earn sh.60, 000,000, profit per month
Example 11
Maria Ltd produces and sells three products namely A, B and C. The following data was
obtained for the year 2004.

Products A B C
Sales units 600 2,500 2,000
Unit selling price 2,500 1,000 3,000
Unit variable cost 1,000 400 2,200

Maria Ltd incurs total fixed costs given below:

Production costs UGX. 3,200,000
Selling and administration costs UGX. 2,800,000
Required:
a) Determine multi-product firm’s C/s ratio
b) Compute the firm’s break-even point in shillings
c) Determine each product’s break-even point in shillings and units.

Review question 1
Maria Autos has two models of cars, Carina and Carib. They are sold in a ratio of 6:4.
The following details are given.
Carina Carib
(UGX) (UGX)
Average sales price 12,000 20,000
Less average variable costs
-Cost to Maria Autos (9,600) (14,600)
- Supplies used to prepare cars for sale (200) (400)
- Sales commission (1,200) (2,000)
Average contribution margin per car 1,000 3,000

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The fixed costs for the dealership amounts to UGX 36,000

Required: Calculate the break-even point for Maria Autos.

Revision Question 2
1. Muchomo Ltd purchases and markets a wide variety of goods. Turnover and costs for
the previous two quarters are as follows:

Quarter 1 Quarter 2
Turnover 850,000 1,250,000
Total costs 400,000 560,000

Required:
a) Calculate the break-even turnover per quarter

b) Calculate the sales needed in Quarter 3 to achieve a profit of shs300,000

c) Explain why your results may not be reliable.

Revision Question 3

A summary of a manufacturing company’s budgeted profit statement for the next

financial year, when it expects to be operating at 75% of capacity, is given below:
$ $
Sales: 9,000 units at $32 288,000
Less:
Direct materials 54,000
Direct wages 72,000
Production Overheads:
Fixed 42,000
Variable 18,000
186,000
Gross Profit 102,000
Less:
Administration, selling &distribution costs:
Fixed 36,000
Variable 27,000
63,000
Net Profit 39,000

Required;
a) Calculate the breakeven point in units and in value

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b) Draw a contribution/volume (profit-volume) graph on graph paper
c) Ascertain from your graph above, what profit could be expected if the company
operated at full capacity

Revision Question 4
Druid Limited makes and sells a single product W, which has a variable production cost
of $10 per unit and a variable selling cost of $4. It sells for $25. Annual fixed
production costs are $350,000, annual administration costs are $110,000 and annual fixed
selling costs are $240,000

Required;
Calculate the volume of sales required to achieve an annual profit of $400,000.

Revision question 5
(a) Despite its usefulness in profit planning, cost control and decision making, cost-
volume-profit (C-V-P) analysis lies on premises that are unrealistic.
Required: Outline Six assumptions and limitations underlying C-V-P analysis.
(b) Maji Maji Enterprises Limited deals in the bottling of drinking water. The
Management Accountant has submitted the following statement for the period ended
31 October 2016.

Shs ‘000’ Shs ‘000’

Sales (4,000 units) 40,000
Less cost:
Direct Materials 14,000
Direct Wages 10,000
Direct Expenses 6,000
Fixed Overheads 4,000 34,000
Net Profit 6,000
Management is in the process of preparing plans for the year 2017.
Required:

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Compute the following to provide sufficient information to management to support their
planning process:
(i) The current break even sales volume.
(ii) The margin of safety at the current level.
(iii) If Management plans for a net profit of Shs 10 million over the next period.
What sales volume will make management achieve that level of profit?
(iv) If sales volume and price are expected to remain the same, but management still
plans to earn net profit of Shs 10 million, by what percentage should they reduce
variable costs?
(v) If management double output, how much net profit will they earn?

Revision question 6
Norvik a UK Company operates in the leisure and entertainment industry and one of its
activities is to promote concerts at locations throughout Africa. The company is
examining the viability of a concert in Nairobi Kenya. Estimated fixed costs are £60,000.
These include the fees paid to performers, the hire of the venue and advertising costs.
Variable costs consists of the cost of a pre-packed buffet which will be provided by a
firm of caterers at a price, of £10 per ticket sold. The proposed price for the sale ticket is
£20.
The management of Norvik has requested you to assist them with the following
information:
i) The number of tickets that must be sold to break even
ii) How many tickets must be sold to earn £30,000 target profit before tax?
iii)Assuming, the tax rate is 25%, how many tickets must be sold in order to make a
profit of £30,000 after tax?
iv)What profit would result if 8,000 tickets were sold?
v) What selling price would have to be charged to give a profit of £30,000 on sales of
8,000 tickets, fixed costs of £60,000 and variable cost of £10 per ticket?
vi)How many additional tickets must be sold to cover extra cost of television advertising
of £8,000? (assuming the selling price per unit remains £20 and variable cost per unit
is £10)

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TOPIC 6
Standard Costing and Variance Analysis

Standard costing is a control technique which establishes and compares standard costs
and revenues with actual results to obtain variances which are used to stimulate improved
performance.

It involves establishment of predetermined estimates of the costs of products or services,

the collection of actual costs and the comparison of the actual costs with the pre-
determined estimates.

The pre-determined costs are known as standard costs and the difference between the
standard and actual cost is known as variance. The process by which the total difference
between standard and actual results is analyzed is known as Variance Analysis.

Types of Standards

(1) Ideal cost standard: is a standard which can be attained under perfect operating
conditions, i.e. no-wastage, no inefficiencies, no idle time, and no breakdowns.
This standard demands perfection and hence it obviously unrealistic and
unattainable.
(2) Basic cost standard: is a long term standard which remains unchanged over the
years and is used to show trends. They are established and operated without
revision for a number of years.(a long term standard wc is used by the orgn for a
long period of time without revision)
(3) Currently attainable standards: is a standard which can be attained if
production is carried out efficiently, machines are properly operated or materials
are properly used. However allowances are made for normal losses and machine
breakdown time.

Advantages of standard costing

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(i) Enhances effective cost control: Every organization tries as much as possible to
contain its costs within manageable levels. To achieve cost control actual costs
should be continuously monitored and compared with standard costs to measure
variance.
(ii) Helps in planning: The set standards instill into management a habit of thinking
ahead since standard costing generates information on future costs which should
be incurred in achieving the desired performance such information would assist
managers in putting in place plans that would benefit the organization in future.
(iii) Fixing prices and formulating policies: Since prices are usually set in advance
standard costs can provide a valuable aid to management in determining prices
and formulating production policies.
(iv) Evaluation of performance: The set standards are usually based on to evaluate
the performance of employees, managers and cost centres. This is done by
comparing the expected results with the achieved results.
(v) Helps in building budgets: Once standards are set for various elements of costs
budget can easily be prepared, yard sticks in the form of standards provide for
tighter and more effective budgets.
(vi) Elimination of waste: Since the set standards indicate the resources expected to
be used in providing goods and services the company will be forced to spend
within means. This will enable it to reduce on the amount of resources to be
consumed in providing such goods and services.
(vii) Quality control: Standard costing helps in quality control in that comparison is
usually made of standard quality with actual quality results registered.
(viii) Variance analysis: The standards set are compared with the actual results to get
the variance. This variance can be analyzed so as to get factors responsible for
such variance or gap.
(ix) Provides incentives: If standards are reasonable and attainable they act as
incentives to employees to improve their performances and to maintain the quality
of the product. This implies that standards encourage workers to work hard so as
to achieve the desired or expected results.

Disadvantages of standard costing

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(1) Difficult to apply in managerial control: It is at times difficult to explain
variances as problems are faced in distinguishing between controllable and non
controllable elements of variances.
(2) A business may not be able to keep standards up-to-date since firms operate in a
dynamic environment, it is important that standards must be continuously up-
dated to reflect the prevailing conditions. This involves a rigorous exercise that
may not be affordable by some firms.
(3) Resentment from employees: If standard costs are not well designed and
administered, employees might consider them as “pressure tactics.” They might
be taken as oppressive measures and hence deterrent to motivation.
(4) Expensive: The costs of setting up, maintaining and operating a standard cost
system are generally very high. Standards have to be revised and new standards
fixed involving larger costs thus small firms find it expensive to operate a
standard costing system.
(5) The use of standard costing relies on the existence of repetitive operations and
relatively homogeneous output. Nowadays organizations are forced to
continually to respond to customers changing requirements.
(6) Most standard costing systems produce control statements weekly or monthly.
The modern Managers need much more prompt control information in order to
function efficiently in a dynamic business environment.

Variance Analysis

This is the process of analyzing variances by subdividing the total variance in such a way
that management can assign responsibility for any deviation on standard performance.

The main objective of variance analysis is to detect operating problems and report them
so that corrective action may be taken where possible.

Variances provide feedback information for management control and thus serve as red
flags to alert management.

Variance analysis involves two phases:

(i) Computing individual variances.

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(ii) Determining the cause of each variance.

A variance may be favourable or unfavourable (adverse)

A favourable variance – Means that the actual cost incurred is lower than the
predetermined cost or the actual performance is greater than the expected level of
performance.

Unfavourable/Adverse variance – This represents a scenario where actual cost is

greater than standard cost or where the expected revenues are lower than the actual
revenues. The unfavourable variance represents poor performance & a sign of
inefficiencies in the production systems.

Requirements of good variance Analysis

The following conditions should be in place for the analysis to provide positive results to
the organization.

(1) Standards must be meaningful and realistic.

(2) Responsibility for variances must be pin pointed.
(3) It must be possible to control the production variables, i.e. the operating
conditions should be controllable.
(4) It must be possible to measure the performance objectively and correctly, variance
information should be simple to be effective.

Types of variances

(i) Cost variances

(ii) Sales/revenue variances

(i) Cost variance

The total cost variance represents the difference between the total cost value of
the output achieved in a period and the total actual cost incurred. The total cost
variance is divided into variances for each element of cost including direct
material cost variance, direct labour cost variance and overhead variance.

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Management Accounting Page 65
Calculating Cost Variances

Total Cost variance

Overhead cost variance

Material Cost variance Labour Cost variance

Material Material Labour Labour Idle time

Price usage rate efficiency variance
variance variance variance variance

Material Material Labour Labour Fixed OH Variable O/H

mix yield mix yield variance variance
variance variance variance variance

Expenditure Volume Variable Variable

variance variance OH efficiency
variance variance

Efficiency Capacity
variance variance

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Material cost variance

This is the difference between the standard cost of direct materials specified for the
output achieved and the actual cost of direct materials used. The overall material variance
is known as material total variance which is calculated as:

Material cost variance = Standard cost for actual output – actual cost

MCV = SC – AC

MCV = (SQ x SP) – (AQ x AP)

Where SQ – is the standard quantity for actual production.

AQ = is the actual quantity consumed in producing goods and services

SP = is the standard price per unit.

AP = is the actual price per unit

Material price variance can further be subdivided into material price and material usage
variances.

(i) Material price variance. This represents that portion of material cost variance
which is due to the difference between the standard price specified and the actual price
paid. The formula is given as under:
(MPV) = Actual quantity (Standard price – Actual price)
MPV = AQ (SP – AP)
If the actual price for materials is greater than the specified price (standard price), then
unfavourable or adverse variance is registered and the reverse represents favourable
variance.
Reasons for material price variance. It arises due to the following reasons:
 Change in basic prices of materials
 Failure to purchase the standard quantity, thereby resulting in a different price
being paid,

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 Change in the quantity of materials, which lead to lower or higher quantity
discount.
 Failure to put in place procurement procedures or system in place. This leads to
rush purchasing.
 Change in delivery costs.
 Change in the rates of excise duty and purchase tax.

The material price variance is generally the responsibility of purchasing manager.

(ii) Material usage (or quantity) variance

This is that portion of the material cost variance which is due to the difference between
the standard quantity specified and the actual quantity used.

Material usage variance = Standard price (Standard quantity for actual output –
Actual quantity)

MUV = SP (SQ – AQ).

If the actual quantity materials used in production is greater than the specified quantity
(standard quantity), then unfavourable or adverse variance is registered and the reverse
represents favourable variance.

Reasons for the material usage variance:

 The level of materials handling by production staff,

 Pilferage of material, excessive wastage and spoilage.
 Changes in quality control requirements or changes in the methods of production.
 Use of a material mix different from the standard mix,
 Failure to purchase the standard quality resulting in different amounts used in
production,
 Use of a class of workers in production different from what was planned to be
employed.

Example I

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The standard cost sheet reveals that:-
Standard price of materials = 5,000/=
Standard material quantity = 1,000 units
During the period, 1,500 units of materials were purchased and used at a cost of 6,000/=
per unit.
Required: Calculate the following variances
(a) Material cost variance
(b) Material price variance

(c) Material usage variance

Material mix variance

Material usage variance is further sub-divided into: (a) Material mix variance

(b) Material yield variance

Material mix variance

Arises where more than one type of material is used for producing the product. If there is
a shortage of one or more of the specified materials, it is possible that the proportion can
be changed or different material may be used. These may be cheaper or more expensive
hence resulting in a mix variance. The Chartered Institute of Accountants, London,
defines material mix variance as “that portion of direct materials usage variance which is
due to the difference between the standard and actual composition of a mixture.” The
formula is given as under:

Mmv = (Revised standard qty – Actual qty) x Standard price

Revised standard quantity represents the revised standard proportion of actual input. The
revised standard quantity can be computed as follows:

Revised standard quantity (RSO):

= Individual standard material quantity x Actual input

Total standard quantities of all materials

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Example 2.

The Company planned to produce one unit of product M by using standard mixes of raw
materials X&Y in the following proportions and prices

Raw-material Standard

X 80 units @60/=

Y 120 units @ 50/=

Total 200 units

The actual results are as below:

Actual output 2,000 Kgs

Raw-material Actual

X 160,000 units @ 80/=

Y 180,000 units @ 65/=

Total 340,000 units

Required

Calculate material cost variance

- Calculate material price & usage variances

- Calculate material mix variances

Material yield variance:

This represents part of materials usage variance which is as a result of difference between
standard output and actual output. In this case yield can be defined as the amount of
output expected from a given quantity of materials. In many cases a changed mix will
have an impact on the yield of the final product.

The difference between the actual output (yield) and the standard (expected) output is
multiplied by the price per unit of standard output to compute the materials yield
variance. This is given by the following formula:

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Material yield variance (MYV) = (Actual yield – Standard yield) x Standard price per
unit of output.

If the actual yield is more than the standard yield, the material yield variance is
favourable and vice-versa.
The standard or expected yield can be computed as under:
Standard yield = Unit output x Actual input
Total standard materials units
In example 2, the standard yield = 1 x 340,000 = 1,700 Kgs
200

The standard price per unit of output = X:80 units x shs 60 = UGX.4,800

Y:120 units x shs 50 = UGX.6,000

UGX.10,800

Material yield variance = (Actual yield – Standard yield) x Standard price per unit of
output.

MYV = (2000 – 1,700) x UGX.10,800 = UGX.3,240,000 Favourable.

Alternatively, the material yield can also be calculated as follows:

(i) Material yield variance = Standard quantity - Revised standard qty x S. Price
For actual output for actual output

MYV: Material X: (160,000 – 136,000) x shs.60= 1,440,000 favourable

Material Y: (240,000 – 204,000) x shs.50 = 1,800,000 favourable

3,240,000 favourable

(ii)Material yield variance = Standard quantity – Actual quantity x Average S. Price

For actual output

MYV: Material X: (160,000 – 160,000) x UGX.54 = 0

Material Y: (240,000 – 180,000) x UGX.54 = 3,240,000 Favourable

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3,240,000 Favourable

The average standard price = Standard price per unit of output

Material units to provide a complete unit

= 10,800 = UGX.54
200 units

One can apply any of the three approaches or methods to calculate the yield variance and
none of the methods is superior to the other.

Direct Labour Variances:

The primary labour variance is the labour total cost variance which can be analyzed into
the basic components of Labour rate variance, labour efficiency variance and idle time
variance.

(i). Labour cost variance. This represents the difference between the standard labour
cost for the actual production and the labour cost. To be more specific, labour cost
variance is the difference between total standard labour cost and total actual labour cost.
This can be determined by using the following formula:

Labour cost variance (LCV) = Standard labour cost for actual output – Actual cost

LCV = Standard hour rate x std. hours for actual output – actual hours x actual hour
rate
LCV = (SR x SH) – AH x AR)
Labour cost variance can be broken into labour rate variance, labour efficiency variance
and idle time variance.

(i) Labour rate variance.

This represents the portion of the labour cost variance which is due to the difference
between the standard rate specified and the actual rate paid.

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Labour rate variance = Actual labour hours x (Standard labour rate – Actual labour
rate)
LRV = AH x (SR – AR)

Reasons for labour or wage rate variance:

 Change in the basic wage rate,
 Use of a different method of wage payment,
 Employing workers of grades different from the standard grades specified.
 Unscheduled overtime or overtime work in excess of that provided in the standard
rate.
 New or fresh workers not being paid at full rates.
 Faulty recruitment and placement of workers.

(ii) Labour Efficiency variance

This is the portion of the labour cost variance which is due to the difference between
labour hours specified and the actual labour hours expended.

Labour efficiency variance = Standard rate {Standard hours for

actual output
–
hours worked }
Actual

LEV = SR (SH – AH)

The possible causes of labour efficiency variance include:

 Changes in working conditions or environment,
 Introduction of new equipment or tools,
 Incompetent supervision or lack of proper supervision,
 Use of inferior or non-standard materials,
 Time wasted by factors like waiting for materials, tools or machine break-down,
 Inadequate training of workers, and
 Changes in the method of operation or production process.
(iii) Idle time variance.
It is a part of labour cost variance which represents the difference between idle normal
standard cost and idle actual cost incurred. The normal idle time is always provided for at
Management Accounting – Page 73
standard setting process but because of certain factors such as machine break down and
power failure, the company may register more idle time than the specified one.

Idle time variance can be calculated as follows:

Idle time variance = (Idle standard time – Actual idle time) x standard hourly rate.

Example 1.
The standard cost sheet of KK Ltd shows that the production of each unit requires 1hour
at UGX.2,000 each. During the period, 2,500 units were produced in 2,100 hrs with a
total amount of UGX.3,570,000. Out of the 2,100 hours taken on production, 100 hours
were spent waiting for materials and tools by employees.

Required: Determine
(i) Labour cost variance (LCV)
(ii) Labour rate variance (LRV)
(iii) Labour efficiency variance (LEV) and idle time variance (ITV).

Labour mix variance

This is the same as material mix variance and is part of labour efficiency variance.
Labour efficiency variance is subdivided into labour mix variance and labour yield
variance. Labour mix variance arises if, during a period, the grades of labour used in
production are different from those budgeted. It is computed by:
Labour mix variance (LMV) = Revised standard time – Actual time) x Standard rate
LMV = (RSH – AH) x SR
Total timeof actual workers
Where, Revised standard time = x Standard time
Total time of standard workers

Example 2:
The details regarding the composition and weekly wage rates of labour force engaged on
a job scheduled to be completed in 30 weeks are as follows:

Standard Actual
Category of No. of Weekly wage No. of Weekly wage

Management Accounting – Page 74

workers Labourers rate per labourers rate per
labourer labourer

Skilled 75 60 70 70
Semi-skilled 45 40 30 50
Unskilled 60 30 80 20
The work is actually completed in 32 weeks

Required .

Calculate the various labour variances.

Labour yield variance

This is like material yield variance. It represents the difference between the standard
labour output and the actual output or yield. This variance measures the level of
efficiency or inefficiency attributable to a favourable or unfavourable yield.

Labour yield variance (LYV) = {Standard

for actual output
–
output }
production Actual
x Standard cost per

unit

If the actual production is more than standard production, the difference would be a
favorable variance and vice-versa.

Example 3

Mat Ltd planned to produce 5,000 units of certain product in 10 days and categories of
workers involved in production process include:

Standard Actual
Category of No. of workers Rate per Day No. of workers Rate per Day
Workers (UGX) (UGX)

Management Accounting – Page 75

Skilled 20 4,000 22 3,800
Unskilled 40 2,500 38 2,800
Total 60 60

The workers took 12 days to produce the same amount of output.

Required:
Calculate labour yield and labour mix variances and other labour variances.

Overhead Cost Variances:

This is the difference between standard cost of overhead absorbed in the actual output
and actual overhead cost incurred.

Overhead cost variance = (Absorbed overhead – Actual overhead incurred)

= {forStandard hours x Standard overhead

actual output rate } – Actual overhead incurred
Overhead variances are classified as follows:-
(a) Variable overhead cost variances
(b) Fixed overhead cost variances
Variable Overhead Variances:
This represents the difference between variable overhead absorbed in production and
actual overhead costs incurred. This can be computed as under:
Variable overhead variance = variable overheads absorbed – Actual overheads

{Standard hours for x Standard variable

actual output overhead } – Actual variable overheads

Management Accounting – Page 76

Total variable overhead cost variance can further be analyzed into the variable overhead
expenditure variance and the variable overhead efficiency variance.

Variable overhead expenditure variance:

This represents the difference between standard or budgeted variable cost and actual
variable cost incurred. This variance tries to measure the gap between the overhead
absorption rate used to absorb overheads and the actual rate incurred.

variable overhead
Expenditure variance (VOEV )
= {Standard variable –
Overhead rate
Actual variable overhead
Absorption rate } x

A/Hours
(SVOAR) - (AVOAR)

VOEV = (SVOAR - AVOAR) AH.

Variable Overhead efficiency variance:

Variable overhead efficiency variance measures the company’s level of efficiency in
carrying out the production work. It is equal to the difference between the standard hours
for the actual output and the actual hours taken multiplied by the standard overhead
absorption rate. If lesser time is taken to do the same piece of work than the allowed time,
it means that the company is efficient in its operations. This can be calculated using the
following formula:

{forStandard }
Variable overhead efficiency variance hours – Actual hours
¿ = x
¿ actual output taken
Std . overhead
rate

VOEV = (SH - AH) x SVOAR.

The standard variable overhead absorption rate is calculated by dividing the budgeted or
standard variable overheads by the budgeted or normal output for the period.

Management Accounting – Page 77

Example 1
The organization has planned to absorb its variable overheads into production at a rate of
500/= per hour. Each unit is planned to take 0.5 hours to complete. During the period,
4,200 hrs were paid for with overheads absorbed being 2,520,000/=. Output stood at
6,000 units.

Required
Calculate variable overhead variances.

NB: The causes of the variable overhead variances are exactly the same as those for
labour variances.

Fixed Overhead Variances:

Fixed overhead costs remain constant irrespective of the volume of output. The fixed
overhead cost variance represents the difference between standard fixed overhead costs
absorbed or charged and actual fixed overhead costs incurred. The fixed overhead cost
variance is calculated as under:

Fixed overhead cost variance = (Absorbed or charged fixed costs – Actual fixed costs)

¿ }
¿ standard ¿ Overhead rate ¿ – Actual ¿ overhead costs ¿
¿
= (SH x SFOAR– AFC)

Fixed overhead cost variance is analyzed into two variances i.e.

(i) Fixed overhead expenditure variance,
(ii) Fixed overhead volume variance.
(i) Fixed Overhead Expenditure Variance:
The variance arises due to the difference between budgeted fixed overhead and actual
fixed overhead.
Fixed overhead expenditure variance = Budgeted fixed overhead – Actual fixed
overhead.

(ii) Fixed Overhead Volume Variance:

Management Accounting – Page 78

It is that portion of total fixed overhead variance which is due to actual production being
different from the budgeted production. The volume variance is equal to the difference
between the budgeted fixed overheads and the standard fixed overheads charged to
production (i.e. fixed overheads absorbed at standard hours).
Fixed overhead volume variance = Standard fixed overhead cost – Budgeted fixed
overhead.

¿ overhead volume variance = {forStandard hours – Budgeted

actual production hours } x Std . ¿ overhead rate ¿
¿

= (SH – BH) x SFOAR

Fixed overhead volume variance is further sub-divided into fixed overhead efficiency or
productivity variance and fixed overhead capacity variance.

a) Fixed overhead capacity variance:

The variance tries to measure the extent to which capacity has been utilized. It represents
the difference between the actual hours of input utilized and the budgeted hours of input
multiplied by standard fixed overhead rate.
Fixed overhead capacity variance = (Actual hours – Budgeted hours) x
standard ¿ overhead rate¿
¿
= (AH – BH) x SFOAR

(ii) Fixed overhead efficiency variance:

This represents the difference between the standard hours allowed for the actual
production and the actual hours taken multiplied by the standard fixed overhead rate.
It indicates a failure to utilize capacity efficiently. The formula is:

¿ overhead efficiency = {Standard hours allowed – Actual hours

for actual output taken } x Std . ¿ overhead rate ¿
¿

FOE = (SH – AH) x SFOAR

It is important to note that the sum of fixed overhead efficiency variance and fixed
overhead capacity variance is equal to fixed overhead volume variance.

Management Accounting – Page 79

Example 2
Kamu (U) Ltd the producer of plastic products presented to you the following data;
Budgeted output 200,0
00
Units
Budgeted hours 5,000
Hrs
Budgeted fixed overhead 100,0
00/=
Actual output 190,0
00
Units
Actual hours 4,500
Hrs
Actual fixed overhead 105,0
00/=
Calculate fixed overhead variances

SALES / REVENUE VARIANCES:

These variances measure the changes in profit due to changes in sales, the main variance
being the sales contribution to total variance which is basically analyzed into;
 Sales contribution price variance
 Sales contribution volume variance.
The contribution approach uses only variable costs and any costs are written off as period
costs in the income statement.

}
Standard Actual
Actual
(i) Sales contribution = ¿ x contribution x contribution
quantity
margin margin

= (B.Q x SCM) – (AQ x ACM).

Management Accounting – Page 80

{ }
Standard Actual
Sales contribution Sales margin ¿ Actual
(ii) ( = contribution contribution
Price variance : Price variance quantity
margin margin

SCPV = AQ (SCM – ACM).

Standard
(iii)
Sales contribution Sales margin ¿
(
Volume variance : volume variance
= contribution
margin
{
Actual
quantity
Budgeted
quantity }
SCV = SCM (AQ – BQ)

Standard Standard
But: (a) Standard contribution margin (SCM) = –
Selling price Variable cost

Actual selling Standard variable

(b) Actual contribution margin (ACM) = –
price cost

Example 1:
MK (U) Ltd. Produces ice cream whose standard selling price is 400/= and the cost of
production from standard cost card being:

Cost per unit

(UGX)
D/materials 200
D/labour 60
Variable overheads 40
Fixed overheads 20
320

The budgeted output for the period was 16,000 units but during the period, 15,000 units
were produced and sold at 380/= each.
Required:
Calculate the sales variances.

Management Accounting – Page 81

Sales contribution volume variance can be analyzed into sales margin mix variance and
sales margin yield variance. Such variances are as a result of the company selling several
products with different profit margins.

Sales contribution/ margin mix variance:

This variance is registered when the standard composition of sales is different from the
actual composition of sales made. The formula for calculating the variance is given
below;

SMMV= (Actual sales quantity – actual sales quantity in budgeted proportions) x

standard margin

Sales contribution/margin yield/quantity variance:

This variance is registered when the standard output is different from the actual output
achieved. This can be calculated as follows:

SMYV = (Actual sales quantity in budgeted proportions – budgeted sales quantity) x

Standard
margin

Example 2
N&M (U) Ltd provided the following sales data to you for further analysis. Managers are
not sure whether the company has performed to its expectations or not. You have
therefore been identified to assist in providing information that can assist them in
assessing the company’s level of performance. The sales data is given below:

Budgeted sales
Product Uni Unit selling price Unit variable cost
ts
Ice cream 8,00 1,000 600
0
Chocolate 12,0 800 300
00
Sandwich 5,00 2,000 1,2
Management Accounting – Page 82
0 00

Actual sales
Product Uni Unit selling price Unit variable cost
ts
Ice cream 10,0 800 500
00
Chocolate 11,0 900 400
00
Sandwich 7,00 2,100 1,1
0 00

In an attempt to provide the information, you are required to compute the following sales
variances;
i) Sales contribution/ margin price variance
ii) Sales contribution/ margin volume variance
iii) Sales contribution/ margin mix variance
iv) Sales contribution/ margin yield variance
Required: Calculate the above variances and advise accordingly.

Reconciliation of budgeted and actual profit

Depending on the technique (i.e. marginal or absorption costing) managers should
endeavour to reconcile the target profit and the actual profit achieved. The reconciliation
involves the calculation of the variances and matching them with the budgeted or actual
profit that has been registered in a period.
Through performance reports, the managers of responsibility centres are expected to
carry out a detailed analysis of the variances to enable them to exercise control. A typical
departmental performance report should include only those items that the responsibility
manager can control or influence.
Example 3:

Management Accounting – Page 83

Daniel Furniture Limited manufactures office chairs for different categories of clients.
From the information provided below, you are required to analyse the cost and sales
variances and prepare an operating statement incorporating the result of your analysis.

Standard/Budgeted data:
Unit variable costs:
- Direct material 6 metres at 50/= per meter = 300
- Direct labour 2 hours at 80/= per hour = 160
- Variable overhead 60/= per direct labour hour = 120
580

Budgeted fixed overhead for the year UGX 250,000 and the standard selling price is
700/= per unit.
Daniel Furniture Ltd plan to produce 5,000 units and the company’s budgeted operating
statement is shown below:

Daniel Furniture Ltd budgeted operating statement

UGX
Sales (5,000 units x 700) 3,50
,000
Less cost of sales:
Variable production costs (5,000 x 580) 2,90
0,00
0
Budgeted contribution 600,
000
Less fixed factory overhead costs 250,
000
Budgeted profit 35
0,00
0

Management Accounting – Page 84

Daniel Furniture Ltd’s actual results are presented in the actual operating statement
below:
Sales (5,500 units x 680/=) 3,740
,000
Less cost of sales:
Direct materials 32,000 metres x 45/=
1,440,000
Direct labour cost 12,000 hours x 75/=
900,000
Variable overheads 12,000 hours x 65/= 3,120
780,000 ,000
Actual contribution 620,0
00
Less fixed factory overhead 230,0
costs 00
Actual profit 390,0
00

Required:
Calculate all the relevant variances and reconcile them

Factors to be considered before Investigating and reporting Variances:

Materiality/significance: If the variance is so small, it will be meaningless to investigate
into the causal factors of the variance and make an adverse report on it. Management
might set control limits (i.e. upper & lower) for variances. If a recorded variance falls
outside these control limits, then it’s deemed worthy of investigation. This can be
illustrated on a variance control chart in figure 10.2. The set limits will vary from
company to company and influenced by materiality of the variance.

Management Accounting – Page 85

Control chart.

Upper limit

Standard cost

Lower control limit

Type of standard used: Some types of standards will always show adverse variances
especially the ideal standards. Such variances need not to be investigated.

Cost benefit analysis: Some variances may incur more costs of investigation relative to
the benefit derived there from. If that is the case, then it should not be investigated.

Interdependence of variances: At times, one variance has an influence over the other and
normally reversing the directions. Before investigating such variances, the
interdependence should first be looked out for and the variance report should take this
into account e.g. a favourable price variance may mean that poor quality materials were
bought at a cheap price causing unfavourable materials usage variance due to
unnecessary wastage.
Also unfavourable labour efficiency variance could be due to difficulty of handling such
materials.

Controllability: Some variances arise from external factors which cannot be controlled
by management and thus investigating and reporting on such variances is meaningless.
This is typical of the material price variances, labour rate variance and sales contribution
price variance which are determined by market forces of demand.

Topic 7
BUDGETING AND BUDGETARY CONTROL

Management Accounting – Page 86

Budget - definition
A budget is a quantitative plan of action expressed in monetary terms.

A budget is a plan that can be expressed in quantitative or qualitative form. It's usually
prepared for a period of one year but it can be for shorter time periods in order to
facilitate control.

A budget is a financial plan that serves as a formal statement of revenue and expenses of
an organization. A budget provides a time frame for decisions about the services and
activities. A budget provides indications of revenue flows.

A forecast is a predication about possible future events. A budget is more than just a
forecast. It is a commitment and it is a method of control. Actual performance is
continuously compared with the budgeted performance and if variances arise corrective
action is instigated &/or the differences explained.

Budgeting refers to the act of preparing a budget. The budgeting process provides
managers with the opportunity to match carefully the goals of the organization with the
resources necessary to accomplish those goals.

Budgetary control is continuous comparison of actual results against budgets to form a

basis of revision of standards and budgets and taking a corrective action.ie use of budgets
to control a firm`s activities.

Budgetary Control is a feedback control technique whereby actual performance is

compared with budgeted performance and any differences, which are called variances,
are made the responsibility of certain managers who will either take the necessary
control action or revise the original budgets.

Example: AB Ltd budgets to have sales of £2m per quarter. If the sales only reach £1.8m
there's an adverse variance of £0.2m. If the shortfall is outside the company's control, e.g.
due to a recession, then the budget will have to be revised. If the shortfall is due to
reasons within the control of the company e.g. due to a poor marketing strategy, then
management can take the necessary action to get over the shortfall.

Feedback and Feed forward Control

Feedback is the traditional control system where information is accumulated about what
has already happened, this information is examined and action is then taken.

Management Accounting – Page 87

ADVANTAGES OF PREPARING BUDGETS
1. Planning - budgets convey the firm's plans throughout the organization. They are
the tools that enable the long-term corporate goals to be attained, as they compel
management to plan ahead and anticipate likely problems.

2. Performance Evaluation - It is better to compare actual performance with a plan

(i.e. a budget) rather than with a past performance, which may have been less than
efficient. Budgets therefore can be used to evaluate the performance of managers
in an organization.

3. Co-ordination - The budgeting system co-ordinates various departments e.g.

production is brought into line with sales; purchases with production etc.

4. Communication - The budgeting system will increase inter-departmental

communication as the firm's plans are communicated throughout the organization
by the budgets.

5. Motivation - It is important that the work force participates in the setting of

budgets that will boost morale and have a motivational impact. budgets are
therefore used as a motivational tool for employees

6. Control - A good budgeting system will highlight areas of efficiency and

inefficiency, in the form of favourable and adverse variances, and will prompt
control action where necessary through feedback.

7. Responsibility - A budgeting system matches responsibility with control, which

is important, as managers can not be held responsible for costs they have no
control over. To do so could de-motivate them.

8. Allocation of Scarce Resources - Budgeting will ensure that resources are

allocated in the best way so that corporate goals are achieved.

9. Management by exception - By highlighting inefficiencies management can

quickly see where activities are not going to plan. Management time can be
concentrated on those areas thereby maximizing management efficiency.
Management Accounting – Page 88
PROBLEMS WITH BUDGETING

1. Apathy - Some members of the workforce may be difficult to motivate as they

don't want to participate. Furthermore, the budgets may be perceived by the
workforce as pressure devices imposed by top management and can have an
adverse effect on employee morale.

2. Departmental conflict - This can arise for the following reasons:-

(a) Competition for scarce resources.

(b) Lack of co-operation between departments as they're preoccupied with

their own budgets.

(c) "Passing the buck" - one department may blame another for failing to
achieve targets.

3. Sub optimal Decisions - These can arise where managers try to obtain short-run
divisional gains which, in the long-run, are detrimental to the organization as a
whole e.g. when departments under-invest to obtain high returns on capital
employed.

4. "Slack" - Managers often try to obtain a larger budget allowance than is really
needed which may go to hide inefficiencies. (Some slack is, however,
permissible for contingency purposes.)

5. Unnecessary spending - This can take place when a manager fully utilizes the
budget allowance through fear of future cutbacks

6. Setting Standards - There is the problem of setting the right standards and
subsequently revising them.

7. Matching responsibility and control- It may be difficult to match these two.

Costs will be more controllable over the long-term e.g. insurance costs, and it
should be seen that if a manager has the power to influence a cost, that he or she

Management Accounting – Page 89

is responsible for it. If you have the power to hire/fire you should be responsible
for the wage bill.

8. Uncertainty - Uncertainty about future demand, competition, technological

change, economic & political factors etc. can lead to uncertainty in budgeting.
Uncertainty in budgeting may be overcome by

a) Having shorter budget periods

b) Using expected values - i.e. probabilities (see example below)

c) Undertaking market research

d) The use of rolling budgets - where budgets are continuously updated on a

monthly or quarterly basis.

e) Sensitivity Analysis

TYPES OF FUNCTIONAL BUDGETS

These are drawn from the different functions of the business.

Production budget.

The production budget is derived from the quantities that are expected to be produced in
the period

Budgeted production= budgeted sales + desired closing stock- opening stock

Sales budget.

The sales budget consists of the expected sales units and the selling price per unit. To get
the expected sales per unit, the sales manager will base on past data as well as the future

Cash budget

This is a forecast of expected cash inflows and expected cash out flows. It will show
either a shortage or surplus. In case of a shortage, negotiations for other sources of
finance can begin
Management Accounting – Page 90
Labour budgets

The labour budget will represent the labour requirements to meet the production levels.
The labour budget is derived from the production budget.

Raw material purchases budget

This shows the estimated costs of raw materials to be used in the production process.
Raw material budgets will show the quantities and estimated prices of raw materials

Capital expenditure budget

The budget will show expected expenditure on acquisition of non current assets e.g.
machinery, buildings etc

Example 1

The following information has been made available from the records of Mk Ltd
enterprise for the next six months of 2006

Jan Feb March APRIL May Jun

Budgeted sales units 4000 4200 4500 5000 4800 4700

Closing stock units 1000 1500 1300 800 1200 1400

MK Ltd anticipated to sell each units at 2,000/= every month. The company had opening
stock of finished goods amounting to 500 units.

MK Ltd planned to reserve closing stock of finished goods at the end of the month and
are part of the produced units.

Information got from the production manger indicates that each unit requires the
following composition of cost to be complete.

Cost element unit cost in shilling

Raw materials 5litres @ 2,000 each 10,000

Labour costs 10 hours @ 500 each 5,000

Management Accounting – Page 91

Variable overhead costs 20% of labour costs 1,000

Total 16,000

The stores manager states that the company’s policy is to reserve raw materials
equivalent to 5% of the next month’s requirement because the suppliers are unreliable.
Closing inventory of raw materials in June will be the same figure as in May.

The raw materials are purchased from the suppliers at 1,500/= per litre

Required: prepare the following functional budgets

i. Sales budget
ii. Production budget
iii. Raw materials utilization/ cost budget
iv. Labor cost budget

The Cash Budget

The cash budget is a detailed statement showing all the planned receipts and payments of
cash for the coming year usually broken down into monthly intervals
Receipts of cash may be from cash sales, payments by debtors, the sale of fixed assets,
the issue of new shares etc. Cash payments may be for purchase of stock, payment of
wages or other expenses, the purchase of capital equipment, interest on loans etc. A cash
budget only takes cash flows into account when they happen. If an item is not a cash
flow, it is ignored.
The two important things to remember when compiling a cash budget are to ignore
depreciation and to allow necessary time lags on credit transactions.
Example: Goods bought in January are paid for in March. The cash flow occurs in
March so it's recorded in the March cash budget.
The main functions of a cash budget are to:
1. Ensure that cash is available for covering day-to-day expenses and other revenue
expenditure.
2. Indicate when, where and how much cash will be needed and whether this is
permanent or temporary.
3. Preserve liquidity throughout the year.
4. Reveal surplus cash for investment or expansion of facilities.

Management Accounting – Page 92

5. Guide management on whether to finance capital expenditure internally or
externally.
6. Reveal the effects of changes in corporate policy e.g. credit control policy.
A suggested layout for a monthly cash budget is:
(a) Receipts
(b) Less payments
(c) = Net cash flow in month
(d) +/- Opening cash balance
(e) = Closing cash balance
The following items appear in a profit and loss account but not in a cash budget.
Depreciation
Bad debt provision
Profit/(loss) on sale of a fixed asset
Accruals (i.e. amounts that are owed and will be paid in the future)

PREPARATION OF CASH BUDGETS

A cash budget is a detailed estimate of cash receipts from all sources and cash payments.
The cash budget contains every type of cash inflow and outflow (Capital and revenue).

Receipts include

 Cash sales
 Receipts from accounts receivable
 Receipts from disposal of assets
 Interest received
 Rental income etc
Payments include

 Payments to creditors
 Salaries
 Acquisition of fixed assets
 Payment of loans etc
Cash budgets have the following purposes
Management Accounting – Page 93
 Ensure that sufficient cash is available
 in case of surpluses , short term investments can easily be invested in
 In case of cash deficits , action can be taken immediately to look for sources of
finance
Cash budgets show whether the capital expenditure will be financed internally or
externally.

FORMAT OF A CASH BUDGET

Period 1 Period 2
Period 3
Bal b/d xx xx xx
Receipts
Cash sales xx xx xx
Debtors xx xx xx
Sale of fixed assets xx xx
xx
Total receipts xx xx xx
Less : Payments
Salaries xx xx xx
Payments to xx xx xx
Suppliers
Acquisition of assets xx xx xx
Total payments xx xx xx
Bal c/d xx xx xx

CASH BUDGETING

In business cash is king’ remember if you fail to plan, you plan to fail! Cash is one of the
most popular assets in the organization. Its presence or absence can affect the company’s
performance greatly. The more cash that is available to the business, the more, the ability
to meet its obligations as and when they fall due.

WHY PEOPLE NEED MONEY

In Financial management you looked at a number of reasons as to why people need
money. A recap of these reasons include;
Speculative motive: That is money in one’s hands to buy or deal in goods whose future
price is still uncertain in the hope of a large profit.

Transaction motive: Money is needed to meet day to day expenditures.

Management Accounting – Page 94

Precautionary motive: The need to meet unforeseen circumstances.

CAUSES OF CASH FLOW PROBLEMS

There are often many questions raised as to why some businesses which seem to be
profitable at one time begin to struggle financially. Among the many reasons are the
following:

a) Persistent making of losses: Even a business with bigger reserves will reach a
point where it no longer has anywhere to get capital if it continues to make losses.
b) Inflation: A business can be making profits using historical cost but still not
receiving enough cash to buy the replacement assets. High price levels increases
in monetary terms but what money can really buy decreases.
c) Growth: A business might need to acquire more fixed assets and to support
higher amounts of stocks and debtors. These additional assets must be paid for
somehow (or financed by creditors).
d) Seasonal business: When a business has seasonal or cyclical sales, it may have
cash flow difficulties at certain times of the year, when
(i) Cash inflows are low, but
(ii) Cash outflows are high, perhaps because the business is building up its
stocks for the next period of high sales.
(e) Large one-off expenditure: A single non-recurring item of expenditure may
create cash flow problems i.e. repayment of loan capital, purchase of
exceptionally expensive items e.g. freehold property.
HOW TO EASE CASH SHORTAGE
1. Postpone capital expenditure – where possible i.e. if company’s policy is to
replace cars every 2 years, it might decide to replace every after 3 years.
2. Accelerating cash inflows, which would otherwise be expected in a later period,
e.g. press debtors for early payments.
3. Reversing past investment decisions by selling assets previously acquired.
4. Negotiating a reduction in cash outflows by:
 Taking a longer credit from suppliers

Management Accounting – Page 95

 Rescheduling loan repayment with agreement with lenders.
 A delay in payment of corporation tax might be agreed with tax authorities.
 Reduction/suspension of dividend payments
 Where inevitable reduction in the number of workers.
THE BUDGET
First of all a budget is planning and control tool. A budget is a plan expressed in
monetary terms and like any other plan a cash budget is designed to carry out the
functions of: planning, evaluating performance, coordinating, implementing plans,
communicating, motivation, authorizing and controlling functions. Cash flow budgeting
is not done in isolation. It is a part of a culture of planning and controlling and is
therefore part of the budgetary framework.

You are in business to make money (cash). This cash must be effectively managed to
generate more wealth.
Definition of a cash budget:
A cash budget is “a detailed budget of cash inflows and outflows incorporating both
revenue and capital items.” It is a statement in which estimated future cash receipts and
payments are tabulated in such a way as to show the forecast cash balance of the
organization/project/business at the end of each operating period.

OBJECTIVES OF CASH FLOW BUDGETING

 Coordinate activities of various departments towards achievement of the
business/project goals and objectives.
 Communicate targets to managers responsible for the achieving them.
 Establish a system of control by having a plan against which actual results can be
compared.
 Compels responsible cash management and adopt proactive approach so that the
business/project does not run out of cash without management knowing or
alternatively get too much cash without management knowing what to do with it.
 Alert management to take pre-emptive remedial action e.g. tightens expenditure
control and avoids wastefulness.
 Motivate employees with the planning process and give them the assurance that
the prospects are good. Even though they know that there is a cash deficit they
are encouraged that management is in control.

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STEPS IN PREPARATION OF THE CASH BUDGET INVOLVES FOUR
DISTINCT STEPS
Step:
1. Forecast the expected cash inflows. The main sources of cash in a business are
receipts from operations – i.e. sales of merchandise. Other cash inflows would
include borrowing from banks/micro finance institutions, income from
investments and cash from disposal of fixed assets and others. These other
sources are only supplementary.
2. Forecast the expected cash outflows: The principal payment is the payments for
project/business materials for resale and general supplies. Other cash outflows
include wages and salaries, some of these expenses are fixed and must be paid
whether the business makes profits or not.
3. Compare the anticipated cash inflows and outflows to determine the net cash flow
position for each period.
4. Calculate the cumulative cash flow position for each period by adding the opening
cash balance to the net cash flow position for the next period.
WHAT TO INCLUDE IN A CASH BUDGET

A cash budget is prepared to show the expected receipts of cash and payments of cash
during a budget period.
Receipts of cash may come from one or more of the following:
a) Cash sales, Government contributions/Grants, donations and debt collections etc.
b) Payments by debtors (credit sales)
c) The sale of fixed assets
d) The issue of new shares
e) Bank loans or micro finance loans
f) The receipt of interest and dividends from investments outside the business.
g) Borrowings from family members and friends.
Payments of cash may be for one or more of the following:
 Purchase of stocks and materials
 Staff salaries and other payroll costs or other expenses
 Purchase of capital items
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 Payments of interest, dividends
 Taxation

THE CASH FLOW STATEMENT

Reflects the business/project’s cash inflows and outflows during a period, distinguishing
those that are a result of operations and those that are a result of other activities.
The statement provides useful information about the ways in which the project generates
and uses cash, thus helping users of the statement assess factors such as risk, liquidity and
financial adaptability.
A cash flow however, does not provide complete basis for judging the future cash flows.
It is only a management tool.
Financial adaptability is the ability of the business/project to take effective action to alter
the amounts and timing of cash flows so that it can respond to the unexpected needs and
opportunities.
IMPLEMENTATION OF A CASH FLOW STATEMENT
Set up procedures for:
Collecting all projected income as promptly as possible, Monitor revenue arrears and take
action to recover outstanding amounts, Manage payments within the projected amounts,
work plans and agreed policy on payment periods, Avoid over-commitments, Revising
monthly cash budgets in light of new information.
Where due to unforeseen reasons cash flow balances are inadvertently run down,
management should consider restrictions on non-essential services funding. Suspension
of proposed recruitment. Suspension of non-urgent purchase e.g. machinery. Freeze on
construction projects. Reviewing of budgets to remove or postpone some items.
CORRECTIVE MANAGERIAL ACTION
A cash budget can show four positions. Management will need to take appropriate action
depending on the potential position.

CASH POSITION APPROPRIATE MANAGEMENT ACTION

Short-term surplus -Pay creditors early to obtain discount.

-Attempt to increase sales by increasing debtors and stocks.

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-Make short-term investments

Short-term deficit -Increase creditors. –Reduce debtors. – Arrange an overdraft

Long term surplus -Make long term investment. –Expand. –Diversify.

– Replace/update fixed assets

Long term deficit -Raise long-term finance. –Consider

shutdown/disinvestments opportunities.
Sale off some non- performing assets.

MOST COMMON MISTAKES MADE IN CASH FLOW MANAGEMENT AND

DEBT COLLECTION THAT MAY LEAD TO BUSINESS FAILURE:
1. Failure to plan cash flow in advance.
2. Failure to anticipate financial needs.
3. Failure to keep and monitor financial statements.
4. Failure to manage growth.
5. Failure to know costs of operations and prices of inputs.
6. Failure to structure debt properly.
7. Poor banking relationships.
CONCLUSION
To ensure that there is sufficient cash in hand to cope adequately with budgeted activities,
management should therefore prepare and pay close attention to a cash budgets rather
than a profit loss account. Cash budgets are more effective if they are treated as rolling
budgets. Rolling budgets involve a process of continuous budgeting whereby regularly
each period (week, month, quarter) a new future period is added to the budget whilst the
earliest period is deleted. In this way the plan/budget is constantly revised to reflect the
most up to date position.

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CASH FLOW BUDGETIGN EXERCISE – EXAMPLE
The following information was extracted from the books of ABC LTD – a company
which deals in general merchandise and started trading some years ago.
Year 2009
Month Sales Purchases
Shs’000 Shs’000
April 150,000 100,000
May 160,000 110,000
June 160,000 90,000
July 170,000 90,000
August 200,000 80,000
September 200,000 130,000
October 180,000 140,000
November 180,000 60,000
December 200,000 60,000
The following additional information is available
(a) Cash in hand at the end of May 2009 was shs 180,000,000.=.
(b) 60% of the sales proceeds were received in the current month 30% in the
following month and the balance is received two months after sale.
(c) Suppliers are paid one month after delivery of goods.
(d) Corporation tax for 2008 amounting to shs 20,000,000.= was paid on 30th
September 2009.
(e) Contractors retention money amounting to shs 500,000,000.= was paid on 30th
June 2009.
(f) The shareholders at their last extra ordinary meeting increased share capital by
shs.70,000,000.= and the first call of Shs 40,000,000.= was received in October
2009.

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(g) In October 2009 the company received shs.20,000,000.= as compensation for a
civil suit.
(h) The monthly administration expenses amounting to Shs.33,000,000.= include
factory depreciation charge of shs 4,000,000.= and preliminary expenses of
shs.3,000,000.=.
(i) Office equipment worth shs.13,000,000.= was bought in November 2009.

Required:
1) Prepare a cash budget for the period 1st June to 31st December 2009.
2) Advise the management of ABC LTD using information provided by the cash
Budget.

Illustration 2
a) Stefan brothers Inc is planning to request for credit from its bank and the following
sales forecast have been made.
Month 2013 Amount $ ‘000
May 850
June 850
July 1600
August 2,350
September 3,100
October 1,600
November 1,700
December 475
January 2014 850

Collection estimates were obtained from the credit and collection department as follows;
i) Collection within the month of sale 10%
ii) Collection within the month following sale 70%
iii) Collection in the 2nd month following sale 20%

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Payments for labour and raw materials are typically made during the month following the
month in which these costs are incurred. The estimated costs are as follows;

Month 2013 Amount $ ‘000

May 475
June 475
July 625
August 3,775
September 1,375
October 1,075
November 775
December 475
Additional Information
i) General and administrative salaries amount to 113,500 per month
ii) Rent per annum was $ 462,000
iii) Depreciation charges are $ 200,000 per month
iv) Insurance expenses are $ 10,000 per month
v) Income tax payment of $ 250,000 was paid in September 2013 and a progress
payment of $ 700,000 on a new research laboratory was paid in October 2013.
Required
a (i) Prepare the monthly cash budget for Stefan brothers Inc for the six months of 2013
(July –December)
b) A cash budget can show four positions & management will need to take
appropriate action depending on each potential position. Clearly explain the four major
positions that may be shown by the cash budget and give appropriate recommendations
on what management should do for each potential position in case it arises.

APPROACHES TO BUDGETING

1). LINE ITEM BUDGETING

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This is a budgeting approach which indicates the expenses that are expected to be
incurred but usually fails to indicate the planned level of activity or output for each
service. In short, this approach indicates a list of items without showing the benefits
that are likely to be derived from them. It is mostly used in non-profit making
organizations, for example churches.

Line Item Budget (for local authority e.g. Sub County)

Expenses: Employees x
Transport x
Supplies $ services x
Support services x
Capital financing assets x xx
Incomes: Court grants x

Fees charges x

Rent x
Interest x xx

Balance to be met from council tax xxx

2. PLANNING PROGRAMMING BUDGETING SYSTEM (PPBS)

This is where resources are allocated according to available programmes. It was

introduced because of weaknesses associated with line item budgets; because of failing
to;

i. To provide information on planned and actual accomplishment.

ii. Line budgets failure to provide information on efficiency with which the
organisations’ activities have been achieved or performed (or its effectiveness in
achieving objectives)
iii. Line budgets further fail to provide a sound basis for deciding on how resources
available should be allocated.

The aim of PPBS is to enable the management of non profit making organizations to
make more informed decisions about the allocation of resources to meet the overall
objectives of the organization.

This is done by first establishing the overall objectives of the firm which is followed by
analyzing or evaluation of programmes that might achieve these objectives and finally the

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cost and benefits of each program are analyzed and determined so that budget allocation
can be made on the basis of cost of different programmes.

Advantages of PPBs
 It provides information on the objectives of the organization.
 It cuts across conventional lines of responsibility and departmental structures by
drawing together the activities that are directed towards a particular objective.
 It concentrates on long-term effects.
 It provides information on the impact that existing and alternative programmes
will have on objectives and associated programme costs.
 It enables resource allocation choices to be made on the basis of benefit and cost
relationships.

Disadvantages
 The information needed for PPBs is far from readily available.
 It is always difficult to define the objectives and to measure the output of a
service e.g. social service.
 It is always difficult to determine costs collected because many activities are of a
multipurpose nature and it is always obvious to determine and allocate such costs
collected.

INCREMENTAL BUDGETING
This is a budgeting approach where budgets are made and formulated basing on the
previous year’s budget.

This is done by adjusting some budget items down or upwards to reflect the current state
of affairs.

The attention is focused on the marginal or incremental difference between this year’s
budget and last year budget.

DISADVANTAGES
 Mistakes of the previous budget are carried forward to the following year.
 It is argued that such an approach fails to consider whether a particular item is
required or whether the amount currently incurred is reasonable.
 Once the item appears in the budget its inclusion in further budgets is taken for
granted and only incremental changes in the item are considered.
 It encourages complacency in managers i.e. discourages innovation, but they just
relax.
ADVANTAGES
 It is easy to apply not so much time is taken.
 It does not require experts.

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 Reduces the level of conflicts (the question of what should be included and why
will be reduced).

ZERO BASED BUDGETING

This involves the preparation of operating budgets from a zero base even though the
organization might have been operating more or less the same as in the previous years.
The resources are not necessarily allocated in accordance with the previous patterns and
hence each existing item of expenditure has to annually be re-justified. Thus by focusing
on this need to re-justify existing levels of expenditure, the apparent weaknesses of
incremental budgeting are avoided.

Advantages

 Unlike incremental budgeting, it does not assume that last year’s allocation of
resources is necessary appropriate for the current year.
 It provides or produces in a readily accessible form more and better management
information.
 Its application involves the participation of lower level management in the
budgeting process, and the smaller the decision units are, the greater this
involvement will become.
 Unexpected events that occur during the financial year can be more readily
adjusted e.t.c.

Disadvantages
 Skilled manpower is needed
 Consumes a lot of time in preparing the budget
 Expensive to operate e.t.c

Common budget terminologies

Budget period

Period of time covered by budget and can be annual, semi-annual, or quarterly or

otherwise.

Control period

Is a period normally shorter or equal to budget period within which budgets are reviewed
and adjustments made? It is normally seen where there is continuous or rolling budgets.

Limiting/key/principal budget factor

Is any factor that limits the activities of the organization? It can be sales and manpower
resource, material shortages or plant capacity. A limiting factor like shortage of raw

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materials will have an effect on the production budget which will then in turn affect the
sale budget.

This implies that when an organization is budgeting it will have to look at how many
units can be produced from the available raw materials.

Budget center

Is a section of an entity for which control may be exercised and budgets prepared.

Budget manual

A budget manual is a book that lays down the procedure of budgeting, the people
responsible and the budget time table.

Contents of a budget manual

i. Purpose of budget
ii. Organizational structure
iii. Budget centers ,their Heads and responsibility
iv. Types of budgets prepared by the organization
v. Membership of budget committee
vi. Procedures for preparing budget and format
vii. Budget time table specifying stages in which the budget should be prepared.

Budget committee

The budget committee formulates the general procedures to be followed during the
process. It is always headed by a chairman who is a senior member of management
assisted by the budget officer who should be an accountant and plays the role of a
secretary to the committee

Functions of the committee

 Coordinating budget process

 Issuing of budget manuals
 Issuing of time tables for preparation of functional budgets
 Allocation of budgetary functional responsibilities
 Provision of information necessary for budget preparation
 Communication of final budgets to managers
 Carry out disciplinary functions in reference to budgets
 Comparison of actual results with budgets and investigation of budget variances
 Continuous assessment of budgeting and planning process with the aim of
improving it.

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Steps /Stages in budgeting process

Planning stage:

 Communicating details of the budget policy to that responsible for

preparation of budgets
 Determining the limiting factor
 Preparation of sales budget
 Initial preparation of various functional budget estimates
 Negotiation of budgets with superiors
 Coordination and review of budgets
 Final acceptance of the budgets and preparation of the master
budget

Control stage:

 Budget review: This involves comparison of actual results and

budgets ,feedback and corrective action
Budgetary control

This is a management technique which is adopted to control the business more

effectively. It is a policy that involves continuous comparison the actual results and the
budgeted results to ensure that corrective action of any variances is taken. While doing
this, care must be taken in the choice of budgets to be used;

 Fixed budget: This is designed not to change irrespective of the changes in output.
The original budgets at the planned outputs are compared with the actual
performance with at whatever level of output.
 Flexed budget: This is one which recognizes cost behavior patterns and is
designed to change as volume of output changes. This is useful for control
purposes.
Steps in flexing the budget

 Identify the activity levels

 Classify the costs as variable, fixed and semi-variable
 Flex the variable costs 100%
 Don’t flex fixed costs but take budgeted amounts
 Split semi-variable into variable and fixed components and flex the variable
component and then add the fixed component (High-Low/Range method is used to
separate costs for this method

The Human Element in Budgeting

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So far the emphasis has been on the technical aspects of budgeting viz. the preparation
and administration of budgets. However, the behavioural context deserves mention. One
of the main components of budgeting is control which is all about altering the behaviour
of the human resources in the organisation. Consequently, there may be some staff who
regard budgets as a constraint on their freedom and may try to subvert the effectiveness
of the budget.

How can senior management ensure that the budgeting system can be most
effective?

Research findings assert that managers prefer to work towards achieving objectives
which motivate them. It appears that motivation is the glue which holds the budgeting
and control systems together so creating this motivation is the key. There appear to be a
number of factors involved.

1 Budgets (targets) should be set at a level which is stringent and challenging but
attainable. If set too high to be unattainable the staff may be demoralized and may
not try to achieve the targets.
2 Departmental managers in consultation with their staff should be permitted to
participate in the setting of their budgets by so doing they will have ownership of
them and will strive to attain them. Participation clarifies responsibilities,
increases communication throughout the organisation and can help to promote
line-staff relations.

However, it is well to acknowledge possible dysfunctional behaviour as a

consequence of participation in budget-setting such as ‘budgetary padding’ or
‘budgetary slack’. It may serve the manager to build ‘slack into the budget ie. to
have a ‘pad’ between the formal plan and the expected actual results so that they
have a cushion in case unanticipated events cause their performance to decline.

3 Since budgets tend to be used as a management performance criteria there should

be a reward system in place. Too often budgets are used as a mechanism to focus

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on poor performance so is it any wonder that the staff have negative feeling about
them.
4 Overemphasis on performance/variance reports may encourage negative attitudes
to budgeting. Hopwood referred to the ‘budget constrained’ style of management
with performance in meeting the budget as the main criteria.
The organization should be concerned with other management performance criteria such
as concern with quality, good industrial relations, cooperation with colleagues etc.

Improving the Budgeting Process

The following should be done:-

-Make the budgeting process participatory. (Management by Objectives).

-Adopt bottom-up rather than top-down approach to budgeting.
-Budget with a human face, i.e. consider employees financial difficulties.
-Amend or revise budgets when necessary. Do not maintain rigid budgets.
-Shorten the budgeting periods, i.e. the period between the onsets of budgeting and actual
spending.
-Emphasize outputs or results.
-Budgeted items should be linked to the existing chart of accounts.

THE BUDGETARY PROCESS (BUDGET CYCLE)

Budgetary process or cycle varies from one organization to another depending on its size
and policies. However the following stages do apply to various organizations.

Planning Activities: Any meaningful budget should start from planning activities to be
done in the forthcoming period. How core are those activities in the main stay of the
organization i.e. prioritizing. Core activities should have the first call on resources.
Releasing funds without being sure of activities to be funded is poor budgetary
management.

Determining of resources and other budgetary constraints (limiting factor).

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The budgetary process requires one to determine the available funds to be allocated.
Activities planned for cannot be implemented unless there are adequate budgetary
resources to fund all those activities. One needs to check his/her financial strength or
position in order to avoid being too ambitious while budgeting.

A financial resources constraint is a principle budgeting factor because it limits activities

to be undertaken. Since financial resources or revenue is the limiting factor most cases,
revenues analysis needs to be carried out before estimating expenditures.

Other than financial resources other limiting factors include; human resources, raw
materials, weather for the case of farmers, etc.

The chief executive officer normally communicates budget policy guidelines and hints on
the limiting factor before the onset of preparation of budgets.

Preparation of Budgets

Having determined the various budget constraints and having an idea on likely resources
inflows, the various expenditure and revenue budgets are then prepared. Revenue
budgets should be prepared before expenditure budgets. Proposed expenditure will be
based on the expected revenues. The various budgets of sections are compiled into one
document for the organization called the Master Budgets, which is then sent for
discussion

Budget Discussions and Approval

Once the various budgets have been prepared and perhaps compiled into a mater budget,
a budget committee is constituted to discuss and approve the budget. The chairperson of
the budget committee should be the chief executive officer of the organization and the
Accountant or Finance officer should the secretary.

Budget discussion should focus on priorities and objectives. Non-core activities or

functions should be significantly cut and the money be transferred to core activities.

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Once budget discussions or negotiations are completed and positions agreed, the budget
is then approved and spending can start.

The Accountant must identify inconsistencies and bring them to the appropriate manager
who will then rectify them. Such modifications may be several until the budgets are
acceptable to all parties concerned. During the co-ordination process, a budgeted P&L
A/C , Income and expenditure statement, balance sheet and cash flow statement should
be prepared to:-

Ensure that all parts of the budget combine to produce an acceptable whole.
If not further adjustments may be necessary until acceptability is achieved.

Final Acceptance of the Budgets

When all budgets have been harmonized they are summarized into a master budget
consisting of:-

Budgeted P & L, Income Statement, Balance sheet and Cash flow statement

After the Budgets have been approved the budgets are then passed down to the
appropriate responsibility centres for implementation.

The approval of the master budget is the authority for the responsibility center to carry
out the plans contained in each budget

Budget Implementation & Review

Periodically actual results should be compared with budgeted results and comparisons
should be made on a monthly basis. A report should be sent to the budget committee in
the first week of the following month so that it has the maximum motivational impact.

This will enable management to:

-Identify items that are not proceeding according to plan

-Investigate the reasons for the differences
-Take corrective action where feasible and avoid similar deficiencies occurring
again in future

During the year the Budget committee should periodically evaluate the actual
performance and re-appraise the company’s future plans in view of changes in actual
conditions from those originally expected. If these changes are major this may lead to
budget revisions/adjustments for the remaining period.

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Note: The Budgeting process is a continuous and dynamic process.

Topic 8

SHORT –TERM DECISIONS AND LIMITING FACTOR ANALYSIS

On completion of this section you should be able to:
 Define relevant and irrelevant costs and revenues
 Explain the importance of qualitative factors in decision making
 Distinguish between the relevant and irrelevant costs and revenues for decision
making
 Describe the opportunity cost concept
Introduction
In this section we are going to focus on measuring costs and benefits for non-routine
decisions. In other words, special studies are undertaken whenever a decision needs to be
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taken; such as discontinuing a product or a channel of distribution, making a component
within the company or buying from an outside supplier, introducing a new product and
replacing existing equipment. Short term decisions require only those costs and revenues
that are relevant to the specific alternative courses of action to be reported.

The term decision relevant approach is used to describe the specific costs and benefits
that should be reported for short term decisions. We shall assume that the objective when
examining alternative courses of action is to maximise the present value of future net
cash inflows.

It is important that you note at this stage that a decision relevant approach adopts
whichever planning horizon the decision maker considers appropriate for a given
situation. However, it is important not to focus excessively on the short term, since the
objective is to maximise long term net cash flows. We start by introducing the concept of
relevant cost and applying the principle to decisions relating to the following:
 Dropping a segment
 Make or buy
 Special order
 Joint products
 Extra shift
 Limiting factor situations
Relevant and Irrelevant information
7.1.1 What are relevant costs and revenues?
A managerial decision is a choice between alternative options, possibly including the
option of doing nothing. The choice is likely to have cost implications, in the sense that
the amount of some costs will differ depending upon which option is selected. Such costs
are described as relevant to the decision: the manager must consider what will happen to
these costs as a result of this decision. On the other hand, there may be costs which
remain the same no matter which option is selected; such costs are not relevant to the
decision. A similar argument applies to relevant and non-relevant revenues.

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Since relevant costs and revenues are those which are different, the term effectively
means costs and revenues which change as a result of a decision. Since it is not possible
to change the past (because it has already happened), then relevant costs and revenues
must be future costs and revenues. Past costs are usually referred to as sunk costs, and
can never be relevant to a decision.

A relevant cost is a future cash flow which arises as a direct result of a decision. . It’s a
future cash flow that will differ between the various alternatives being considered.
In relevant costing the only costs and revenues that should be considered are those which
differ as a result of a decision or decisions; i.e. only those which vary under the different
alternatives being considered. Occasionally relevant costs are also referred to as
differential costs or incremental costs.

Relevant costs are those costs appropriate to a specific management decision.

Rules about relevant costs/Fundamental features of relevant cost
Identifying the relevant costs for decision making is largely a matter of spotting that a
decision is under consideration, so that relevant costs must be used, then applying some
logical rules.
 Only relevant costs should be considered when evaluating the financial
consequences of a decision. This is because a decision is forward-looking. All
we need to know is what will happen as a consequence of taking a particular
decision, or choosing option A instead of option B.
 A relevant cost is a future cash flow that will arise (or be reduced) as a direct
consequence of the decision.
 A relevant cost is a future cost. This means that any costs that have been incurred
in the past (historical costs) cannot be relevant to a decision.
 A relevant cost is a cash flow. Any ‘costs’ that are not cash flow items are not
relevant. These include:
o Non-cash charges such as depreciation of non-current assets
o Notional costs such as notional interest charges

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o Absorbed fixed overheads. Cash overheads incurred are relevant if they
are future cash flows, but absorbed overheads are a notional accounting
cost.
 A relevant cost is one that will arise as a direct consequence of the decision being
taken. If a cost is a future cash flow that will be incurred anyway, regardless of
the decision that is taken, it is not relevant to decision and so should be ignored.
 Opportunity cost: is a benefit foregone by choosing one option instead of the next
best alternative e.g. if a material is in short supply, it may be transferred from the
production of one product to that of another product. The opportunity cost is the
contribution lost from ceasing production of the original product.
 As a general rule, it is assumed that variable costs are relevant costs and fixed
costs are unchanged regardless of a decision and so are irrelevant. However, in
many decisions situations, the effect of a decision could be to alter the variable
cost per unit or to result in a step rise or fall in total fixed costs. These changes,
provided that they affect future cash flows, are relevant costs.
7.1.2 Sunk costs
These are costs that have already been incurred or committed. They cannot be relevant
costs. For example, suppose that a company is wondering whether to sell a new product
as part of its summer season range. It has spent $10,000 on market research, which has
shown that if the product is sold for $10 per unit (variable cost of sale =$8 per unit), the
company will sell 4,000 units.

The money spent on research is a sunk cost and irrelevant to the decision. The question
for the company’s management is: Should we make a product for a variable cost of $8 in
order to sell 4,000 units at $10 each. Contribution and profit would increase by $8,000.

7.1.3 Avoidable and Unavoidable Costs

If a cost can be avoided, it is a relevant cost, because a decision will be taken that will
prevent the cost from occurring. If a cost is unavoidable, it cannot be relevant to a
decision, because it will be incurred anyway.

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7.1.4 Opportunity costs
This is the value of benefit sacrificed in favour of an alternative course of action. An
opportunity cost may be described as the cost of a particular course of action compared to
the next best alternative course of action.
Relevant costs may involve incurring a cost or losing revenue which could be obtained
from an alternative course of action. Incurring of costs is sometimes referred to as cash
flow costs whereas the loss of revenue is an opportunity cost. Both are relevant for the
purpose of decision making.

4.1.5 Cash flow costs

Cash flow costs are those arising in cash terms as a consequence of the decision. Such
costs can never include past costs or costs arising from past transactions. Costs such as
depreciation based on the cost of an asset already acquired can never be relevant, nor can
committed costs, e.g. lease payments in respect of an asset already leased, nor will re-
allocations of total costs ever be relevant to the decision. Only costs which change in
total because of the decision are relevant costs.
7.1.6 Historical costs
Historical costs are those costs which were incurred in the past and are not relevant for
decision making, although they may be useful as the basis for predicting future costs.
7.1.7 The relevance of Variable costs
Variable costs are those costs which change in proportion to changes in the level of
activity. Thus whenever the decision involves increases or decreases in activity it is
almost certain that variable costs will be affected and therefore will be relevant to the
decision.

7.1.8 The relevance of fixed costs

Fixed costs are generally regarded as those costs which are not affected by changes in the
level of activity. However a variation on the basic fixed costs; is known as a stepped
fixed costs as depicted below.

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$

A B C Activity

A change in activity from point A to point B does not affect the level of total fixed costs
because both the activity levels lie on the same fixed cost step. For such a decision the
fixed cost is irrelevant because it is not changing. However a change in activity level
from point B to point C does affect the level of fixed costs. Thus a decision causes the
total fixed costs to change and in such circumstances they are relevant. When fixed costs
become relevant in such a way, the extra fixed cost is usually referred to as the
Incremental fixed cost.

7.1.9 The relevance of Semi-variable Costs.

These are costs which comprise both a fixed and variable element. The variable element
is relevant to decision making using the same reasoning as applied in 7.1.7. The fixed
element is irrelevant unless it is a step fixed cost.
7.2.0 Use of relevant, Opportunity and Notional costs
7.2.1 Structure of a decision
The structure of a decision is illustrated in the following figure. Although the cost
accountant may be involved in all four stages, the main concern is with the evaluation
process. The costs which will be considered are those which are relevant to the decision.
These costs are relevant costs, opportunity costs and notional costs

Become aware of the

need for a decision
Management Accounting – Page 117
Decide what
alternatives are
available

Alternative Alternativ Alternative

Decision making:
Decision making involves the process of evaluating two or more alternatives so as to
select the best alternative. It is directed towards achieving specific goal or objective. It’s
a fundamental exercise of management and successful decision making involves the
following steps:-
(i) Identification of a problem.
(ii) Identification of objectives.
(iii) Searching for alternative course of action.
(iv) Gathering data about alternatives.
(v) Evaluation and selection of a course of action.
(vi) Implementing the decision.
(vii) Monitoring the results to ensure that the desired results are achieved.
(viii) Taking corrective action in case of discrepancies between planned and actual
results.
7.2.2 Quantitative and Qualitative Factors
In an evaluation of alternatives the manager will take into account factors of two types:
 Those which may be quantified in monetary terms
 Those which may not as easily be quantified, e.g. effect on customer relation

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7.2.3 General approach to decision making Problems.
In the examples which follow, remember the key question: do the relevant revenues
exceed the relevant costs? If they do, the proposals are to be recommended, at least on
financial grounds.
Example
A decision has to be made whether to use production method A or B.
The cost figures are as follows:
Method A Method B
Expected Costs Expected
Costs Last costs next Last costs next
Year year Year year
$ $ $ $
Fixed Costs 5,000 7,000 5000 7,000
Variable Costs per unit:
Labour 2 6 4 12
Materials 12 8 15 10

Which costs are relevant?

a) First, ignore past costs. Past costs may be helpful in estimating future costs, but in
themselves they have no relevance.
b) Second, ignore expected fixed costs because, although they are not past, they are
the same for both alternatives and may therefore be ignored.
c) Hence the only relevant costs are as follows:
Method A Method B
$ $
Expected Future Var. Cost
Labour 6 12
Materials 8 10
14 22

It is concluded that the analysis should eliminate all irrelevant figures, i.e. those
unaffected by the decision. This, of course, considerably simplifies the decision, because
it eliminates from consideration many irrelevant costs.
Note that fixed costs are not always irrelevant. If they vary between decision
alternatives, they are relevant and must be taken into account

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7.2.4 Determining the relevant costs of materials
In any decision situation the cost of materials relevant to a particular decision is their
opportunity cost. This can be represented by a decision tree.

Are Materials
No
already in stock?

Cost of Purchases
Yes

Will they be
No
replaced?

Will they be used

Yes
for other Purposes?

Replacement Cost

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Yes No

Contribution from Net realisable Value

alternative use
This decision tree can be used to identify the appropriate cost to use for materials.
The replacement cost is that cost at which material identical to that which is to be
replaced could be purchased at the date of valuation (as distinct from actual cost at the
actual date of purchase).

7.2.5 Determining the relevant cost of labour

A similar problem exists in determining the relevant costs of labour. In this case the key
question is whether spare capacity exists and on this basis another decision tree can be
produced.

Does Spare
Capacity Exist? Yes

Nil cost unless

No
overtime worked or
extra labour hired,
when cash outlay
Can extra
employees be No
hired?

Yes Contribution from

alternative products
which must be
Cost of hiring abandoned to create
spare capacity

Again this can be used to identify the relevant cost of labour.

Exhibit: Identification of Relevant Costs:

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KK (U) Ltd deals in construction of houses to its clients. During the year 20x3, the
company got an order from Deal enterprises for a house to be constructed around Mulago
hill at a contract price of 45,000,000/=. In February 20x6, when the company has done
40% of the work, it got information that Deal enterprises had gone into liquidation and
there is no prospect that any money will be obtained from the winding up of the
company.
KK Ltd had already spent 8,000,000/= on the house and progress payments of
10,000,000/= had been received from the customer (Deal) prior to liquidation.
MM has however offered to purchase the same house at 28,000,000/= once it is
completed.
KK realized that to complete the house, the following costs will be incurred:-
Materials: These have been bought at cost of 6,000,000/=. They have no other use and
if the house is not completed, they will be sold for scrap at 2,000,000/=. Additional
materials needed will cost 4,000,000/=.
Labour costs: KK established that more workers will be hired at a total cost of
2,000,000/= if the house is to be completed. Besides this, employees who are
permanently employed their wage bill will increase by 2,500,000/=.
Labour is in short supply and if the house is not complete, the workforce will be switched
to another job and will earn 3,000,000/= in revenue and incur 1,200,000/=.
If the work is not completed, KK Ltd will pay subcontract fees amounting to 1,100,000/=
otherwise the fees will amount to 3,300,000/=.
Required:
Assess whether the new customer’s offer should be accepted and bring out the reasons for
inclusion or exclusion of any costs.
Solution:
Relevant Cost and Revenue Data:
UGX. UGX
Materials: Opportunity cost salvage value 2,000,000
: Future cost 4,000,000 6,000,000

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Labour costs: Future costs 2,000,000
: Opportunity cost (3-1.2)m 1,800,000
: Incremental cost 2,500,000 6,300,000
Subcontract charges: Differential cost (3,300,000-1,100,000) 2,200,000
Total relevant costs 14,500,000
Relevant Revenue
28,000,000
Incremental profits
13,500,000
The new customer’s order (MM) should be accepted as it leads to incremental profits of
13,500,000/=.

Explanatory notes:
1. The material cost of 6,000,000 is irrelevant as it is a sunk cost. However, 2,000,000/=
and 4,000,000/= are the relevant amounts as they are the salvage and future values
respectively.
2. The cost of labour amounting to 2,000,000/= is a relevant amount as it’s a future cost.
3. When the contract is undertaken, a net benefit of 1,800,000/= will have to be foregone
by switching off labour, this is an opportunity cost of labour to be charged to the contract.
4. The Subcontract fees of 3,300,000/= of which 1,100,000/= is not escapable leaving
relevant cost of 2,200,000/=.
5. The revenue of 10,000,000/= was received prior to liquidation and therefore sunk
revenue. However, 28,000,000/= is the relevant future revenue.

7.2.6 Make or Buy decision.

Management sometimes may have to make a choice between manufacturing the
component parts of the product and buying them from outside. Such a situation of make
or buy decision may arise whenever the firm has the idle plant capacity and the technical
capability of manufacturing the component parts.

Management Accounting – Page 123

The economics of the two alternatives is examined on the basis of differential cost
analysis. The aggregate of purchase price, transportation, insurance and ordering costs
represent the amount applicable to the buy alternative.
While costs associated with make alternative include the differential variable costs of
materials, labour and variable overhead costs. Allocated fixed costs that remain
unchanged in total when components are produced cannot be relevant to make-or-buy
decisions.
The costs that will be incurred under both alternatives are not relevant to the analysis.
In make or buy decision, there could be two situations:
when spare capacity exists
When spare capacity does not exist.

When spare capacity exists, say a machine is under-utilized and the capacity can be
utilized into manufacture of the component, relevant cost of manufacture will be the
variable cost of manufacture and the specific or additional fixed cost, where possible.
Where spare capacity does not exist say machine is fully busy, the manufacture of the
component will require the withdrawal or suspending the production of existing products.
This will cause opportunity cost and therefore, the opportunity cost will be taken into
consideration.

However, if the spare capacity that will be created in case the components are to be
purchased can be utilized in the most effective way, the amount realized from that spare
capacity is relevant to decision- making.

Example
JK enterprises manufactures 1,000 components used to make the final product and the
cost structure is as below.
Cost per unit ($)
Direct materials 2
Direct labour 6

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Variable overheads 3
Fixed overheads 4
Total 15

BMK who is an outside supplier is offering to sell the component to JK for $ 11 each.
The labour force is in short supply and existing labour force is fully occupied. To produce
the component the company will have to divert 2 workers who are currently producing
product A and each worker’s contribution is $ 4 per unit if each component is to be
produced. These 2 workers are part of the permanent staff but each worker’s salary will
increase by $1 for every component produced.

All the materials to make the required components are already in the warehouse and have
no alternative use at all. The materials were purchased at a cost of $ 2 per unit.
If the components are to be manufactured, purchasing manager's salary will decrease by $
2 for every component manufactured though the supervisor’s salary will increase by $3
per unit made.
For every component manufactured or purchased, quality test will be carried out at rate of
$4 per unit.
Required:
i) Advise the firm whether the component should be manufactured or purchased or
whether the offer should be accepted.
ii) Other than the cost criterion, what qualitative factors are likely to affect the decision
made above?

7.2.7 Operate or shut – down decisions

Where the organization operates several production lines, one or more of these lines may
appear to be unprofitable hence perpetuating management to reach a shut down or delete
decision. Differential cost analysis is used when the firm or business is faced with the
possibility of temporary shut down. The type of analysis has to determine whether in the
short-run a firm is better off operating than not operating.

Management Accounting – Page 125

Discontinuance or shutdown decisions involve the following decisions:
(1) Whether or not to close down a product line, department or other activity, either
because it is making losses or because it is too expensive to run.
(2) If the decision is to shut down, whether the closure should be permanent or
temporary.
In practice, shut down decisions may often involve longer term considerations and capital
expenditures and revenues.
- A shut down should result in savings in annual operating costs for a number of
years into the future.
- Closure will probably release unwanted non-current assets for sale.
- Employees affected by the closure must be made redundant or relocated perhaps
after retraining or else offered early retirement.

Before the decision of shut down is taken, its impact on overall profits must be assessed.
As long as the production line recovers all the variable costs and makes a contribution
towards the recovery of fixed costs, it may be preferable to operate and not to shut down.

If the profits rise due to shutting down, then shut down otherwise maintain the production
line.

However, management should consider the investment in the training of its employees
which would be lost in the event of a temporary shutdown. Another factor is the loss of
established markets for the products the company has been selling. The danger of
obsolescence of the plant cannot be ignored.

Other qualitative factors to consider include:

- How will customers react? Will they loose confidence in the Company’s
products?
- What signal will the decision give to competitors? How will they react?
- What impact will a shut down decision have on employee morale?

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Timing of shutdown
The organization may also need to consider the most appropriate timing for a shut down
because some costs may be avoidable in the long run but not in the short run e.g office
space may have been rented and a 3 months notice is required. This cost is therefore
unavoidable for three months. On other hand supply contracts may require notice of
cancellation.
A month by month analysis of when notice, should be given and savings will be made
will help in the decision making process.
Example (operate or shut down decisions)
A company manufactures three products:
Pawns Rook Bishops Total
Sales 50,000/= 40,000/= 60,000/= 150,000/=
Variable costs 30,000/= 25,000/= 35,000/= 90,000/=
Contribution 20,000/= 15,000/= 25,000/= 60,000/=
Fixed costs 17,000/= 18,000/= 20,000/= 55,000/=
Profit/loss 3,000/= (3,000) 5,000/= 5,000/=

The Company is concerned about its poor profit performance and it considering whether
or not to cease selling Rooks. It is felt that selling prices cannot be raised or lowered
without adversely affecting net income if the production of Rooks is suspended 5,000/=
of fixed costs will be avoided because the cost is directly related to the production of
Rooks. Assume that Rooks cannot be substituted by any other product and that
investment in assets cannot be reduced if this product is dropped. All other fixed costs
are considered to remain the same.
Required
Advise the Company on the shutdown of Rooks and make any reservations.

7.2.8 Product Mix decisions Under Limiting (Key) Factor.

When a company manufactures more than one product, a problem is faced by the
management as to which product mix (product composition) will give the maximum
profits. If there is demand for all the products that can be produced, the company may at

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times find it difficult to meet the needs of the customers especially if demand is in excess
of its productive capacity.

The level output of the company may be restricted by shortage of resources known as
limiting factors. A limiting factor is an element that restricts the output and the profit
potential earning capacity of the firm. Limiting factors could be shortage of labour,
materials, equipment or factory space.
A limiting factor is any factor that is in scarce supply and that stops the organization from
expanding its activities further i.e. it limits the organizations activities.

An organization may be faced with just one limiting factor (other than maximum sales
demand) but there might also be several scarce resources – with two or more of them
putting an effective limit on the level of activity that can be achieved examples of
limiting factors include:

 Sales demand
 Production constraints such as:
 Labour- the limit may either be in terms of total quantity or particular skills.
 Materials – There may be insufficient available materials to produce enough units
to satisfy sales demand.
 Manufacturing capacity – There may not be sufficient machine capacity for the
production required to meet sales demand.
To make matters worse, within a short time it is unlikely that these production constraints
can be removed and additional resources acquired. Where the limiting factors apply,
profit can be maximized when the greatest possible contribution to profit is obtained each
time the scarce or limiting factor is used.

The contribution approach to limiting factors:-

In making the product mix decision, the following steps are followed:-
(a) Determine the contribution per product.(i.e. Unit Selling price – Variable cost)

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(b) Determine contribution per limiting factor. This gives the measure of
profitability for a unit of a limiting factor. This can be calculated by using
the formula below:

Contribution per limiting factor = Unit contribution (unit selling price – variable cost)
Units of scarce resource to make complete unit
(c) Rank the products by contribution per limiting factor with one being
assigned to product with highest contribution per limiting factor and
in that order.
(d) Produce to full satisfaction of each product following the ranking
order until the limiting factor units are used up.
Illustration
Sausage King makes two products, the Mash and Sauce. The unit variable costs of the
above products are as follows:

Mash ($) Sauce ($)

Direct materials 1 3
Direct Labour ($ 3 per hour) 6 3
Variable overhead 1 1
8 7
The sales price per unit is $ 14 per mash and $ 11 per sauce. During July the available
direct labour is limited to 8000 hours. Sales demand in July is expected to be as follows:
Mash - 3000 units
Sauce - 5000 units

Required
Determine the production budget that will maximize profit assuming that fixed costs per
month are $ 20.000 and that there is no opening inventory of finished goods or work in
progress.

Note: where there is only one ‘real’ scarce resource the method above can be used to
solve the problem. However where there are two or more resources in short supply

Management Accounting – Page 129

which limit the organisation’s activities, then linear programming is required to find the
solution.

7.2.9 Special Order Decision:

In some situations it makes sense for the company to sell a product at a price below total
cost but above incremental costs. As long as incremental revenues are in excess of
incremental costs, a company will increase short-term profits (or reduces losses if it is
currently making losses).

This decision arises, when a customer outside the normal customer base offers a price
less than the normal selling price. For the decision to be accepted, we first look at the
operating capacity to service the order and then compute the relevant cost of the order
that is, marginal cost (direct cost) with the price offered and if there is any contribution,
we accept the offer.
Example
Mugimu produces a single product and has budgeted for the production of 200,000 units
during the next quarter. The cost estimates for the quarter are as follows:

Cost per unit (UGX)

Direct materials 4.5
Direct labour 8.0
Variable overheads 3.5
Fixed overheads 4.0
20.0
The company has received orders for 160,000 units during the coming period at the
generally accepted market price of UGX.25 per unit. It appears unlikely that orders will
be received for the remaining 40,000 units at a selling price of UGX.25 per unit, but
Mr.Brown is prepared to purchase them at a selling price of UGX.17 per unit.
Mugimu normally employs workers who are permanently employed.
Required:

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i) Should the company accept Mr. Browns offer?
ii) Analyze qualitative factors that may be considered before the decision is
taken.

Review question
A one off order for 3,000 garden chairs has been received from an overseas customer for
the coming period. Your budgeted production for the period is for 16,000 chairs which
represent 80% of your special capacity to manufacture garden chairs.
Budgeted data for the period is as follows:-
UGX.
Sales 672,000
Materials 192,000
Labour 196,000
Overheads 200,000 588,000
Profit 84,000

You ascertain that UGX. 20,000 of labour and 20% of overheads are fixed in nature and
the rest of the costs are variable.
Required:
(a) Prepare a cost statement to show whether the order should be accepted. If
the customer was prepared to pay:
(i) 30/= per chair
(ii) 36/= per chair and give reasons for your answer.

(b) What other factors need to be taken into consideration before the order is
accepted or rejected?

7.2.10 Process Further Decision:

At times organizations are faced with decisions of whether to improve on the condition of
an item before it is sold or to sell it as it is. The decision to be taken in this case will be

Management Accounting – Page 131

made after incremental revenue is compared with the incremental costs to be incurred in
case the item is processed further. If the incremental revenue outweighs the incremental
costs it is advisable to process an item further before it is sold because the company’s
profits will increase.
Illustration:
COBAMS wants to sell its staff van which was bought in 2009 at Shs 7,000,000.=. The
University has got two offers from two customers where by the first customer is offering
to pay 2,500,000/= in its current state. If COBAMS accepts the offer it will only pay a
commission of UGX 100,000 to the brokers. However the second customer is advising
COBAMS to panel beat the vehicle before the College sells it and is willing to pay UGX
3,500,000/= cash.
The University Engineer has established that if the panel beating is to be done the
following costs will be incurred:-
Spraying the vehicle = 120,000.=
Labour costs = 160,000.=
Spares = 380,000.=
Tyres = 600,000.=
COBAMS will not pay a commission to the brokers since the vehicle will not be parked
in their yard.
Required
You are employed as a Management Accountant by the college and the
Management team has requested for your advice on what offer should the
University accept and why?
Revision Questions
1. Mountain Goat Cycle Company is now producing the heavy-duty gear shifters used
in its popular line of mountain bikes. The company’s accounting deft reports the
following costs of producing the shifter internally.

Per unit 8,000 units

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Direct materials $6 $ 48,000
Direct labour 4 32,000
Variable overheads 1 8,000
Supervisors salary 3 24,000
Depr. Of special equipment. 2 16,000
Allocated general overhead 5 40,000
$ 21 $ 168,000

The company has just received an offer from an outside supplier who can provide 8,000
shifters a year at a price of only $ 19 each. Should the company stop producing the
shifters internally and start purchasing them from the outside supplier?

2. A firm manufactures component BK 200 and the costs for the current production level
of 50,000 units are:
Costs / unit
Materials 2.50
Labour 1.25
Variable Overheads 1.75
Fixed Overheads 3.50
Total cost 9.00
Component BK 200 could be bought in for 7.75 and if so, the production capacity utilised
at present would be unused. Assuming there are no overriding technical considerations,
should BK 200 be bought in or manufactured?

3. K.C Ltd purchases every year 10,000 units of spare part from another manufacturer @
2 per unit. The production manager of K.C Ltd has presented a proposal before the
management that the production of this spare part be undertaken by the co. in order to

Management Accounting – Page 133

have full control over the supply of the spare part. He has supplied the following
information along with his proposal:
a) The cost of the machine needed would be $ 25,000 the machine will have a
production capacity of 15,000 units and a life span of 5 years.
b) A foreman will be employed at a salary of $ 500 P.M
c) The cost of material required for one unit will be $0.30 and Direct Labour cost will
be $ 0.25 per unit.
d) Variable overheads will be 100% of Direct Labour there will be no recovery of any
other fixed expenses.
e) Additional funds can be easily obtained at an interest rate of 10% per annum
Required
You are required to advise the management about the proposal

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