Mary 1
Mary 1
Mary 1
CHAPTER I
INTRODUCTION
Definition
Various definition have been advanced by different authorities
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v). Financial analysis and interpretation – providing highly summarized information
from the basic financial statements.
vi). Management reporting
vii). Forecasting and budgeting
Functions of Management
The manager carries out four broad functions in an organization i.e.
a) Planning
b) Organizing and directing
c) Controlling
d) Decision making
Planning
Managers outline the steps to be followed or taken in achieving the organizations
objectives. The plans of the management are expressed formally as budgets such are
typically prepared on an annual basis and express the desires and goals of management in
specific qualitative terms.
In directing managers oversee day to day activities and keep the organization functioning.
Therefore to meet these functions managers have a constant need for cost accounting
information in the routine conduct of the organization eg sales volumes, inventory control
levels , prices etc.
Controlling
Managers take those steps necessary to ensure that each part of the organization in
following the plan that was outlined for it at the planning stage.
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Accounting information thus assists in the controlling function by supplying performance
reports that help focus the manager’s attention to problems or opportunities that might go
unnoticed.
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iii). Management accounting emphasizes the relevance and flexibility of data. Information
is considered to be relevant if it is pertinent to be the problem at hand. Information is
flexible if it can be used in a variety of decision making situations.
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These includes direct materials, direct labour and manufacturing overheads
Direct materials
Are those materials that become an integral part of a company’s finished product and
that can be conveniently traced into it.
NB: Not all Raw materials are direct materials
Direct labour
Refers to those labour costs that can be physically traced to the creation of products
without undue cost or inconvenience.
Manufacturing overheads
These includes all costs of manufacturing other than direct materials and direct
labour. Example of manufacturing overheads include;
i). Indirect labour i.e. labour costs that cannot be physically traced in the products or
involve a lot of expenses in tracing them eg janitor *** , supervisors etc.
ii). Indirect materials ie they can only be traced in the products at great
cost/inconvenience eg paint.
iii). Other costs of operating the factory eg electricity, insurance, maintenance and all
other costs incurred to operate the manufacturing division of a company.
Non-manufacturing costs
These can be sub-classified into two categories
i). Marketing and selling costs
This group includes all cost necessary to secure customer orders and get the finished
product or services into the hands of the customer. They include sales commissions,
sales travel, salaries of salesmen, advertising etc.
ii). Administrative costs
These include all executive, organizational and clerical costs that cannot logically be
included under either manufacturing or marketing. Examples include executive salaries,
general accounting, secretarial public relations and similar costs having to do with the
overall general administration of the organization as a whole.
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b) Classifying costs according to cost behaviour
Cost can be classified according to how they react to changes in the level of business
activities ie how they react to number of units sold, member of hours worked etc.
As the activity level rises and falls a particular cost may rise and fall as well or may
remain constant. Thus, we have fixed costs and variable costs.
Fixed costs
Are those costs that remain constant in total regardless of the changes in the level of
business activity within the relevant range. However, beyond some range these costs may
cease to be fixed.
COST
ft
Activity
COST/init
Activity
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Variable costs
These vary in total in direct proportion to changes in the level of activity but within the
relevant.
Cost v-c
Activity
Cost/
unit
V-c
0
Activity
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Cost
Activity
Period costs
Are those costs that are matched against revenues on a time period basis and are therefore
not included as part of the cost of the product. They are treated as expense and deducted
from revenues in the time period in which they are incurred.
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Indirect costs
Is the cost that must be allocated in order to be assigned to the segment under
consideration. They are also known as commons costs eg manufacturing overhead costs.
h) Other costs
Opportunity costs
Sunk costs
Differential costs
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i) Opportunity costs
Is the potential benefit i.e. cost or sacrifice when the selection of one course of action
makes it necessary to give up another course of action. It is the cost of foregone
alternative. It is therefore the maximum positive alternative earnings that might have
been achieved if the productive capacity or service had been put into alternative use.
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COST ESTIMATION
The analysis of mixed costs into fixed and variable cost is very important in planning and
control of operations. The fixed portion of a mixed cost represents the basic, minimum
charge for just having a good or service ready and available for use. The variable portion
represents the charge made for actual consumption of the service. There is therefore need
to break do costs into fixed and variable elements. There are several methods of
estimating costs.
The main disadvantage of this method is its costline. If the production process is
complex the preparation of a full specification of inputs will require much expert work,
entailing large cost which will be worthwhile only if the additional net benefits it creates
surpass the costs involved. However the industrial Engineering Approach or at least some
variation of it may be used if there are no past records on which to base an analysis.
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Example
Assume that the maintenance costs for HACO Ltd. Have been observed as follows within
the relevant range of 5,000 to 8,000 direct labour hours:
Month D.L.Hs Maintenance Cost (sh)
January 5,500 745
February 7,000 850
March 5,000 700
April 6,500 820
May 7,500 960
June 8,000 1,000
July 6,000 825
Required
Determine the fixed and variable cost elements of the mixed costs?
Solution:
D.L.Hs Maintenance cost (shs)
High point observed 8,000 1,000
Low point observed 5,000 700
Change observed 3,000 300
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This method entails plotting all the relevant observations on a scatter graph and then
fitting a line to the data by visual inspection. This is a more accurate way of estimating
costs than the high-low method since it includes all points of observed cost data in the
analysis through use of a graph. Cost is shown on the vertical axis and the volume or rate
of activity is shown on the horizontal axis. The line fitted to the plotted points is known
as a regression line. The regression line, in effect, is a line of averages, with the average
variable cost per unit of activity represented by the slope of the line and the average fixed
cost represented by the point where the regression line intersects the cost axis.
Cost Y=a+bx
Activity
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From this basic equation, and a given set of observation , n, two mathematical equations
known as normal equations which must be solved simultaneously to derive values for a
and b for inclusion in the total cost function can be developed.
1.............y na bx
2.............xy ax bx 2
Required
Determine the business fixed and variable costs for its manufacturing costs.
Solution:
Normal equations:
1y na bx...............1
xy ax bx 2 ......... 2
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x (y) xy x2
January 80 10,200 816,000 6,400
February 90 10,900 981,000 8,100
March 100 12,100 1,210,000 10,000
April 80 10,800 864,000 6,400
May 120 13,700 1,644,000 14,400
June 110 12,500 1,375,000 12,100
Totals x 580 y 70,200 xy 6,890,000
x 2 57,400
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PRODUCTION COSTING SYSTEMS
The basic purpose of any costing system is to accumulate cost data for managerial use.
Managers need unit cost data for several reasons:
1. Unit costs are needed to cost inventories and to determine the net income of a
period.
2. Unit costs are needed to assist the management in planning and controlling
operations. Budgets must be prepared as expected costs at various operating levels
And reports must be generated to provide feedback on where operations can be
improved. The usefulness of these budgets and reports depend on the accuracy of
the unit cost data.
3. Unit costs are needed to assist management in a broad range of decision making
situations e.g. setting selling prices for products and services, deciding whether to
add or drop a production line or whether to make or buy production components
and whether to accept special orders at special prices or not.
each job. Examples of industries that use job-order system include; printing, furniture,
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equipment manufacturing, construction firms and in services such as hospitals. Law
firms, audit firms etc.
Example:
Assume that a firm has estimated its total manufacturing overhead cost for the year to be
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sh.400, 000 and has estimated 20.000 total direct labour hours for the year. A particular
job requires 40 direct labour hours to complete.
Required -- Compute:
(a) The predetermined 0/H rate
(b) The manufacturing 0/H cost assigned to the job.
Solution
(a) predetermined 0/H rate =sh. 400,000
20,000 hrs
=sh. 20 per D.L.H.
(b) Manufacturing 0/H cost assigned = 40 x20
=sh. 800 to its completion
Illustration
King’eero Company employs a job order system. The company uses predetermined
overhead rates in applying manufacturing overhead cost to individual jobs. The
predetermined overhead rate in department A is based on machine hours and the rate in
department B is based on direct materials cost. At the beginning of the year 2001, the
company management made the ff estimates for the year.
Department A Department B
Machine hours 80,000 21,000
Direct labour hours 35,000 65,000
Direct material cost shs. 190,000 shs. 400,000
Direct labour cost shs. 280,000 shs. 400,000
Manufacturing O/H cost shs. 416,000 shs. 720,000
A particular job no. 400 was initiated into production on 1st January 2008 and was
completed on 14th May 2008. The company’s records show the ff information on the job;
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Department A Department. B
Machine hours 250 70
Direct labour hours 80 130
Direct material cost shs. 940 shs. 1,200
Direct labour cost shs. 710 shs. 980
Required
(a) Compute the predetermined O/H rates that should be used during the year in
departments A and B.
(b) Computer the total O/H cost applied to job no. 400
(c) Compute the total cost of job no. 400
Solution
(a) For dept. A; application rate will be determined by:
Estimated total mfg O/H cost A = shs. 416, 000
80,000 M.Hs
= shs. 5.20 Per machine hour
For dept. B; application rate will be determined by:
Estimated total mfg O/H cost B = shs. 720, 000 x 100
Shs. 400,000
= 180% of D.M.C
(b) Total O/H cost applied for job no. 400;
A B
350* 5.20 shs. 1,820 -
1,200* 180% - shs. 2,160
Shs. 1,820 shs. 2,160
Total O/H cost applied = 1,820 + 2,160 = shs. 3,980
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Direct material cost A 940
B 1,200
Direct labour cost A 710
B 980
7,810
Or
A B Total
Direct material cost shs. 940 shs. 1,200 shs. 2,140
Direct labour cost 710 980 1,690
Total O/H cost applied 1,820 2,160 3,980
3,470 4,340 7,810
Illustration 2:
Grogon Company is highly automated and uses computers to control manufacturing
operations. The company has a job order system in use and applies manufacturing
O/H cost to products on the basis of computer hours of activities. The following
estimates were used in preparing a predetermined O/H rate for the year 2007:
Computer hours 85,000
Manufacturing O/H cost shs. 1,530,000
The company’s cost records revealed the following actual cost and operating data for
the year:
Computer hours 60,000
Manufacturing O/H cost shs. 1,350,000
Inventories at year end:
Raw materials shs. 400,000
Work in progress shs. 160,000
Finished goods shs. 1,040,000
Cost of good sold shs. 2,800,000
Required
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i) Compute the company’s predetermined O/H rate for 2007
ii) Compute the under/over applied O/Hs for 2007
iii) Prepare the appropriate journal entries to close out the under/over applied O/Hs
Solution
i) Predetermined O/H rate = shs. 1,530,000
85,000 C.Hrs
= shs. 18 per computer hour
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Alternative 2:
For under applied;
Dr. Cost of goods sold a/c XX
Finished goods a/c XX
Work in progress a/c XX
Cr. Manufacturing O/H Control a/c XX
For over applied
Dr. Manufacturing O/H control a/c XX
Cr. Cost of goods sold a/c XX
Finished goods a/c XX
Work in progress a/c XX
In our case this is an under application
1. By using alternative 1
Dr. cost of goods sold a/c sh. 270,000
Cr. Manufacturing O/H control a/c sh. 270,000
2. By using alternative 2:
Apportionments: % rate amount
Work in progress 160,000 4 10,800
Finished goods 1,040,000 26 70,200
Cost of goods sold 2,800,000 70 189,000
4,000,000 100% 270,000
Journal entries
Dr. cost of goods sold A/C sh. 189,000
Finished goods a/c/ 70,200
Working in progress a/c 10,800
Cr. Manufacturing O/H control a/c sh. 270,000
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2) Both systems provide a mechanism for computing unit costs.
3) Both systems maintain and use the same basic manufacturing accounts
e.g. manufacturing O/Hs, raw materials, work in progress and finished
goods.
(b) Differences between jobs order and process costing methods
(a) Nature and scope
In a job order costing system many different jobs are worked or done during each
period with each job having different production requirements while in process
costing a single product is produced either on a continuous basis or over a long period
of time and all units of the product are identical.
(b) Accumulation of costs
In a job order costing system, costs are accumulated by individual jobs while in a process
costing system costs are accumulated by departments
(c) Documents used
In a job order costing system the job sheet/card is the key document controlling the
accumulation of costs by a job while in a process costing system, the production report is
the key document showing the accumulation of costs.
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Example: Assume that a company has 5,000 units in its ending WIP inventory that are
60% complete
Required:
Determine its equivalent units of production
Solution :
The EU will be given by;
5,000* 60%= 3,000 completed units (EU)
Example:
Fabisch company manufactures a product that goes through two processes i.e mixing and
firming. During the year 2004, the following activities took place in the mixing
department:
Percentage of completion
Units Materials Conversion costs
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Beginning WIP inventory 10,000 100% 70%
Units started into production 150,000
During the year
Units completed during the year 140,000
& transferred to firming dept.
Ending WIP inventory 20,000 60% 25%
Required
a) Compute EU using WAM
b) Compute EU using FIFO method.
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b) The units that were both started and completed during the current period.
2. Full consideration is given to the amount of work expended during the current period
for units in the beginning WIP inventory as the units in the ending WIP inventory
For beginning WIP inventory, the EU represent the work done to complete the units and
for the ending WIP inventory, EU represent the work done to bring the units to a stage of
partial completion at the end of the period.
Therefore, the EU figure under the FIFO method consists of three amounts:
1) The work needed to complete the units in the beginning WIP inventory
2) The work expended on the units started and completed during the period.
3) The work expended on partially completed units in the ending WIP inventory.
Solution:
Physical units materials conversion
Beginning WIP inventory 10,000 0 3,000(30%)
Units started & completed during
The period(140,000-10,000) 130,000 130,000 130,000
Ending WIP inventory 20,000 12,000(60%) 5,000(25%)
160,000
Equivalent units of production 142,000 138,000
Illustration
XYZ company uses two processes, for mixing in department A and firing in department
B to produce a particular product. Direct materials are introduced at the beginning of the
process in department. A and additional materials are added at the end of the process in
department. B conversion costs are applied evenly throughout both processes.
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Data for the mixing department for the month of November 2004 was provided as
follows:
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CHAPTER IV
COST VOLUME - PROFIT ABNALYSTS (C-V-P)
C-V-P analysis is a managerial techniques used to determine how costs and profits are
affected by changes in the level of business activity. It is a deterministic analysis. It seeks
to evaluate the relationship between investment outlays, activity volumes and
profitabi1ity of particular interest is the point where sales revenues are able to cover all
costs i.e. Break- even point, since this shows minimum scale of operation so as to stay in
business.
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BREAK- EVEN POINT (B.E.P)
The B.E.P is the sales volume at which revenues and total costs are equal. At this level
both the variable costs and fixed costs are covered by the sales revenue. It defines
minimum production and sales level to stay in business. It also allows us to evaluate
profitability associated with various output levels. In new markets. We are able to
compare the volume demanded in the market (through market survey with the break-
even qua’hty4om this comparison we determine whether it is worthwhile to venture into
such a market.
TR
Cost of revenues P TC
Losses
B.E.P FC
i.e. TR-T.C=0
Mathematical determination of the B.E.P
Profit=T.R-T.C I.E Q.SP-(Q.V.C)-F.C
At B.E.P; profits=0
QSP-(QVC)-F.C=0
Q (S.P-V.C) =FC
Q=F.C
S.P-V.C
Where S.P=selling price
V.C-variable cost per unit.
F.C-fixed costs
And S-P-V.C=contribution margin per unit.
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Contribution margin ratio=C.M/unit
S.P
To get the B.EP in revenue (sales) =F.C
CM ratio
N/B while the B.E.P is not a derived performance target because of the lack of profit it
does indicate the level of activity necessary to avoid incurring a loss. As such the B.E.P
represents a target of the minimum sales volume that must be achieved by a business.
Example
A summarized income statement of XYZ co.LTD for the first year operation is given
below. XYZ CO.LTD.
Income statement for the year ended Dec 31; 2008
Sales (8,000 [email protected] each) 400,000
Variable cost 280,000
Contribution margin 120,000
Fixed cost (150,000)
Net income/loss (30,000)
Required
i. B.E.P in units
ii. B.E.P in revenue
Solution:
I. B.E.P (units) =F.C
C.M /units
=150,000 - 150,000
50-35 15
=10,000 units
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ii B.E.P (sales) = F.C
CM ratio
CM ratio =15 = 0.3
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Hence, B.E.P =150,000 =Sh. 500,000
0.3
Margin of safety
Margin of safety is the excess of actual sales over the break – even sales. It shows the
amount by which sales revenue can decline before the firms makes losses.
Ms =Actual Sales-B.E.sales
The margin of safety is useful for a firm facing a declining market share. It shows the
extent to which revenue can fall before contemplating a shut-down decision.
The B.E.P gives an indication of the level of sales that is required below which the form
would face the risk of insoluency i.e. if sales are below the B.E.P revenue then the firm is
facing the risk of insoluency.
In such situation
Units to attain for cash B.E.P =F.C less non –cash expenses
C.M per unit
Non cash expenses include:
Depreciation
Amortization
Deferred expenses – arise from timing differences between incurrence and actual
payment.
In revenue (actual cash) F.C-Non cash expenses
C.M ratio
Examples:
Assume that the manager of XYZ co.Ltd expects sales of shs. 800,000 in the year 2000
without any change in its B.E.P compute its margin of safety.
Ms=Expected sales- B.E sales
=800,000 -500,000
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= sh. 300,000
As a percentage of sales=300,000x100=37.5%
800,000
Target net income
C-V-P analysis can be used to determine the sales volume required to meet a target net
profit figure
Where management is targeting a given level of profits;
Q = F.C+Target Profit
Contribution margin/unit
Example:
Assume that the manager of XYZ co. Ltd wants to earn a net profit before tax of sh.
200,000 in the year 2,000 and expects the same selling price and costs as those
experienced in 1999 required.
What sales volume would achieve this target profit?
Q = 150,000+200,000 = 23,333 Units
15
Using equation: T.R- T.V.C-F.C = 200,000
50Q-35Q-150,000=200,000
15Q=350,000
Q=23,333 Units.
Illustration
ABC Company produces and sells a certain product at shs. 800 each with variable
manufacturing costs of shs 380 per unit and fixed manufacturing costs of shs 1,000,000
per year.
In addition, the company incurs selling and administrative costs of 2.5 %of sales revenue
and fixed selling costs of sh 200,000 per year
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Required
i. Determine the B.E.P in units and in shillings
ii. Determine the units that should be sold to earn a net income of shs. 500,000
iii. If the company was in the 35% tax bracket, how many units would have to be
sold to earn the sh. 500,000 targeted?
iv. Management in considering a policy which would increase the fixed
manufacturing costs by sh. 400,000 but cut down on the variab1e manufacturing
costs by 20% .
v. At what sales level would management be indifferent among the two policies.
vi. Assuming that the maximum possible demand is 8,000 units, determine the range
of sales in which each policy will be more financially beneficial?
Read sensitivity analysis
1. Changes in the variable cost.
2. Changes in selling prices.
3. Changing in fixed costs and sales volume.
4. Change in fixed and variable cost.
Solution
i. B.EP in units = fixed cost
Contribution margin /unit.
Fixed cost =1,000,000+ 200,000=1,200,000
Variable cost = 380+(2.5% of sh. 800)
= 380+(0.025x800)
= shs. 400
Contribution margin/unit = 800-400
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= Shs. 400
B.EP (units) 1,200,000 = 3000 units
400
= 4250 units
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= 3,361 units
B.E.P in shillings = 1,600, 000
0.595
= shs. 2,689, 075.6
b) Q = 1,600,000 + 500,000 = 1,600,000 + 769,231
0.65 476
SALES MIX
The term sales mix refers to the relative combination in which a company’s products are
sold or the relative combination of quantities of products that comprise total sales
.Managers will always use the sales that mix that yields the greatest amount of profits.
Profits will be greater when high margin items make up a relatively large proportion of
total sales and less if sales consist mostly of low margin items.
Illustration
ABC Company produces two products A and B and has the following budgets
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A B Total
Sales (Units) 240,000 80,000 320,000
Sales @ shs. 5 (A) shs. 10 (B) 1,200,000 800,000 2,000,000
Variable costs @ shs. 3 (A) shs (B) 720,000 480,000 1,200,000
Contribution Margin 480,000 320,000 800,000
Fixed cost (500,000)
Net Income (300,000)
Required:
Compute the Break even point.
Solution:
The sales mix = 240,000: 80,000 = 3:1 (A: B)
Let X be the number of units of B sold: then
3x will be the number of units of A sold.
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CHAPTER V
PRODUCT COSTING METHODS
There are only two known methods to product costing
a) Absorption costing method/Full costing method/Traditional costing.
b) Direct costing/Variable costing/ marginal/ Contribution costing method.
It allocates a portion of the fixed manufacturing overheads to each unit of the product
along with the variable manufacturing costs. The cost of the unit of a product under this
method therefore costing of direct materials, Direct labour, variable overheads and an
applied overheads.
Illustration
ABC Company produces and sells a single product selected costs from the operating data
relating to the product for a recent year are given below.
Beginning inventory (unit) 0
Units produced during the year 10,000
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Units sold during the year 8,000
Ending inventory (units) 2,000
Selling price per unit shs. 50
Selling and administration cost:
Variable per unit shs. 5
Fixed per year shs. 70,000
Manufacturing costs
Variable per unit - Direct materials shs. 11
Direct labour shs. 6
Variable overheads shs. 3
Fixed per year shs. 100,000
Required
a) Prepare income statements under the two methods.
b) Reconcile the direct costing and absorption costing net income figures.
Solution;
A) Absorption costing approach
Unit Manufacturing cost of product:
Direct materials Sh. 11
Direct labour 6
Variable overhead 3
Fixed manufacturing cost/unit 100.00 10
10,000 30
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Cost of goods available for sale 300,000
Less: Ending inventory (2,000 x 30) 60,000
Cost of goods sold (240,000)
Gross profit 160,000
39
Illustration 2:
Basic data only :
Sales price per unit shs.20
Variable manufacturing cost per unit shs. 11
Fixed manufacturing overheads shs 150,000
Selling and administration cost (all fixed) shs. 30,000 per annum
Normal production volume shs. 25,000 units
Additional data:
Year 1 Year 2 Year 3
Beginning inventory (units) Nil Nil 5,000
No. of units produced 25,000 25,000 25,000
No. of units sold 25,000 20,000 30,000
Ending Inventory (units) Nil 5,000 Nil
Required
Income statement under both absorption costing and direct costing for each of the three
years.
Solution;
a) Direct costing Approach
Income statement
Year 1 Year 2 Year 3
Sales @ shs. 20 per unit 500,000 400,000 600,000
Less; Variable costs @ shs 11 275,000 220,000 330,000
Contribution margin 225,000 180,000 270,000
Less: Fixed Costs: Fixed manufacturing 150,000 150,000 150,000
Fixed selling and Administration 30,000 30,000 30,000
Net Income / Loss 45,000 Nil 90,000
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Income Statement
Year 1 Year 2 Year 3
Sales @ shs. 20 per unit 500,000 400,000 600,000
Less: Cost of goods sold
Beginning inventory @ shs 17 per unit Nil Nil 85,000
Cost of goods manufactured (25,000 x 17) 425,000 425,000 425,000
Cost of goods offered for sale 425,000 425,000 510,000
Less: Ending inventory @ shs 17 per unit Nil 85,000 Nil
Cost of goods sold (425,000) (340,000) (510,000)
Gross profit 75,000 60,000 90,000
Less: Selling and Admin costs (30,000) (30,000) (30,000)
Net income/loss 45,000 30,000 60,000
Conclusion
1) When production and sales are equal, the same net income will be realized regardless
of whether direct or absorption costing is used, because there is no chance for the fixed
overhead costs to be deferred in inventory or realized from inventory under absorption
costing.
2) When production exceeds sales, the net income reported under absorption costing will
generally be greater than the net income reported under direct costing. The reason is
that when more is produced than sold, part of the fixed overhead costs of the current
period are deferred in the inventory to the next period under absorption costing
3) When sales exceed production, the net income reported under absorption costing
approach will generally be less than the net income reported under direct costing
approach. The reason is that, when more is sold inventories are drawn and fixed overhead
costs that were previously deferred in inventory under absorption costing are released and
charged against income
41
PRODUCT COSTING METHODS
There are two major methods of product costing i.e.
(a) Direct costing
(b) Absorption costing
42
However, these methods differ in only one conceptual respect. The fixed manufacturing
overhead is excluded from the cost of products under direct costing but included in the
cost of products under absorption costing.
Direct/Variab1e/marginal/Contribution Costing.
This method signifies that fixed manufacturing overhead (fixed factory overhead) is not
inventoried. The fixed manufacturing overhead is regarded as an expired cost to be
immediately charged against sales. Fixed manufacturing costs are not applied to any
products but are regarded as expenses as actually incurred.
The cost of the product under this method will therefore consist of direct materials, direct
labour and the indirect cost known as variable manufacturing overhead. The costs of the
product are therefore accounted for by applying all variable manufacturing costs to the
goods produced. This method is widely used for internal reporting in performance
measurement and cost analysis.
Absorption Costing
This method signifies that fixed manufacturing overhead (fixed factory overhead) is
inventoried. Fixed manufacturing overhead is treated as an un-expired cost to be held
back on inventory and changed against sales later as part of cost of goods sold.\
The cost of the product under this method therefore consists of direct materials, direct
labour, variable manufacturing overhead and an applied amount of the fixed
manufacturing overhead.
Example
ABC co. had the following operating data in 2006 and 2007
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Direct material sh. 1.30
Direct labour 1.50
Variable manufacturing overhead .20
Standard variable costs per unit sh 3.00
The fixed manufacturing overhead (fixed factory overhead) was sh. 150,000. expected
production in each year was 150,000 units. Sales price was sh 5 per unit. Selling and
administrative expenses were all fixed at sh 65,000 annually except for sales commission
at 5% of sales.
There were no variances from the standard variable manufacturing costs and fixed
manufacturing overhead incurred was exactly sh 150,000 per year.
Required
(a) Prepare income statements for 2006 and 2007 under direct costing
(b) Prepare income statements for 2006 and 2007 under absorption costing
(c) Prepare a reconciliation of the direct costing and abosorption costing net profit
figures
Solution
(a) Direct costing 2006 2007
Sales 140,000 and 160,000 units respectively 700,000 800,000
Opening inventory - 90,000
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Add costs of goods manufactured
(170,000 & 140,000) 510,000 420,000
Cost of goods available for sale 510,000 510,000
Less ending inventory 90,000 30,000
Variable manufacturing costs of goods sold 420,000 480,000
Variable selling expense @ 5% of sales 35,000 40,000
Total variable cost (455,000) (520,000)
Contribution margin 245,000 280,000
Fixed factory overhead 150,000 150,000
Fixed selling & administrative expenses 65,000 65,000
Total fixed expenses (215,000) (215,000)
Operating profit/income 30,000 65,000
(b) Absorption costing 2006 2007
Sales 700,000 800,000
Opening inventory (sh 4) - 120,000
Cost of goods manufactured 680,000 560,000
Cost of goods available for sale 680,000 680,000
Less: closing inventory 120,000 40,000
Cost of goods sold (560,000) (640,000)
Gross profit at standard 140,000 160,000
Production volume variance 20,000 (10,000)
Gross profit at standard 160,000 150,000
Selling and administrative expenses:
Variable 35,000 40,000
Fixed 65,000 65,000
Total selling & administrative expenses (100,000) (105,000)
Net income 60,000 45,000
Workings
Production volume variance
2006 sh 20,000 F(170,000 – 150,000) X sh 1
2007 sh 10,000 U (140,000 – 150,000) x sh 1
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(c) Reconciliation: 2006 only
Net income under direct costing sh 30,000
Add: fixed manufacturing overhead cost differed in
Closing inventory under absorption costing 30,000
Net income under absorption costing 60,000
CHAPTER V
BUDGETING
Definitions
1. A budget is a quantitative expression of a plan of action of a specified period of time.
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2. A budget is a financial and/or a quantitative statement prepared prior to a defined time
period to serve as a basis for the implementation of a policy to be followed during
that period for the purpose of attaining a given objective.
The main purpose of a budget is to implement the policies formulated by management for
attaining the company’s objectives.
The budget can be independent for a particular unit in the organization or for the entire
organization
FUNCTIONS OF BUDGETS
1. Planning:
Budgeting requires managers to give planning top priority among their duties. Planning
involves the development of future objectives and the preparation of various budgets to
achieve these objectives
. The budget brings out the firm’s requirements and expectations in terms of inputs and
outputs and in this way many unforeseen contingencies may be anticipated in
advance.
2. Communication
Budgets are devices for communication. The plans summarized in budgets are read and
interpreted through out the firm. Thus budgets are an important channel of
communicating certain types of information that will enable managers in different
parts of the organization to o- ordinate their activities more efficiently.
3. Motivation
Budget often serve as a means of motivating managers to strive towards the achievement
of the organizational objectives. They do this by acting as an external standard the may
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be accepted by a manager as his own target, thus providing a motivational force.
Extensic rewards and penalties .ay also be attached to budget achievement to increase its
motivational effect e.g. bonuses performance awards etc.
4. Controlling
Budget serves as standard against which managerial performance is evaluated. The
budget offers the only available quantitative reference point against which performance
can be assessed.
A danger in this situation is that performance which is relatively reported can become the
dominant measure of overall performance yet the budget itself represents only an
imperfect standard. A strong stress on budget attainment is likely to lead to budgets that
are met but at the expenses of worse long- run performance with various harmful side-
effects.
Nevertheless, properly used budgets can be vial tool in monitoring and controlling
managerial and business unit performance.
5. Co-Ordination
A budget is important for effective co- ordination.
The various departmental managers will be expected to co- ordinate one another so as to
be able to determine man-power needs, facilities, raw materials and other resources in the
organization. This can be done using the relevant budget.
LIMITATION OF BUDGETS
1. The budget plan is based on estimates and therefore absolute accuracy is not
possible in budgeting. The strength and weakness of a budgeting system depends
to a 1are extent on the accuracy’ with which the estimates are made.
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2. Danger of rigidity
The budget program must be dynamic and continuously deal with the changing
business conditions. Budgets reduce much of their usefulness if they acquire
rigidity and are not revised with the changing circumstances.
3. Budgeting is only a tool of management but cannot take the place of management.
Execution of budgets will not occur automatically. i is therefore necessary that the
entire organization participates in the budget programme if the budgeting goals
are to be achieved.
However, some firms will not use continuous budgets because budgets that are
automatically revised downwards to accommodate some informal set of external
circumstances may weaken employees’ motivation. Once the budget for a department or
division has been discussed and agreed on, the manager of that department is deemed to
have made a commitment to achieve the results reflected in the budget. If conditions
change, the manager is expected to exert extra effort and develop new strategies to
achieve the expected results.
2. Participative Budgets.
The behavioral studies of the budgeting process indicate that managers usually feel a
great commitment to achieving the budgeting goals if they have played a part in
construction of the budget.
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The participative approach to budgeting emphasizes the active involvements of managers
who will subsequently be evaluated on the basis of budgeted goals. One approach of
participative budgeting is to give subordinates on opportunity to construct the first round
(initial) budgets which is then revived and modified by the subordinates’ superior. This
approach gives the lower level manager a large creative role.
Another approach is to review the initial budget with the subordinates in a group which
collectively arrives at a final budget decision through a consensus. Effective use of the
approach requires special skills on the part of the superior who managers
the group in the decision making process.
This allows the top management to evaluate each decision package independently and to
rule out those that appear less critical or that do not appear to be justified in terms of costs
involved.
TYPES OF BUDGETS
1. Sales Budget.
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The sales budget is the starting point in preparing the master budget. The sales budget
is constructed by multiplying the expected sales in units by the selling price.
Example: ABC Co. manufactures two products A and B
The sales forcast for ABC co’s products for the coming year has been made as
follows:
Products Sales (Units
A 1000,000
B 20.000
Selling price is sh.20 for A and sh. 10 for B
Required:
Prepare the sales budget for ABC Co.
Solution
ABC Co’s sales budgets
Products Total
A B
Units 100,000 20,000 120,000
Selling price(s) 20 10
Sales (sh) 2,000,000 200,000 2,200,000
2. PRODUCTION BUDGETS
This follows the sales budget. It is used to determine the number of units to be produced.
The units to be produced will be made up as follows:
Desired inventory of finished goods (in units) + budgeted sales in units – Beginning
inventory of finished goods in units.
The production required of the forthcoming budget period is determined and organized in
the form of production budgets.
Sufficient goods will have to be available to meet sales needs and provide for the desired
ending inventory. The remainder will have to be produced.
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Sufficient goods will have to be available to meet sales needs and provide for the desired
ending inventory – A portion of these goods will already exist in the form of beginning
inventory. The reminder will have to be produced.
Example
ABC Co. has the following data:
Direct materials: unit cost input requirement per unit
A B
Material x sh. 4 per kg 10 kg 10 kg
Material y sh 10 per kg 7 kg 9kg
Direct labour sh 5/hour 20 hrs 25hrs
Additional information:
X Y
Beginning inventory (kg) 10,000 10,000
Desired ending inventory (kg) 8,000 2,000
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Required:
(i) The direct material purchases budget
(ii) Direct labour cost budget
SOLUTION
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(ii)ABC Co’s labour budget
A B Total
Units to be produced 119,000 21,000
Labour requirement per units (hrs) 20 25
Total labour required (hrs) 2,380,000 52,500
Labour rate per hour (sh) 5 5
11,900,000 262,500 12,162,500
5. CASH BUDGET
A cash budget is used to plan for an adequate but not excessive cash balances. The goal
of a cash budget is to ensure that the business has sufficient liquidity to pay its bills as
they fall due.
A cash budget has three section i.e.
i. The cash receipts section
- opening balance is also included plus all cash receipts
ii. The ending balance section
- consists of the difference between the receipts total and the disbursements total.
The difference either show a deficit or a surplus
ILLUSTRATION:
ABC co. has the following data from which a master budget has to be prepared for the
coming year.
2006 2007 2008
Current year coming year year after
4th Q 1ST Q2nd Q3rd Q4th Q 1st Q
SALES (UNITS) 1800 1000 2000 1500 2000 1000
Expected selling is shs. 200 per unit
Inputs requirement cost/unit
Material 2kg sh.5/kg
Labour hour’s 3hrs sh.10/hr.
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Beginning inventory of finished goods for each quarter must be equal to 10% of sales for
the previous quarter. Raw material inventory at the end of any quarter must be equal to
the requirements to produce units for sale in the next quarter. Variable manufacturing
overheads are based on direct labour costs at the rate of 80% of direct labour cost. In
addition, fixed manufacturing overheads of sh. 20,000 will be incurred each quarter
including depreciation sh. 2,000 per quarter.
Required
Prepare the Sales budget, Production budget, Raw materials purchase budget, Direct
labour cost budget and Manufacturing overheads budget for the year on the basis of
quarters.
SOLUTION
(a) Sales Budget
Quarters
1 2 3 4
Expected sales in units 1,000 2,000 1,500 2,000
Selling price per unit (shs) 200 200 200 200
Expected sales revenue (shs) 200,000 400,000 300,000 400,000
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Quarters
1 2 3 4
Units to be produced 920 2,100 1,450 2,050
Requirements per units (kg) 2 2 2 2
Materials for production (kg) 1,840 4,200 900 4,100
Add: Closing inventory required (kg)4,000 3,000 4,000 2,000
Total requirements 5,840 7,200 6,900 6,100
Less: Required opening inventory 2,000 4,000 3,000 4,000
Price per unit (sh) 5 5 5 5
Budgeted R Material cost (sh) 19,200 16,000 19,500 10,500
e) Compute the manufacturing cost per unit (Assume the variable cost approach)
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Input item Quantity Cost/unit Total
Direct materials 2kg sh.5 10
Direct labour 3 hours sh. 10 30
Variable overhead 3 hours sh. 8 24
Sh. 64
Additional data:
In addition to the manufacturing costs selling and administrative costs of sh.32,000 are
incurred per month sales are made on cash and credit terms as follows:
In any quarter: 30% cash sales
70% credits sales
Credit sales are collectable in the quarter following the quarter of sales and 2% of the
credit sales are considered uncollectable. Raw materials are paid for in the month of
purchase. Wages, overheads and administrative expenses are paid for in the month they
are incurred. Equipment worth, shs. 380,000 will be bought in the fourth quarter of the
coming year. The company requires a minimum cash balance of sh. 25.00 and the cash
balance at the beginning of the first quarter in expected to be sh. 27,000.
Required
(a) Prepare projected income statements
(b) The cash budget for the company for the year on quarterly basis.
Solution:
a) Project income statement for the quarters to 31st Dec
1 2 3 4
Sales (shs) 200,000 400,000 300,000 400,000
Less: variable costs 64,000 128,000 96,000 128,000
Contribution margin 136,000 272,000 204,000 272,000
Less: Fixed mfg. costs 20,000 20,000 20,000 20,000
Selling & adm. Costs 96,000 96,000 96,000 96,000
Project net income/less 20,000 156,000 88,000 156,000
b) Cash from sales
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Quarters
1 2 3 4
Cash sales (Shs) 60,000 120,000 90,000 120,000
Add: Collection from credit 249, 960 137,200 274,400 205,800
Sales customers
Cash from sales 306,960 257,200 364,400 325,800
CHAPTER 8
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RELEVANT COST FOR DECISION MAKING
A relevant cost can be defined as a cost that is applicable to a particular decision making
situation in the sense that it will have a bearing on which alternative(s) the manager
selects. Any cost that is avoidable is relevant for decision making purposes. An avoidable
cost is any cost that can be eliminated completely or partially as a result of choosing an
alternative over another alternative in a decision making situation.
All costs are considered to be avoidable except for:
i) Sunk costs
ii) Future costs that do not differ between the alternatives at hand.
TYPES OF DECISIONS
1) Make or buy decisions
A decision which will produce a component part internally rather than buy the part
externally is called a make or buy decision.
Example:
Assume that XYZ Co. is now producing a small sub assembly, that is used in the
production of the company’s main production lines. The company’s accounting
department reports the following costs of production the sub assembly internally
Per unit 8000 units
Direct materials sh. 6 sh. 48,000
Direct labour 4 32,000
Variable O/H 1 8,000
Supervisor’s salaries 3 24,000
Deprn. Of special equipment 2 16,000 sunk cost
Allocated general O/H 5 40,000 irrelevant
Total cost sh. 21 sh. 168,000
XYZ Co. has just received an offer from an outside supplier who will provide 8,000 units
of sub assemble per year at a price of sh. 19 each.
Required:
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Should XYZ Co. stop producing the sub-assemblies internally and start purchasing them
from the outside supplier or not?
Solution:
Check on the relevant cost only
Make Buy
Direct materials sh. 6
Direct labour 4
Variable 0/H 1
Supervisor’s salary 3
Total cost sh. 14
Outside purchase sh. 19
The difference is in favour of the making of sub-assembly i.e. sh. 5 saving per unit or sh.
5 * 8000 = sh. 40,000 can be saved
Decision: The company should therefore reject the outside offer.
Example 2:
Assume that the space now being used to produce sub-assemblies will be used to produce
a new product line that would segment a product margin of sh. 50,000 per year should
XYZ Co. accept the supplier’s offer or not?
Make Buy
Differential costs sh. 14 sh. 19
No of units needed annually 8000 8000
Total annual cost sh. 112,000 sh. 152,000
The difference of sh. 10,000 is in favour of purchasing from the outside supplier.
Decision: The company should therefore accept the suppliers offer and use the available
space to produce the new product.
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2) Sell or Process – further decisions
Under these decisions joint products are considered joint products: - These are two or
more product from a common input.
Joint cost; - Are manufacturing costs that are incurred in producing joint products up to
split-off-points
Split – off: - This is that point in the manufacturing process at which the products can be
recognized as individual units of output
This join costs are irrelevant in decision making: As a general guide it will always be
profitable to continue processing a joint product after the split off point so long as the
incremental revenue from such processing exceeds the incremental processing costs.
Example: -
Cost and revenue data relating to three products are as follows
A B C
Sales value at the split off point 120,000 150,000 60,000
Sales value after further processing 160,000 240,000 90,000
Allocated joint product costs 80,000 100,000 40,000
Costs of further processing 50,000 60,000 10,000
REQUIRED
Which product (s) should be processed further
A B C
Incremental Revenue shs. 40,000 90,000 30,000
Cost of further processing (50,000) (60,000) (10,000)
Profit/Loss for further processing (10,000) 30,000 20,000
Therefore B&F should be processed further
A should be sold after split off point
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Firms are always faced with problem of deciding how scarce resource can be utilized eg
limited number of machine hours/ D.C.Hs, floor space etc
The firm should select the course of action that will maximize its total contribution
margin. Total contribution margin will be maximized by promoting those products or
accepting those order that promise the highest contribution margin relation to the scarce
resources of the firm.
Example:
Assume that a firm has two products A&B. Cost and revenue characteristics of the two
product lines are as follows;
A B
Sales price per unit shs. 25 sh. 30
Variable cost per unit shs. 10 shs 18
Contribution Margin per unit shs 15 shs 12
It takes two machine hours to produce one unit of product A and only one machine hour
to produce one unit of product B. The firm has only 18,000 machine hours of capacity
available in the factory per period
Required:
If demand becomes strong which orders should the firm accept
Solution:
A B
Contribution margin per unit shs 15 shs. 12
Machine hours required to produce/Unit 2hrs 1hrs
Contribution margin per machine hrs shs 7.50 shs 12
Total machine hrs available shs. 18,000 shs. 18,000
Total contribution margin shs 135,000 shs. 216,000
VARIANCE ANALYSIS
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Variance analysis is typically performed for the production costs of manufactured goods.
However, conventional procedures for decomposing a cost variance into its quantity and
price components can be extended to explain deviations of actual from planned
profitability.
Standard costs
A standard can be defined as a benchmark or ‘norm’ for measuring performance. In
management accounting the standards used relate to the quantity and cost of inputs used
in manufacturing goods or providing services. Managers, set standards for the three
elements of cost input i.e. direct materials, direct labour and manufacturing overheads.
Quantity standards indicate how much of a cost element, such as labour time or raw
materials should be used in manufacturing a unit of a product or in providing a unit of a
service.
Cost standards indicate what the cot of the input i.e. labour time or raw materials should
be. By comparing actual quantities and actual costs of inputs with these standards we can
be able to tell whether operations are proceeding within the limits set by management.
This model provides a base for variance analysis. It deals with variable costs, isolates
price variances from quantity variances and shows how each of these variances is
computed.
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Reasons for separating standards into price and quantity
1. Control decisions relating to price paid and quantity used will generally fall at
different points in time e.g. for raw materials, control over price paid comes at the
time of purchase while control over quantity used does not arise until raw materials
are used in production.
2. Control over price paid and quantity used will generally be the responsibility of two
different managers and will therefore need to be assessed independently.
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2. Delivery method used.
3. quantity discounts available
4. rush orders
5. quantity of materials purchased e.t.c
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Labour Efficiency Variance
This measures the productivity of labour time. i.e.
(A.H * S.R) – (S.H * S.R)
=S.R(A.H – S.H)
Or S.R(S.H – A.H)
Causes.
1. Poorly trained workers
2. Poor quality materials
3. faulty equipment
4. Poor supervision e.t.c.
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Direct labour 0.6 hours sh. 12 per hour 7.20
Variable overhead 0.6 hours sh. 2.50 per hour 1.50
Sh. 17.70
During June 2008, the following activity was recorded by the company relative to
production of Fruta:
1. The company produced 3,000 units during the month.
2. A total of 8,000 pounds of material were purchased at a cost of sh. 46,000.
3. there was no beginning inventory of materials on hand to start the month;
at the end of the month , 2,000 pounds of material remained in the
warehouse unused.
4. The company employs 10 persons to work on the production of Fruta.
During June, each worked an average of 160 hours at an average rate of
sh. 12.50 per hour.
5. Variable overhead is assigned to Fruta on a basis of direct labour hours.
Variable overhead costs during June totaled sh. 3,600.
BUDGETING
Definitions.
A budget is a detailed plan outlining the acquisition and use of financial and other
resources over some given time period. It represents a plan for the future expressed in
formal quantitive terms.
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Budgeting is very critical for effective profit planning since it focuses on those steps to
be taken by a business organization to achieve certain desired levels of profits.
When several budgets are prepared, they form an integrated business plan known as the
master budget. Usually, the data going into the preparation of the master budget forms
heavily on the future, rather than the past.
Functions of budgets
The reasons for producing budgets are as follows:
i. to aid the planning of annual operations
ii. to coordinate the activities of the various parts of the organization and to ensure
that the parts are in harmony with each other.
iii. To communicate plans to various responsibility centre managers.
iv. To motivate managers to strive to achieve the organizational goals
v. To control activities
vi. To evaluate the performance of managers.
Planning
Planning involves the development of future objectives and the preparation of various
budgets to achieve these objectives. The budgeting process ensures that managers do plan
for future operations, and that they consider to conditions are likely to change in the
future, and when steps they should take now to respond to such changed conditions. This
process encourages managers to anticipate problems before they arise, and hasty
decisions that are made on the spur of the moment, based on expediency rather than
reasoned judgment, will be minimized.
Coordination:
The budget serves as a vehicle through which the actions of the different parts of an
organization can be brought together and reconciled into a common plan.
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Without any guidance, managers may each make their own decisions believing that they
are working in the best interests of the organisations and end up creating problems of
conflict of interest e.g the purchasing manager may prefer to place large orders so as to
obtain large discounts; the production manager will be concerned with avoiding high
stock levels while the accountant will be concerned with the impact of the decisions on
the cash resources of the business. Hence budgeting reconciles all these differences for
the good of the organization as a whole.
Communication
The budget effectively defines lines of communication so that all parts of the organization
are kept fully informed of the plans and the policies, and constraints, to which it is
expected to conform. It ensures that everyone in the organization has a clear
understanding of the part he or she is expected to play in achieving the organizational
objectives. This process ensures that the appropriate individuals are made accountable for
implementing the budget.
Motivation
Budgets can be useful devices for influencing managerial behaviour and motivating
managers to perform in hire with the organizational objectives. Budgets often provide
standards that under certain circumstances, managers must be motivated to strive to
achieve. However budgets can also encourage inefficiency and conflict between
managers.
If individual have actively participated in preparing the budget (bottom-up strategy) and
it is used as a tool to assist managers in managing their respective units, it can act as a
strong motivational device. However, if the budget is dictated from the top, and imposes
a threat rather than a challenge, it maybe resisted and do more harm than good.
Control
Budgets assist managers in managing and controlling the activities for which they are
responsible. Managers can compare actual results with budgeted results and can ascertain
which items do not conform to the original plan, and thus require their attention.
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Deviations identified should be investigated to identify inefficiencies and take
appropriate control actions to remedy the situation
Performance evaluation
The budget provides a useful means of uniforming managers of how well they are
performing in meeting targets that they have previously helped to set. e.g. in some
companies bonuses or promotion may be partly dependent upon a manager’s budget
record. Hence, a manager’s performance may be evaluated by measuring his or her
success in meeting the budgets. Furthermore, the manager may be the budget to evaluate
his or her own performance.
Accounting staff:
These will normally assist managers in the preparation of their budgets and ensure that
managers submit their budgets on time. However, the accounting staff do not determine
the content of the various budgets but they do provide valuable advising and clerical
service for the hire managers.
Budget manual
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This is usually prepared by the accountant describing the objectives and procedures
involved in the budgeting process. It provides a useful reference source for managers
responsible for budget preparation. The manual may include a timetable specifying the
order in which the budgets should be prepared and the dates when they should be
presented to the budget committee stages in the budgeting process.
1) Communicating details of budget policy and guidelines to those people
responsible for the preparation of budgets.
2) Determining the factor that restricts performance.
3) Preparation of the sales budget.
4) Initial preparation of various budgets
5) Negotiation of budgets with superiors.
6) Coordination and review of budgets.
7) Final acceptance of budgets
8) Ongoing review of budgets.
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