FIA - Managing Costs and Finance (MA2) - Course Notes - 2022-Unlocked

Managing Costs and Finance
MA2
Course Notes
For exams from September 2022
ISBN: 1781 4728 0025 9
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BPP Tutor Toolkit copy

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MA2 Managing Costs and Finance
Study Programme
Page
Introduction to the exam and the course .......................................................................................... 4
Skills bank ...................................................................................................................................... 11
1 Management information......................................................................................................... 29
2 The role of information technology (Home study) ................................................................... 39
3 Cost classification.................................................................................................................... 47
4 Cost behaviour ........................................................................................................................ 59
5 Materials .................................................................................................................................. 75
6 Labour ..................................................................................................................................... 93
7 Expenses............................................................................................................................... 111
Checkpoint 1 – Additional study guidance .................................................................................. 119

8 Absorption costing ................................................................................................................. 125
9 Marginal and absorption costing............................................................................................ 147
10 Cost bookkeeping.................................................................................................................. 163
11 Job, batch and service costing .............................................................................................. 175
Checkpoint 2 – Additional study guidance ................................................................................... 189

12 Process costing ..................................................................................................................... 195

13 Cost–volume–profit analysis.................................................................................................. 213
14 Decision making .................................................................................................................... 225
15 Capital investment appraisal ................................................................................................. 241
16 Cash management ................................................................................................................ 257
17 Information for comparison.................................................................................................... 273
18 Variances............................................................................................................................... 279
19 Reporting management information ...................................................................................... 293

20 Answers to lecture examples................................................................................................. 311
21 Appendix A: Overview summaries......................................................................................... 339
22 Appendix B: Formula & Mathematical tables ........................................................................ 361
Prepare for and book your CBE!

You should plan to sit your CBE within a couple of weeks of finishing ALL phases of the study programme whilst your
knowledge is still fresh. In preparation, use the Learning Media Practice & Revision Kit to test yourself on as many
questions as you can, revising from the Course Notes and Passcards any areas of the syllabus that cause you problems.
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INTRODUCTION
Introduction to MA2 Managing Costs and Finance
Overall aim of the syllabus

The overall aim of the exam is to develop knowledge and understanding of how to prepare,
process and present basic cost information to support management in planning and decision
making in a variety of business contexts.
The syllabus
The broad syllabus areas are:
A Explain the role of costing within the organisation and how costs are classified
B Describe and record costs by classification
C Explain and apply cost accounting techniques
D Use management accounting techniques to make and support decision making
E Explain principles of cash management
Main capabilities
On successful completion of this exam, candidates should be able to:
 Explain the nature, source and purpose of management information
 Explain and apply cost accounting techniques
 Prepare budgets for planning and control
 Compare actual costs with standard costs and understand any variances
 Analyse, interpret and monitor business performance
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INTRODUCTION
Links with other exams
SBL APM ACCA
PM
Foundations FMA MA
in
Accountancy
MA2
MA1
Assessment methods and format of the exam

The exam lasts two hours comprising 50 compulsory two-mark questions which will assess all
parts of the syllabus and include both computational and non-computational elements.
Format of the exam Marks

50 two-mark questions 100
100
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INTRODUCTION
Study Programme Aims

Achieving ACCA's Study Guide Outcomes
A Management information
A1 Management information requirements Chapter 1

A2 Cost accounting systems Chapter 2
A3 Cost classification Chapters 3 & 4
A4 Information for comparison Chapters 17 & 18
A5 Reporting management information Chapter 19
B Cost recording
B1 Accounting for materials Chapter 5

B2 Accounting for labour Chapter 6
B3 Accounting for other expenses Chapter 7
C Costing techniques
C1 Absorption costing Chapter 8

C2 Marginal costing Chapter 9
C3 Job and batch costing Chapter 11
C4 Process costing Chapter 12
C5 Service costing Chapter 11
D Decision making
D1 Cost–volume–profit analysis Chapter 13

D2 Factors affecting short-term decision making Chapter 14
D3 Principles of discounted cash flow Chapter 15
E Cash management
E1 Nature of cash and cash flow Chapter 16

E2 Cash management Chapter 16
E3 Cash budgets Chapter 16
E4 Investing and financing Chapter 16
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INTRODUCTION
Analysis of the pilot exam

Please note that the ACCA will not publish past exams for the Knowledge modules. The analysis
of the Pilot exam should therefore be used as a guide to both the areas that will be examined and
the mix between narrative and computational questions.
Computational
Narrative
Management information
Management information requirements 2
Cost accounting systems
Cost classification
Information for comparison 2 2
Reporting management information 3
Cost recording
Accounting for materials 2 5
Accounting for labour 2 1
Accounting for other expenses 1 2
Costing techniques
Absorption costing 3
Marginal costing 2
Job and batch costing 1 1
Process costing 1
Service costing 1
Decision making
Cost–volume–profit analysis 4
Factors affecting short-term decision making 2 3
Principles of discounted cash flows 2
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INTRODUCTION
Computational
Narrative
Cash management
Nature of cash and cash flow
Cash management 2
Cash budgets 4 1
Investing and financing 1
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INTRODUCTION
Key to icons
Section reference in the Interactive Text
Further reading is needed on this area to consolidate your knowledge.
Formula to learn
Formula given in exam
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INTRODUCTION
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Skills bank
This section explains and demonstrates the key skills

required to enable you to maximise your chance of
exam success. Knowledge of the syllabus is insufficient
on its own. Through question practice you will develop a
set of skills that will enable you to pass this exam.
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Key skills required to pass

Our analysis of the examining team's comments on past exams, together with our experience of preparing students for
this type of exam, suggests that to pass MA2 you will need to develop a number of key skills.
1 Learning and 2 Logical

applying the approaches to
syllabus theory objective test
questions
3 Effective use
of your time in
the exam
Each of these key skills is analysed on the following pages. Examples from past exam questions are included
to illustrate the importance of these skills and how these skills should be applied.
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Skill 1 – Learning and applying the syllabus theory
1 What do I need to know to do well in the exam?

MA2 is a broad syllabus that is examined by objective test questions including multiple choice questions. This means
that you need a broad and yet quite detailed knowledge of the syllabus as well as an understanding of the concepts and
techniques involved.
The type of knowledge that you have to acquire includes the following:
Theoretical knowledge – the fundamental definitions and basic thinking behind different management accounting
techniques. These will often be tested in narrative questions.
Practical knowledge – the application of techniques to 'real life' situations. These will often be tested in numerical
questions.
In this section we will look at approaches that you can take to help you learn the key elements of the knowledge in the
syllabus, and develop your application skills.
2 Learning the theory

In the exam you will encounter questions that test your knowledge of key management accounting theory. These are
the types of questions where there isn't really anything to work out, you just need to have the facts stored in your
memory.
Here are two examples from a past exam:
Q15
Which of the following are objectives of cash budgeting?
(1) To anticipate cash shortages and surpluses
(2) To enable necessary funds to be made available
(3) To monitor trade receivables

Theory
A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3
(2 marks)
This question is testing you on the objectives of cash budgeting. Can you see that there isn't really anything to work
out? Either you know the objectives or you don't. This is one way that theory can be tested.
The correct answer is A.
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Q7
A company has two production cost centres, Cutting and Finishing.

The overheads and operating hours for the two cost centres are:
Cutting: $210,000 60,000 machine hours 4,000 labour hours

Finishing: $200,000 5,000 machine hours 14,000 labour hours
From the information given what should be the basis for overhead
Theory
absorption?
A Both cost centres should be based on machine hours
B Both cost centres should be based on labour hours
C Based on machine hours for Cutting and labour hours for Finishing
D Based on labour hours for Cutting and machine hours for Finishing
(2 marks)
Although this question contains numbers in the question, it is really just another test that you understand how
overheads are absorbed. There is nothing to work out – if you know overheads are absorbed based on the activity that
influences overheads the most then you could have worked out the answer to be C, as the Cutting department is more
machine intensive and the Finishing department more labour intensive.
Therefore you need to do the following to help you learn the theory:
1. For each new topic or technique, make sure you learn a short definition that contains the key elements of what
it's all about.
2. Add some further notes that include the most important bits of detail for each topic or technique. This should
include formulae for numerical techniques. You may like to use the overview diagrams in the notes as a base.
Doing this will set you on your way to achieving the breadth of knowledge you need across the MA2 syllabus. It will also
give you an excellent foundation on which to begin to apply your knowledge in the wide range of questions you'll see in
the exam.
3 Application
Being able to apply your fundamental syllabus knowledge to the situations presented in exam questions is the skill that
will make the difference between passing and failing the exam.
During your studies of MA2, you must gradually build up your exposure to exam style questions so that you can
become 'flexible' and able to deal with whatever questions you see in your exam.
Don't be discouraged if you struggle with application questions on a particular topic – just take this as an indication that
there are still a few gaps in your knowledge of the theory. You can then pinpoint exactly where you need to review your
notes before continuing with more question practice. This really is an excellent way to prepare for the exam.
Two example questions from the Specimen exam are included below – they both require application of knowledge to
the situation you are given in the question:
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Q23
A company planned to produce 4,000 units of Product X during a

particular year and budgeted its fixed production overheads for the year
at $20,000. During the year it actually produced 4,200 units of Product X
and it incurred fixed production overheads of $21,840. A predetermined
fixed production overhead absorption rate per unit is applied.
Application
Which of the following statements is true?
A Fixed overheads were under-absorbed by $840
B Fixed overheads were over-absorbed by $840
C Fixed overheads were over-absorbed by $1,000
D Fixed overheads were under-absorbed by $1,840
(2 marks)
This question needs you to think of what you know about the use of an overhead absorption rate (OAR) to deal with
overheads in an absorption costing environment (ie the theory). To get the correct answer you must then apply this to
the situation you are given.
There are an infinite number of ways that the examining team can test your ability to apply your knowledge of OARs in
situations like these – you need to (a) understand the theory and (b) practise applying it until you are able to cope with a
wide range of possible exam questions.
The following example taken from the question bank also requires you to apply your knowledge, this time of cost
classification, but in a purely narrative format, without any calculations:
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Net
present
value
0 interest
5% 10% 15%
Application
Which of the following is correct with regard to the above graph?

(1) The IRR is 10%
(2) The NPV at 15% is positive
(3) The project's total inflows exceed the total outflows
A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3
(2 marks)
In this question you need to compare the statements you are given in (1), (2) and (3) to what you know about NPV and
IRR, and decide which ones are true.
We'll return to this type of question in the next section and consider how to approach multiple choice options such as
these.
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Skills practice
Learn the content of the syllabus actively and then practise applying it by:
1. Reading your notes
2. Making condensed versions of your notes either as separate lists or on the overview diagrams
3. Recording a basic definition and key points for each new topic or technique
4. Practising as many questions as you can, using them to identify any weaknesses in your
knowledge
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Skill 2 – Logical approaches to objective test questions

The MA2 exam contains a wide range of question styles, for example, multiple choice questions (select one correct
answer from a list), multiple response questions (selecting a number of correct answers from a list), multiple response
matching (clicking on correct options such as true or false) or numeric entry questions (where you type in the answer to
your calculations).
For 'numeric entry' questions you need to read the question carefully and concentrate as you carry out your
calculations – there are no multiple choice options to compare your answer with, so you need to be confident that you
have arrived at the correct answer, enter it and move on.
For multiple choice questions, there are some established approaches that you can follow to help you maximise your
marks. These are discussed in more detail below.
1 What to do if you know the answer to a multiple choice question

If you know the answer to a question you should:
1. Locate the correct answer.
2. Check the other answers.
3. Read the question again – be very careful with questions that contain negatives, like 'which of the following is
NOT…'.
4. Confirm that you have the correct answer.
This systematic check will ensure that you do not throw away marks when you really do know the answer.
2 What to do if more than one multiple choice answer appears plausible

Sometimes more than one option can seem to answer the question. In this case you have to select the most correct
answer. The approach adopted above is useful here too but this time you have to think through the alternatives a bit
more. For example, Q46 from the Specimen exam was as follows:
Q46
Which of the following describes the margin of safety?
A The total sales units up to breakeven sales volume
B The difference in units between the expected sales volume and the breakeven
sales volume
C The difference between sales value and variable costs
D The difference between total costs and the fixed costs at breakeven sales
volume
(2 marks)
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If you don't know the answer you can adopt a three step approach as follows:
STEP Eliminate the incorrect answer(s)

1 You may remember that the contribution is the difference between the sales revenue and the variable
costs and so answer C is not the correct answer.
STEP Assess the remaining answers

2 You may also remember that the difference between total costs and fixed costs would provide you
with total variable costs and so D is not the correct answer.
However, both A and B still seem plausible; so...
STEP Read the question again…

3 'Which of the following describes the margin of safety?'
Although both the remaining answers refer to units, answer A seems to be describing the number of
units required to break even and not the difference between budgeted sales and breakeven sales.
The most likely answer therefore seems to be B.
This systematic approach helps you to break a question down and work through to find the correct answer logically.
3 What to do if you still don't know the answer to a multiple choice question
If you have been through the above steps and cannot identify a preferred answer then you have to guess!
 What you SHOULD NOT do

Two main things to avoid:
1. Wasting time – the question is only worth two marks so time spent dithering over a multiple choice question
could leave you with insufficient time for the rest of the exam.
2. Not answering – this is a common yet serious error – even if you make a wild guess you start with a 25%
chance of success. Your chance of getting the two marks if you don't offer an answer is zero!
 What you SHOULD do

Having used the three-step approach – Eliminate, Assess, Read the question – to narrow down your possible answers
go with the one that feels right. And move on.
If you have a flash of inspiration later in the exam go back and revisit it – but only if you are sure.
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4 Multiple choice numerical questions – beware the 'distractors'

The general approaches described above apply equally to narrative and numerical questions but there is a further
important consideration that relates to numerical questions where calculations are involved.
The majority of numerical questions will have four possible answers – one correct answer and three incorrect answers.
The incorrect answers are known as 'distractors' and they are not random numbers! The examining team goes to
great lengths to produce distractors that represent the answers that students will arrive at if they go slightly wrong in
their calculations. You need to develop a sound technique that means you do not fall into this trap!
Here is an example from the Specimen exam:
Q11
A company is evaluating a project that requires 400 kg of raw material X.
The company has 150 kg of X in inventory that was purchased six months ago
for $55 per kg. The company no longer has any use for X. The inventory of X
could be sold for $40 per kg. The current purchase price for X is $53
per kg.
What is the total relevant cost of raw material X for the project?
A $21,200
B $21,500
C $19,250
D $13,250
(2 marks)
Hopefully, you'll recognise this as a straightforward relevant costing question.

If you assume that the value of the units already held in inventory are to be valued at the amount you purchased them
for and that the remaining units you will have to buy at the current market price, you would have calculated answer B
((150  $55) + (250  $53)).
However, you needed to remember that costs already incurred such as the $55 you paid per unit of inventory currently
held is a sunk cost and therefore not relevant. You needed to identify that the company has no further use for the
material and as such the inventory currently held should have been valued at the scrap value of $40 per kg. This would
have given you answer C as the correct answer ((150  $40) + (250  $53)).

You must concentrate and read numerical questions carefully to ensure that you do not miss vital information.
If the answer you arrive at is among the available options, just take a moment to check that you've answered the
question properly, and have not fallen for one of the distractors.
If your answer is not amongst the available options then you must have gone wrong somewhere. Read the question
again carefully and see if you have missed anything, or if there are any clues that will allow you to eliminate any wrong
answers. Remember to guess if all else fails!
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Skills practice
1. Practise as many multiple choice questions as possible.
2. If you don't know the answer to a question, don't just go to the answer at the back or just guess –
use the three-step approach described above.
3. Practise as many different types of objective test question as you can.
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Skill 3 – Effective use of your time in the exam
It is important that you use your time wisely in the exam itself.
1 Before the exam

In order to start the exam in the best frame of mind, you should ensure that you are practically prepared.
STEP Before the exam

1 Make sure that you are registered with the ACCA and that your exam centre has your exam
booking. This is important because you cannot sit the exam if you are not a registered student.
STEP At the beginning of the exam

2 You want to make the start of the exam as stress-free as possible so ensure you have the following
available:
 Photo identification and exam attendance docket
 Pens and a calculator
2 Exam approach
 What you SHOULD NOT do

Panic! You have two hours to answer 50 questions. This equates to approximately 2.4 minutes per question. For many
questions you will get the answer straight away and so you are likely to have a bit more time to think about some of the
others. The examining team has commented that a number of students struggle with the exam because they rush
through the questions to avoid running out of time, and make mistakes as a result.
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It is important to start the exam positively and keep focused to maximise the use of your time.
STEP Work through questions systematically

3 Start at question 1 and begin answering from there working through questions in order.
If you find a question that you don't know the answer to and want to come back to it later then go onto
the next question.
STEP Monitor your time

4 Do a quick check after each half hour to assess how well you are managing your time. You should
aim to have completed approximately 13 questions after the first 30 minutes, 25 after the first hour
and 38 after an hour and a half.
If you are behind on these targets then you should try and move through the questions at a faster rate.
It may be necessary to move on more quickly from questions that you are struggling with so you get a
chance to make a considered attempt at all of the questions.
STEP Check your exam before the end

5 Having gone through the exam once you should:
1. Go back to any unanswered questions and make your best attempt at an answer.
2. Go through the exam a second time checking you are happy with all the options you have
selected.
If you have taken this logical and systematic approach you should have given yourself the best chance of doing well in
the exam.
3 Specific guidance for your computer-based exam (CBE)

You need to be systematic in your approach. There are however some other guidelines to ensure that you make the
most of the CBE format of the exam.
Starting the exam

To start the exam you will need to do the following:
 Instructions – there are three screens of instructions; read these carefully so that you know
what you have to do to complete the exam.
 Launch the exam – please don't click this screen until you have been advised to do so by your
invigilator AND you are ready because this starts the exam and starts the timer.
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Answering the questions

The exam will start at question 1. You can progress through the questions by clicking <Next> but you
can also go back by clicking <Previous>. When you answer the questions you must follow the
procedure:
 Enter your answer.
 If you are unsure of an answer then just progress to the next question – you can go back to it
later.
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At the end of the exam

At the end of the exam you should check your answers and ensure that you have submitted an
answer for every question as well as double checking any answers you were not sure of.
You have two ways of navigating the questions:
1. Clicking <Previous> to work back through the questions one by one; or
2. Using the drop down menu which shows all the questions and indicates whether an answer
has been submitted or not; clicking on the question number will take you directly to that question.
Closing your exam session

Once you are satisfied that you are happy with your answers, if you have time left in the exam then
you have a couple of options to finish your exam session (subject to any advice you get from the
invigilators in your exam centre).
1. Let the time on the on screen clock run down to zero and the exam session will end
automatically; or
2. Click <Exit> – you will be asked to <Confirm> this so you can not accidentally end your session
early.
Then follow any instructions given by the invigilators with regard to recording your result.
You have now finished your exam.
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4 Some final tips

 If you find a particularly difficult question or one with long calculations, move on and come back to it later in
the remaining time – it is important that you do not run out of time with easier questions later in the exam.
 Keep an eye on the clock so that you can pace yourself.
 Be well prepared for the exam day so that you can concentrate on doing the exam rather than the
administration around it.
 Get to your exam venue in plenty of time so that you are relaxed when you get into the exam room.
Skills practice
1. Always check your answers through before looking at the solutions in the back of the book.
2. Complete the mock exams in the Practice & Revision Kit to time towards the end of your revision
phase.
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Syllabus Guide Detailed Outcomes

Having studied this chapter you will be able to:
 Describe the purpose of management information: planning, control and decision making.
 Describe the features of useful information.
 Describe the nature, source and importance of both financial and non-financial information for managers.
 Describe management responsibilities for cost, profit and investment and their effect on management information
and performance measurement.
 Explain and illustrate the concept of cost units.
Exam Context
The contents of this chapter are mainly to serve as an introduction to the FIA Managing Costs and Finance exam.
Although this chapter is an introductory chapter it is still highly examinable. You should expect questions on every
chapter including this one.
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1: MANAGEMENT INFORMATION
Overview
Information for planning
Information for control

Role of the management accounting
function
Information for decision

making
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1 Management accounting
Purpose
1.1 The purpose of management accounting is to assist management in running their business
to achieve an overall objective.
1.2 What could a business have as its objective?
1.3 The assumption that will usually be made in your studies is that companies wish to
maximise the wealth of their shareholders.
Usually this will be achieved by maximising profit.
2 Planning, control and decision making

2.1 Information for management accounting is likely to be used for planning, control and
decision making.
2.2 Planning  establishing objectives

 selecting appropriate strategies to achieve those objectives
2.3 Long-term strategic planning (corporate plan) involves determining an organisation's

long-term goals and then selecting appropriate strategies to attain those objectives.
2.4 Shorter term planning involves developing tactical and operational plans in order to
achieve the goals of the corporate plan.
2.5 Control  There are two key mechanisms within the control process.
(1) Actual performance is compared with planned performance of the
organisation as set out in the detailed operational plan and
adjusted in response.
(2) The corporate plan is reviewed to reflect significant new
information.
2.6 Decision making  Managers at all levels within an organisation make
decisions.
It is the role of management accountants to provide information so
that management at whatever level can reach an informed decision.
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3 Role of management accountant

Main areas
Management accounting can be broken down into five main areas.
3.1 Costing
What is the cost of goods or services?
We need to know this to calculate the profit that a unit will generate, to help set prices and to
value inventory in the balance sheet.
3.2 Decision making

There are many decisions managers may have to make such as:
 What should we produce?
 How should we finance the business?
 Is a project worthwhile?
3.3 Planning
Planning involves defining objectives as well as assessing future costs and revenues to set
up a budget.
Planning is essential in assessing the purchasing/production requirements of the business.
3.4 Control
Once plans have been made, they must be reviewed to ensure the company is following
them and any identified inefficiencies must be addressed.
3.5 Performance evaluation

The performance of divisions and employees can be assessed by comparing their
performance against budgets or divisional or individual targets.
Lecture example 1 Preparation question
Required
What information may the managers of a business need?
Solution
Financial information Non-financial information
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4 Qualities of good management information

Good management information helps managers make informed decisions. The qualities of good
information are outlined below – in the form of a mnemonic 'accurate'.
Quality Example
A Accurate Figures should add up, the degree of rounding should be appropriate,
there should be no mistakes.
C Complete Information should include all relevant information – information that is

correct but excludes something important is likely to be of little value. For
example external data or comparative information may be required.
C Cost- It should not cost more to obtain the information than the benefit derived
beneficial from having it.
U User- The needs of the user should be borne in mind, for instance senior
targeted managers may require summaries.
R Relevant Information that is not relevant should be omitted.
A Authoritative The source of the information should be reputable and reliable.
T Timely The information should be available when it is needed.
E Easy to use Information should be clearly presented, not excessively long, and sent
using the right communication channel (email, telephone, intranet, hard-
copy report etc).
5 Cost units and cost centres

5.1 A cost unit is a unit of product or service which has costs attached to it. The cost unit is the
basic control unit for costing purposes.
5.2 Cost centres are the essential 'building blocks' of a costing system. They are a production
or service location, function, activity or item of equipment. They act as a collecting place for
overheads before they are analysed further.
5.3 A cost centre is also known as a responsibility centre. Other responsibility centre types:
 A profit centre is accountable for costs and revenues.
 A revenue centre is accountable for revenues only.
 An investment centre is a profit centre with additional responsibilities for capital
investment.
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6 Chapter summary
Section Topic Summary
1 Management accounting The purpose is to assist management in running
their business to achieve an overall objective.
2 Planning, control and Information is used in a business for planning,
decision making control and decision making.
3 Role of management This includes costing, decision making, planning,
accountant control and performance evaluation.
4 Qualities of good Mnemonic ACCURATE
management information
5 Cost units and cost centres Cost unit = unit of product or service which has
costs attached to it.
Responsibility centres: Cost, revenue, profit,
investment
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7 Overview summary

 Establish objectives
 Strategies to achieve
objectives
Role of the management accounting function
 Assist management in running the business
– Costing
– Decision making
– Planning
– Controlling  Comparison of actual and
– Performance evaluation planned performance
Information for decision making

 Aid informed decision making
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Chapter 1 Questions
1.1 Management accountants may provide information for management on which of the
following?
(i) Cost of goods and services
(ii) Actual costs compared to expected costs
(iii) Expected profits and production plans
 (i) only
 (i) and (ii) only
 (ii) and (iii) only
 (i), (ii) and (iii) (2 marks)
1.2 Which of the following statements about qualities of good information is NOT correct?
 It should be relevant for its purpose.
 It should be completely accurate.
 It should be taken from a reliable source.
 It should be timely. (2 marks)
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Chapter 1 Answers
1.1 The correct answer is: (i), (ii) and (iii)
1.2 The correct answer is: It should be completely accurate.
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END OF CHAPTER
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The role of information
technology (Home study)

 Explain the role of information technology in management information.
 Describe methods of capturing, processing, storing and outputting cost and management accounting data by
computer.
Exam Context
This is another introductory chapter but, as with Chapter 1, you should expect questions on every chapter in your
examination.
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2: THE ROLE OF INFORMATION TECHNOLOGY (HOME STUDY)
Overview

technology
Capturing and processing

cost and management
accounting data
Storing cost and

Role of the management accounting function management accounting
f data
Outputting cost and

Management information management accounting
systems data
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1 The role of information technology

1.1 Computers are widely used for data processing because they have certain advantages over
humans.
1.2 Speed. Computers can process data much more quickly than a human, which will result in
cost savings where a computer can process large volumes of data much quicker than if it
were processed manually.
1.3 Accuracy. Computers usually provide much more accurate data processing providing they
are set up properly. Humans tend to be more prone to error.
1.4 Volume and complexity. As businesses grow and their operations become more complex,
so do the data processing requirements of the business, since managers require more
detailed information about business operations. This level of processing would not be
managed effectively enough if it were to be done manually.
1.5 Access to information. The use of databases and the ability to link a number of users
via some form of network improves the distribution of information within and beyond the
organisation.
2 Capturing and processing cost and management

accounting data
2.1 The most common method of data input is to use a keyboard and mouse.
2.2 The visual display unit (VDU) otherwise known as the monitor. Using the graphical user
interface which includes, windows, icons, pull down menus, the VDU allows the user to
review the data they have input and retrieve information.
2.3 Other common methods of inputting data include:

 Magnetic ink character recognition (MICR)
 Optical mark reading
 Scanning
 Barcodes
 Electronic funds transfer at the point of sale (EFTPOS)
3 Storing cost and management accounting data

3.1 Disks
There are two main types of disk which can be used to store data on. The internal hard disk
found in almost all computers, and zip disks which are removable, but require a special zip
drive to be used.
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3.2 Tape storage

Tape cartridges are a means of backing up large volumes of data and are widely used
today. Fast tapes can be used to create a back up file quickly and are referred to as tape
streamers.
3.3 CD-ROM (Compact Disc – Read Only Memory)

CD-ROMs are widely used by organisations as a meaning of storing data. The speed of the
CD-ROM is relevant to how fast data can be retrieved.
3.4 DVD (Digital Versatile Disc)

Digital Versatile Disc (DVD) technology was encouraged by the advent of multimedia files
with video graphics and sound – requiring greater disk capacity.
3.5 Memory stick or 'pen drive'

A memory stick or pen drive is a physically small external storage device usually connected
via a USB port.
4 Outputting cost and management accounting data

4.1 Printers
There are a range of different types of printers, but the most common are laser printers and
inkjet printers. Laser printers print a whole page at a time whereas inkjet printers work by
sending a jet of ink on to the paper to produce the required characters.
4.2 The VDU or monitor

As well as being used with keyboards and a mouse for data input they are also a mean of
outputting data where the volume of output required is relatively low.
5 Management information systems

Definition
5.1 A management information system (MIS) is defined as a collective term for the hardware
and software used to drive a database system with the outputs, both to screen and print,
being designed to provide easily assimilated information for management.
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6 Chapter summary
1 Role of information Computers are used to process large and complex
technology volumes of data to provide information for
management to monitor the performance of the
organisation.
2 Capturing and Data can be captured and processed using
processing cost and keyboard, visual display units, magnetic ink
management accounting character recognition, optimal mark reading,
data scanners, barcodes and EFTPOS systems.
3 Storing cost and Data can be stored on disks, storage tapes,
management accounting CD-ROMs, DVDs, and memory sticks.
data
4 Outputting cost and Inkjet and laser printers are used to obtain
management accounting information from a computer along with the use of
data the VDU.
5 Management information Management information systems are a collection
systems of methods used to retrieve information for
managers to help with planning, decision making
and controlling the organisation.
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7 Overview summary

technology
Capturing and processing cost and

management accounting data
 Keyboard and mouse
 VDU
 Scanning
The role of information technology  Barcodes
 Speed  Optical mark reader
 Accuracy  EFTPOS
 Volume and complexity
 Access to information
Storing cost and management

accounting data
 Disks
 Tape storage
Management information systems  CD-ROM
 Used to drive a database system  DVD
 A system making use of available  Memory stick
resources to provide managers with
the information they need
Outputting cost and management

accounting data
 Printers
 VDU
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Chapter 2 Questions
2.1 Which of the following is NOT an advantage that computers have over humans?
 Computers will always provide more accurate information.
 Computers have the ability to process higher volumes of data.
 Computers will generally be more time efficient.
 Computers will be able to access information more readily. (2 marks)
2.2 Which of the following is NOT something a basic keyboard includes?

 Ordinary typing keys
 Cursor control keys
 Keys to communicate with the operating programme
 Numeric keyboard (2 marks)
2.3 Which of the following are characteristics of management accounting information?

(i) Non-financial as well as financial
(ii) Used by all stakeholders
(iii) Concerned with cost control only
(iv) Not legally required
 (i) and (iv)
 (ii) and (iii)
 (i), (ii) and (iii)
 (ii), (iii) and (iv) (2 marks)
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Chapter 2 Answers
2.1 The correct answer is: Computers will always provide more accurate information.
2.2 The correct answer is: Keys to communicate with the operating programme
2.3 The correct answer is: (i) and (iv)
END OF CHAPTER
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Cost classification

 Describe the variety of cost classifications used for different purposes in a cost accounting system, including by
responsibility, function, direct/indirect, behaviour.
Exam Context
Cost classification is one of the key areas of the syllabus and as well as providing you with key terminology for many of
the following chapters, is also very examinable.
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3: COST CLASSIFICATION
Overview
Cost classification
Cost unit
Classification by function
Production costs Non-production costs
Materials Materials
Further classification
by nature
Labour Labour
Overheads Overheads
Direct Indirect
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1 Cost classification
1.1 Cost classification is the arrangement of cost items into logical groups; for example by their
nature (materials, wages etc) or function (administration, production etc).
The eventual aim is to determine the cost of producing a product/service.
2 Production and non-production costs

Classification by function
2.1 Classification by function involves classifying costs as production/manufacturing costs,
administration costs or marketing/selling and distribution costs.
At the highest level there could be groups of production and non-production costs.
Pool of total costs

Costs associated with the All other costs incurred
production of goods and in the business
services, from the supply of
raw materials to the
warehousing of finished goods
2.2 Costs can then be broken down further into material, labour and overheads elements.
Production costs
Materials Labour Overheads
Cost of materials that Cost of the workforce Cost of any

are used in making the used in making overheads required
product or service the product to support the
production process
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2.3 Non-production costs can also be broken down further by function to aid analysis.
Non-production costs
Administration Selling Distribution Finance
All other costs All costs incurred All costs incurred All costs incurred
incurred in in promoting and in making the to finance the
managing the retaining packed product business
organisation customers ready for despatch
and delivery to the
customer
2.4 The eventual aim of costing is to determine the cost of producing a product or service.
This information is important to management for many reason; however, the most important
reasons are as follows:
(a) Profitability analysis
(b) Selling price determination
(c) Inventory valuation purposes
Lecture example 1
Cost unit
A cost unit is a unit of product or service in relation to which costs may be ascertained.
The cost unit should be appropriate to the type of business. For each of the businesses below
suggest an appropriate cost unit.
Solution
Business Appropriate cost unit
Car manufacturer
Ball bearing manufacturer
Builder
Management consultant
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3 Types of costs/expense
$
Production/manufacturing costs X
Administration costs X
Selling and distribution costs X
Total expenses X
Only the production costs will be relevant in costing.
Direct costs
Direct costs are those costs which can be specifically identified with and allocated to a cost
unit.
TOTAL DIRECT COSTS = PRIME COST
Lecture example 2
Required
Suggest two examples of a direct cost.
Solution
Lecture example 3
Indirect production costs
Indirect production costs are those costs which are incurred in the course of making a
product/service but which cannot be identified with a particular cost unit.
For example:
TOTAL INDIRECT COSTS = OVERHEADS
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TOTAL PRODUCTION COST = PRIME COST + OVERHEADS

Required
Suggest two examples of indirect costs.
Solution
Lecture example 4
Non-manufacturing/production costs
These are the other costs required to run the business.
For example:
TOTAL COSTS = MANUFACTURING COSTS + NON-MANUFACTURING COSTS
Required
Suggest two examples of non-production costs.
Solution
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Lecture example 5
Think about the costs of making a chocolate bar.
Required
Identify two examples of each of the following types of costs
 Manufacturing costs
– Direct costs
– Indirect costs/overheads
 Non-manufacturing costs
Note. Classification will depend on circumstances; there are no hard and fast rules.
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4 Chapter summary
1 Cost classification Cost classification is the arrangement of cost items into
logical groups by their function or by their nature.
The eventual aim of costing is to determine the cost of
producing a product/service.
2 Production and Costs can be split by their function into production and
non-production costs non-production costs.
Production costs can be split further by their nature into
material, labour and overhead costs.
3 Types of Direct costs are costs that can be directly traced to a
costs/expense cost unit.
Indirect costs are costs that are incurred in production
but cannot be directly linked to a cost unit.
A cost card can be built up for an individual cost unit.
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5 Overview summary
Cost classification
Cost unit
Unit of product or
service in relation to
which costs may be
ascertained Classification by function

 Associated with production of  All other costs in a business
goods and services
Materials Materials
 Cost of material used  Cost of material
in production Further classification used elsewhere
by nature in the business
Labour
Labour
 Cost of workforce
 Cost of work
used in production
force used
elsewhere in
the business
Overheads
 Cost of overhead
required to support
production Overheads
 Cost of
overhead
Indirect
Direct required to
 Incurred as a result of
 Directly traced support
making a product but
to product function
not directly traceable
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Chapter 3 Questions
3.1 Which of the following is a definition of a cost unit?
 Functions or locations for which costs are ascertained and related to cost units for
control purposes
 Amounts of expenditure attributable to various activities
 A segment of the organisation for which budgets are prepared
 A unit of product or service in relation to which costs may be ascertained (2 marks)
3.2 Which of the following are indirect expenses?

(i) The depreciation of a machine on an assembly line
(ii) The hire cost of maintenance tools or equipment for a factory
(iii) The salary of a supervisor for the assembly line
(iv) Primary packing materials (eg cartons and boxes)
 (i) only
 (i) and (ii)
 (i), (ii) and (iii)
 (i), (ii), (iii) and (iv) (2 marks)
3.3 Which of the following items might be a suitable cost unit within the sales department of a
manufacturing company?
Item 1: Sales commission
Item 2: Order obtained
Item 3: Unit of product sold
 Items 2 and 3
 Item 1 only
 Item 2 only
 Item 3 only (2 marks)
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Chapter 3 Answers
3.1 The correct answer is: A unit of product or service in relation to which costs may be
ascertained
This is a definition of a cost unit.
3.2 The correct answer is: (i) and (ii)
These are both indirect expenses, because these costs cannot be traced directly to the
products made using them. Answer (iii) would be an indirect labour cost.
3.3 The correct answer is: Items 2 and 3
Either calculating the cost of each order obtained or the cost of per unit of each product sold
would be suitable cost units within the sales department, whereas sales commission is an
item of expenditure.
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END OF CHAPTER
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Cost behaviour

 Explain and illustrate the nature of variable, fixed, stepped fixed, and mixed (semi-variable) costs.
 Use high–low analysis to separate semi-variable costs into their fixed and variable elements.
 Use variable, fixed and semi-variable costs in cost analysis.
 Analyse the effect of changing activity levels on unit costs.
Exam Context
As per Chapter 3 (Cost classification) cost behaviour is a key area of the Management Accounting syllabus and you
should expect it to be examined independently and as part of later chapters.
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4: COST BEHAVIOUR
Overview
Cost behaviour
Variable cost Fixed cost Stepped fixed cost

(VC) (FC)
Mixed cost
Cost estimation
High–low method
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4: COST BEHAVIOUR
1 Introduction
1.1 A business needs to know how costs behave with changes in output so that predictions of
costs can be made.
It is expected that costs will increase as production increases (ie as output increases) but
the exact way costs behave with output may vary.
Lecture example 1
Types of cost behaviour
Required
Draw a line to illustrate the behaviour of each of the following types of costs.
(a) Fixed cost
Total $
cost
Output (units)
(b) Variable cost
Total $
cost
Output (units)
1.2 Stepped costs

Stepped costs are those which are fixed within certain levels of activity. A sketch graph
would look something like this.
$
Total cost
Level of activity
1.3 An example would be rent costs, where accommodation required may increase as output
levels get higher.
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4: COST BEHAVIOUR
Mixed costs (also known as semi-variable costs)

1.4 These are costs which are part fixed and part variable. A sketch graph would look as below.
$
Total cost
Semi-variable cost
Variable part
Fixed part
Volume of output
1.5 An example would be phone bills, where the fixed cost would be the standing charge, and
the variable cost being the number of calls made.
1.6 If there is a linear relationship between output and total cost (TC) the relationship can be
found within this form:
Y = a + bX
Where Y is the dependent variable (eg total cost)
X is the independent variable (eg output)
a is the intersect on the Y axis (eg fixed cost)
b is the gradient of the line (eg variable cost per unit).
Therefore TC = FC + VC/unit  output
Cost behaviour and total unit costs

1.7 If the variable cost of producing a widget is $10 per unit then it will remain at that cost per
unit no matter how many units are produced.
1.8 However if fixed costs are $10,000, then the fixed cost per unit will decrease the more units
are produced.
1.9 One unit will have fixed cost of $10,000 per unit: if 5,000 are produced then the fixed cost
per unit will be $2. Thus as the level of activity increases the total cost per unit (fixed cost
plus variable cost) will decrease.
Determining the fixed and variable elements of semi-variable costs: the high–low
technique
1.10 There are several methods for identifying fixed cost elements and variable cost elements
within semi-variable costs. Each method only gives an estimate, and can therefore give
differing results from the other methods. The only method which is relevant for this unit is
the high–low technique.
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4: COST BEHAVIOUR
Lecture example 2
S and N recorded the following costs for the last four months.
Month Cost Production
$ volume
Units
1 106,000 7,000
2 115,000 8,000
3 112,300 7,700
4 97,000 6,000
Required
Calculate the costs that should be expected in month 5 when output is expected to be 7,500 units.
Ignore inflation.
Solution
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4: COST BEHAVIOUR
Lecture example 3
Required
Using the high–low method and the following information, determine the cost of electricity in June if
2,750 units of electricity are consumed.
Month Cost Electricity
$ consumed
Units
January 204 2,600
February 212 2,800
March 200 2,500
April 220 3,000
May 184 2,100
Solution
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4: COST BEHAVIOUR
Lecture example 4
A company has produced the following two cost budgets for the coming year but now realises that
output will exceed these predictions.
Volume (units) 18,000 20,000

$ $
Material 180,000 200,000
Labour 308,000 340,000
Power and maintenance 33,000 35,000
Rent, insurance and depreciation 98,000 98,000
Total cost 619,000 673,000
Required
Produce a budget for output of 23,000 units showing separately the budgeted cost for each type of
cost.
Solution
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4: COST BEHAVIOUR
2 Why record cost information?
Lecture example 5
It may seem more trouble than it's worth given all the possible classifications but there are
important reasons why costs need to be classified and recorded.
Required
Suggest reasons for classifying and recording costs.
Solution
(a)
(b)
(c)
(d)
(e)
Behaviour of manufacturing costs

2.1 With the linear assumption all costs can be categorised as either fixed or variable. This fits
together with previous definitions:
Direct costs
By their nature direct costs will be variable costs.
Indirect costs/overheads
Overheads can be fixed or variable
Fixed Variable
Direct costs X 
Production overheads  
Non-manufacturing costs  
Cost centres
2.2 A cost centre is any person, place or item of equipment that incurs costs. So cost centres
are the essential building blocks of a costing system. They act as a 'collecting place' for
certain costs before they are analysed further.
Profit centres
2.3 Some organisations work on a profit centre basis. A profit centre is similar to a cost centre
but is accountable for both costs and revenue. Not infrequently, several cost centres will
comprise one profit centre.
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4: COST BEHAVIOUR
Typical cost card for a cost unit – Wooden Duck

2.4
Q Price $ Value $
DIRECT MATERIAL
5 mm board 0.2 sq 4.60 per m2 0.920
metres
4 cm diam. wheels 4 18.20 per 100 0.728
Subtotal 1.648
Time Rate per hr Value $

DIRECT LABOUR
Cutter 1.5 mins 7.50 per hr 0.1875
Assembler 3 mins 6.80 per hr 0.3400
Painter 4 mins 8.20 per hr 0.5470
Packer 30 secs 5.00 per hr 0.0420
Subtotal 1.1170
TOTAL DIRECT COST (OR PRIME COST) 2.7650
PRODUCTION O/H Time Rate $ (OAR) Value $

Cutting 1.5 mins 1.45 per hr 0.036
Assembly 3 mins 3.41 per hr 0.170
Finishing 4.5 mins 1.25 per hr 0.094
Subtotal 0.300
TOTAL MANUFACTURING COST OR FACTORY COST

OR PRODUCTION COST 3.065
NON MANUFACTURING O/H

Administration/selling & distribution 0.10
TOTAL COST 3.165
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4: COST BEHAVIOUR
3 Chapter summary
1 Introduction Cost behaviour is the way in which costs are affected
by changes in volume of output.
A fixed cost will be unaffected by an increase or
decrease in volume of output.
A stepped cost is a cost which is fixed in nature within
certain volumes of output.
A variable cost is a cost that will vary with output. The
variable cost per unit is the same amount for each unit
produced.
The fixed and variable element of a mixed cost can be
determined by the high–low method.
2 Why record cost Cost information is important to an organisation's
information? success as it will help the management accounts to
provide information to management, which will enable
them to ensure products are being sold for a profit.
4 Formulae summary
Total costs = Fixed costs + (Variable cost/unit  Output)
High–low method:
(1) Find highest and lowest output and cost.
(2) Find the difference.
(3) Calculate the VC/unit.
(4) Substitute to find the FC.
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4: COST BEHAVIOUR
5 Overview summary
Cost behaviour
Group costs together according to how they

behave when output volume changes

(VC) (FC)
 Varies directly with the volume of  Unaffected by changes in volumes  Fixed within certain levels of output
output of output
$ $ $
Output Output Output
Mixed cost
 Contains a fixed and variable element
$
Total cost =
FC + (VC/unit  Output)
Output
Cost estimation
 Businesses need to estimate costs in the future
 To do so they need to break down a historic cost
into a VC and FC element
High–low method
(1) Select highest and lowest activity (output) and associated total cost
(2) Find the change in activity and cost
Change in cost
(3) Calculate VC/unit
Change in activity
(4) Substitute back into: TC = FC + VC/unit  output
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4: COST BEHAVIOUR
Chapter 4 Questions
4.1 A company has the following information about its total production costs:
Output Total costs
$
2,000 10,000
4,000 15,000
6,000 20,500
8,000 28,000
What are the company's fixed costs?
 $2,000
 $4,000
 $10,000
 $18,000 (2 marks)
4.2 The following data relates to the overhead expenditure of a control cleaner at two activity
levels: when 12,750 m2 is cleaned, the overheads incurred were $73,950 and when 15,100
m2 is cleaned, the overheads incurred were $83,585. What is the best estimate
of the overheads if 16,200 m2 are to be cleaned?
 $88,095
 $89,674
 $93,960
 $98,095 (2 marks)
4.3 A business has collected data about a cost at four different levels of production: when
production was 100 units, the cost totalled $1,000; when production was 150 units, the
cost totalled $1,500; when production was 200 units, the cost totalled $1,500 and when
production was 250 units, the cost totalled $2,000. Which of the following best describes the
behaviour of this cost?
 A stepped cost
 A fixed cost
 A variable cost
 A semi-variable (or mixed cost) (2 marks)
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4: COST BEHAVIOUR
4.4 A business has collected data relating to a particular cost incurred at four different activity
levels: when the output was 5 units the cost totalled $20; when the output was 10 units the
cost totalled $35; when the output was 50 units the cost totalled $155 and when the output
was 75 units the cost totalled $230. Which of the following best describes the behaviour of
this cost?
 A semi-variable cost
 A fixed cost
 A production cost
 A variable cost (2 marks)
4.5 If an assembly line supervisor is paid a salary of $100 each week, and an extra 10c for
every unit of production made in the week, this wage cost could be described as:
 A semi-variable (mixed) cost
 A fixed cost
 A variable cost
 A stepped cost (2 marks)
4.6 A company's weekly costs ($C) were plotted against production level (P) for the last eight
weeks and a regression line calculated to be C = 2000 + 500P. Which statement about the
breakdown of weekly costs is true?
 Fixed costs are $2,000. Variable costs per units are $10.
 Fixed costs are $500. Variable costs per unit are $8.
 Fixed costs are $500. Variable costs per unit are $2,000.
 Fixed costs are $2,000. Variable costs per unit are $500. (2 marks)
4.7 The following is a graph of cost against volume of output. What might this graph represent?
Cost
Volume of output
 Electricity bills made up of a standing charge and a variable charge
 Bonus payments to employees when production reaches a certain level
 A salesperson's commissions payable per unit up to a maximum amount of
commission
 Bulk discounts on purchases, when purchases reach a certain level (the discount
being given on all units purchased) (2 marks)
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4: COST BEHAVIOUR
4.8 A company makes one delivery per week to all its customers. The cost of these deliveries is:
 A production overhead
 A fixed selling and distribution cost
 An administration cost
 A variable selling and distribution cost (2 marks)
4.9 ABC Co has recorded the following data in the two most recent periods: during period 1,
costs totalling $13,500 were incurred in making 700 units and during period 2, costs totalling
$18,300 were incurred in making 1,100 units. The best estimate of ABC Co's fixed costs per
period is:
 $5,100
 $4,800
 $13,500
 $15,900 (2 marks)
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4: COST BEHAVIOUR
Chapter 4 Answers
4.1 The correct answer is: $4,000
High–low method
Output $
High 8,000 28,000
Low 2,000 10,000
6,000 18,000
18,000
Variable cost per unit = = $3 per unit
6,000
TC = FC + VC/unit  output
Substitute at the highest (or lowest) output.
28,000 = FC + $3  8,000
28,000 – 24,000 = FC
$4,000 = FC
You should have calculated this solution using the high–low method to calculate the fixed
costs ($21,675) and variable cost per m2 ($4.10/m2) then used these to calculate the total
overhead cost of cleaning 16,200 m2.
4.3 The correct answer is: A stepped cost
This is a stepped cost, because the cost remains fixed within a certain range of activity, and
then 'steps up' to a higher cost when the activity level increases beyond this range.
4.4 The correct answer is: A semi-variable cost
A semi-variable cost is a cost which contains both a fixed and a variable element. It can be
shown that this is a semi-variable cost either by calculating the equation of the line using the
high–low method using simultaneous equation or by plotting a scattergraph of the cost
against output.
4.5 The correct answer is: A semi-variable (mixed) cost
As the salary contains both a fixed elements (the basic wage) and a variable element (the
10c paid per unit) the wage expense is a semi-variable (or mixed) cost.
4.6 The correct answer is: Fixed costs are $2,000. Variable costs per unit are $500
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4: COST BEHAVIOUR
4.7 The correct answer is: Bulk discounts on purchases, when purchases reach a certain level
(the discount being given on all units purchased)
The first option: Standard charge (fixed cost) would be reflected by intercept a y-axis at a
point above zero.
The second option: Costs would increase more steeply rather than flatten off.
The third option: Costs would rise with output up to the maximum and then become flat.
The fourth option: Costs increase evenly with price until the discount point. The reduced
price then relates to all purchases so total costs fall. Since the price (given by the gradient)
is reduced the gradient is flatter.
4.8 The correct answer is: A fixed selling and distribution cost
The deliveries will only occur when a sale has been made – it is therefore a selling and
distribution cost.
Presuming the number of customers remains fairly constant, the costs will be constant over
the year and will accrue over time; therefore the cost is fixed.
You should have calculated this using the high–low method (or simultaneous equations).
High/Low method:
Units Cost ($)
High output 1,100 18,300
Low output 700 13,500
Difference 400 4,800
Variable cost per unit = $4,800/400 = $12 per unit
Substitute in high values:
Total cost 18,300
Variable cost ($12  1,100) (13,200)
Fixed cost 5,100
END OF CHAPTER
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Materials

 Describe the main types of material classification.
 Describe the procedures and documentation required to ensure the correct authorisation, coding, analysis and
recording of direct and indirect material costs.
 Explain, illustrate and evaluate the FIFO, LIFO and periodic and cumulative weighted average methods used to
price materials issued from inventory.
 Calculate material input requirements, and control measures, where wastage occurs.
 Describe the procedures required to monitor inventory and to minimise discrepancies and losses.
 Explain and illustrate the costs of holding inventory and of being without inventory.
 Explain, illustrate and evaluate inventory control levels (minimum, maximum, re-order).
 Calculate and interpret optimal order quantities.
 Explain the relationship between the materials costing system and the inventory control system.
Exam Context
Materials cost is a key cost within a manufacturing environment. This is an important part of the syllabus and you need
to feel comfortable with all relevant calculations.
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Overview
Materials
Ordering, receipt and issue Monitoring of inventory Value inventory using FIFO,
of raw materials levels LIFO and weighted average
Inventory control levels
EOQ Re-order level

Minimum level
Maximum level
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1 Introduction
1.1 Materials are an important component of any production process and often make up a
significant proportion of costs.
Classifications of inventories
 Raw materials
 Spare parts/consumables
 Work in progress
 Finished goods
2 Buying materials
2.1 The process of buying materials is simple and straightforward. It can be illustrated using the
following diagram.
Purchase
Stores/production
requisition
Identify supplier
Purchasing/Buying
department
Order goods
Receive goods
(Goods Received Stores
Note)
Pay for goods Accounts
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3 Methods of inventory valuation

3.1 Traditionally, inventory of materials is kept to safeguard against uncertainty (eg supplier
delivery times or quality, production needs).
Lecture example 1
Required
Why do businesses maintain inventory of materials? The main reasons are:
Solution
(a)
(b)
(c)
(d)
It is, however, undesirable for inventory levels to be kept higher than necessary because
holding costs will become expensive. The problem exists, therefore, of ensuring that
sufficient and adequate levels of inventory are maintained without incurring unnecessary
costs.
Lecture example 2
A number of methods have developed to deal with valuing materials issues and inventory.
Required
Describe the approach to each of the following methods:
(a) FIFO
(b) LIFO
(c) Cumulative weighted average
Solution
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Lecture example 3
Inventory on hand at 1 January 20X3 was 6,000 litres, valued at $4,200.
Production and sales information for the following three months was as follows:
Production Sales
Litres Cost Litres
$
Opening inventory 6,000 4,200
1 January 4,000 3,000
25 January 7,000
1 February 8,000 6,560
20 February 6,000
1 March 7,000 6,160
15 March 8,000
Required
Calculate the value of closing inventory using the following methods:
(a) FIFO
(b) LIFO
(c) Cumulative weighted average
Solution
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Which method is correct?

3.2 There is no right answer here, but consider the following:
(a) Oldest inventory is likely to be used first – use FIFO.
(b) FIFO is not useful to production managers as issues are made at historic cost, not
cost to replace, which distorts production managers' view of actual material cost.
(c) LIFO avoids the problem in (b).
(d) Weighted average price is a compromise and easier to calculate.
4 Inventory control
4.1 We are considering the regulation of inventory levels. There are a number of issues to
consider.
Locating inventory
4.2 The warehouse should be set out in an orderly and logical manner with items easy to find.
4.3 For each item of inventory a inventory record card should be set up and kept in the costing
department.
Inventory Record Card

Control qualities
Material/Item description ............................................. Maximum level ..................................................
Material/Item code ............................................................ Minimum level ...............................................
Stores location ref ............................................................ Re-order level ........................................
Receipts Issues Physical Allocations Orders Free inventory

inventory balance
Date Ref Qty Price Date Ref Qty Price Date Ref Qty Date Ref Qty
'Allocations' means inventory to be given out (eg to a job).

'Orders' means those which have been placed and the company is waiting for delivery.
Free inventory balance = Physical inventory + Outstanding orders – Allocations
4.4 To ensure inventory levels are high enough for expected production two methods are most
commonly used.
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4.5 Three control levels are calculated from historical records:

(a) Re-order level = maximum usage  maximum lead time (Lead time is the time
between the issue of a purchase order and receipt of goods.)
This is set so that in theory it is not possible to run out of inventory.
(b) Minimum level = re-order level – (average usage  average lead time)
This is the level below which inventory should not normally fall.
(c) Maximum level = re-order level + re-order quantity – (minimum usage  minimum
lead time)
This is the level above which inventory should not normally rise.
Additional terminology:
(d) Average inventory = minimum inventory + 0.5 re-order quantity
The average inventory formula assumes that inventory levels fluctuate evenly
between the minimum (or safety or buffer) inventory level and the highest possible
inventory level (the amount of inventory immediately after an order is received).
(e) Re-order quantity
This is the quantity of inventory which is to be ordered when inventory reaches the
re-order level. It can be calculated as the economic order quantity (EOQ).
(see Section 5).
Lecture example 4
An order has been placed in the cutting department. The order delivery could take between two
and four weeks and the usage of material fluctuates from a minimum of 3,000 units to 5,000 units
per week.
Required
Calculate the re-order level.
Solution
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5 Economic order quantity (EOQ) (also called optimum

order quantity or re-order quantity)
5.1 Having established re-order level, we need to set an order quantity. Again the aim is to
minimise associated inventory costs.
Formula
2CoD
5.2 EOQ =
Ch
Where Co = fixed cost per order

D = annual demand
Ch = annual holding cost of one unit of inventory
Lecture example 5
Some of the above terms need further consideration.
Required
Identify examples of the following costs.
(a) Holding costs
(b) Ordering costs
5.3 A part of the holding cost can be the 'cost of capital', ie the tying up of capital (cash) when
purchasing the inventory on which interest is being lost.
Demand per annum (d)

5.4 Order costs = cost per order 
Quantity ordered (Q)
Quantity ordered (Q)
Average holding costs = holding cost for 1 item per year  ( )
2
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Lecture example 6
You have been helping the purchasing department to investigate the costs of ordering and holding
DVD players. The annual demand from the department store is 30,000 units and the costs of
placing one order comprise administration costs of $8.75 and purchase department costs of $10.
The cost of holding one video recorder for the year comprise administration costs of $0.125 and
warehouse costs of $0.375.
Complete the table below.
Order No. of orders Ordering Average Total
quantity per year costs holding ordering
Units per year costs per & holding
$ year costs
$ per year
$
1,500
1,200
750
600
400
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Lecture example 7
Purchase price = $80/unit
Fixed cost/order = $50
Cost of capital = 10%
Monthly demand = 600 units
Required
Calculate the EOQ.
6 Accounting for materials costs

6.1 Purchase of materials:
Debit Materials (stores)
Credit Payables or Bank
6.2 Issue of direct materials to production:

Debit Production process/work-in-process (WIP)
Credit Materials inventory
MATERIALS INVENTORY
(1) Materials (2) Issues to
purchased X production X
C/d closing
inventory X
X X
B/d closing
inventory X
6.3 Issue of indirect materials:
Debit Production overhead control
Credit Materials
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7 Chapter summary
1 Introduction Inventory control includes the functions of inventory
ordering and purchasing, receiving goods into store,
storing and issuing inventory, and controlling the level
of inventories.
2 Buying materials Every movement of material should be documented.
3 Methods of inventory There are three methods: FIFO, LIFO and WA.
valuation
4 Inventory control Inventory control levels can be calculated in order to
maintain inventories at the optimum level.
The three critical control levels are:
 Re-order level
 Minimum level
 Maximum level
5 Economic order Inventory costs include purchase costs, holding costs,
quantity ordering costs and stock out costs.
The economic order quantity (EOQ) is the order
quantity that minimises inventory costs.
6 Accounting for When accounting for materials the initial purchase
materials costs should be debit to materials and credit the bank or
payables.
As items are issued to production one should credit
materials and debit production.
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8 Formulae summary
8.1 Formulae to learn
 Re-order level = Max usage  Max no. of
per day days delivery
time
 Minimum level = Re-order level – (Average usage  Average no.
per day of days
delivery)
 Maximum level = Re-order + Re-order – (Min usage  Min no.
level quantity per day of days
delivery)
CoD C Q
 Total costs = + PD + H
Q 2
8.2 Formulae given in exam

2CoD
 EOQ =
CH
9 Journal summary
 Material purchase
Debit Materials inventory
Credit Cash/payables account
 Material issue
Debit Production process/WIP
Credit Materials inventory
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10 Overview summary
Materials
 Purchase requisition form Objective – to maintain  FIFO – assume materials
 Purchase order form accurate records of inventory are issued in order they
 Goods received note levels
were delivered
 LIFO – assume materials
issued in reverse order in
which they were delivered
 WA – calculate weighted
average price for all
inventory
EOQ
Theoretical model: Re-order level
 Quantity of units to order Minimum level
within each other to Maximum level
Theoretical ways of
minimise costs
managing inventory levels
 Purchase costs (=P  D) LEARN:
 Order costs (=Co  D/Q) Inventory levels
 Holding costs (=Ch  Q/2)
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Chapter 5 Questions
5.1 Are the following statements true or false?
True False
Lead time is the time between placing an order and receiving inventory.  
Re-order level is the size of a fresh order placed when inventory are
running low.  
(2 marks)
The following information relates to questions 5.2, 5.3 and 5.4

Data for a component part with inventory number B1422 is as follows:
Minimum usage 1,000 units
Maximum usage 2,250 units
Lead time (delivery time) 8–16 days
Re-order quantity 14,500 units
5.2 What is the re-order level?

 8,000 units
 36,000 units
 18,000 units
 27,000 units (2 marks)
5.3 The minimum inventory holding below which inventory should not fall (in units) is
(2 marks)
5.4 What is the maximum inventory holding above which inventory should not rise?
 32,500 units
 34,500 units
 42,500 units
5.5 What is the economic order quantity (EOQ) where monthly demand is 2,000 units, order
costs are $45 per order, inventory costs $2,160 per unit and the company's cost of capital
10%?
 70 units
 80 units
 90 units
 100 units (2 marks)
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5.6 A company has a cost of capital of 10%. It purchases inventory at $25 per unit. There is a
fixed cost of $30 for each order placed and monthly demand is 1,000 units.
What is the optimal order quantity (to the nearest unit)? (2 marks)
5.7 A manufacturing company uses 25,000 components at an even rate during the year. Each
order placed with the supplier of the components is for 2,000 components, which is the
economic order quantity. The company holds a buffer inventory of 500 components. The
annual cost of holding one component in inventory is $2.
What is the total annual cost of holding inventory of the component?
 $2,000
 $2,500
 $3,000
 $4,000 (2 marks)
5.8 JBJ Co had an opening inventory value of $41,400 (460 units valued at $90 each) on
1 February. The following receipts and issues were recorded during February.
9 February Receipt 1,050 units $100 per unit
20 February Receipt 690 units $88 per unit
28 February Issues 2,060 units
Using the LIFO method, what was the total value of the issues on 28 February?
 $193,940
 $194,800
 $195,000
 $194,520 (2 marks)
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Chapter 5 Answers
5.1 The correct answers are: The first statement is true and the second statement is false.
5.2 The correct answer is: 36,000 units
Re-order level = Max usage per day  Max number of days' delivery time (2,250  16)
= 36,000 units
Minimum level = Re-order level – (Average usage  Average lead time)

36,000 – ((2,250 + 1,000)/2  (8 + 16)/2) = 16,500 units
Maximum level = Re-order level + Re-order quantity – (Min usage  Min lead time)
36,000 + 14,500 – (1,000  8) = 42,500 units
5.5 The correct answer is: 100 units
2CoD 2  45  24,000
EOQ = = = 100 units
CH 216
5.6 The correct answer is: 537 units
2CoD
EOQ =
CH
C = $30
D = 1,000  12 = 12,000
H = 10%  $25 = 2.50
2  30  12,000
EOQ =
2.50
= 537 units
Total holding cost = Cost of holding one unit of inventory for one year  Average inventory
level
Total holding cost = $2  (2,000/2 + 500)
= $3,000
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Units $$
690 @ $88 = 60,720
1,050 @ $100 = 105,000
320 @ $90 = 28,800
2,060 194,520
END OF CHAPTER
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Labour

 Explain, illustrate and evaluate labour remuneration methods.
 Describe the operation of a payroll accounting system.
 Distinguish between direct and indirect labour costs.
 Describe the procedures and documentation required to ensure the correct coding, analysis and recording of
direct and indirect labour.
 Describe and illustrate the accounting for labour costs.
 Explain the relationship between the labour costing system and the payroll accounting system.
 Explain the causes and costs of, and calculate, labour turnover.
 Describe and illustrate measures of labour efficiency and utilisation (efficiency, capacity utilisation, production
volume and idle time ratios).
Exam Context
As with materials costs in Chapter 6, the labour cost within a manufacturing or a service environment is a key area of the
syllabus. You can expect to see questions on this topic in your exam.
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Overview
Labour costs
Methods of remuneration Labour turnover
Measuring labour activity
Accounting for labour costs
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Management accounting
1 Introduction
1.1 Labour costs can be said to include many items but as far as costing goes we are only
interested in the employees' gross pay.
2 Determining labour costs
Lecture example 1
Required
Identify two ways in which labour costs could be determined.
(a)
(b)
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3 Recording labour costs

3.1 This can be organised in a number of ways, but essentially the information flows will be as
follows:
Basic pay
3.2 This is decided by senior management set out in contract of employment and then
maintained on an employee record card.
Time records and performance records

3.3 Attendance records can be simple; ie just showing absence due to sickness, holidays or for
some other reason.
3.4 They can be more complex; for example, using clock cards to record time in and time out.
Idle time
3.5 This is a cost to the company as employees will still be paid. It may be recorded separately
on time sheets or separate idle time cards may be produced.
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Measurement by output
3.6 Pieceworkers are paid for what they produce recorded on a piecework ticket or an operation
card. It may record total units produced and number of rejects.
OPERATION CARD
Operator's name ............................................................... Total batch quantity .......................................
Clock no. .......................................................................... Start time ....................................................
Pay week no. ............................ Date ......................... Stop time ......................................................
Part no. ............................................................................. Works order no. ............................................
Quantity produced No. rejected Good production Rate $
Inspector ........................................................................... Operative .......................................................

Supervisor ........................................................................ Date ..............................................................
PRODUCTION CANNOT BE CLAIMED WITHOUT A PROPERLY SIGNED CARD
4 Overtime, bonuses and absences

Overtime
4.1 An extra amount of pay will accrue. An employee may be paid an overtime premium. This is
the excess of the hourly rate in overtime versus the normal hourly rate.
4.2 An overtime premium is treated as an indirect cost. There are two exceptions:
(a) Overtime worked at specific request of a customer – premium is now a direct cost to
job
(b) Overtime, worked regularly by a production department, which could be incorporated
into an average hourly labour rate
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Lecture example 2
Anna worked from 8:00am to 5:00pm with a one hour lunch break. Her normal hours are 9:00am to
5:00pm with a one hour lunch break. Basic wage is $15 per hour.
Required
What is the overtime premium, and how much has she earned that day? Overtime rate is a time
and a quarter.
Solution
Treatment of labour costs summary

4.3 Direct workers
(a) Basic hours
 Basic pay for normal hours worked = DIRECT COST
(b) Overtime hours
 General O/T working on production: Basic pay = DIRECT COST
(c) O/T premium = INDIRECT COST
 General O/T working on non-production (eg machine downtime, idle time):
Basic pay and O/T premium = INDIRECT COST
 Specific customer work: Basic pay and O/T premium = DIRECT COST
4.4 Indirect workers

(a) Basic hours
 Basic pay for normal hours worked = INDIRECT COST
(b) Overtime hours
 Specific customer work: Basic pay and O/T premium = DIRECT COST
 General O/T: Basic pay and O/T premium = INDIRECT COST
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4.5 Summary
DIRECT WORKERS INDIRECT WORKERS

Normal basic pay Direct cost Indirect cost
General production: Overtime Direct cost Indirect cost

– Basic pay element
General production: Overtime Indirect cost Indirect cost
– O/T premium
General non-production: Indirect cost Indirect cost

Overtime – Basic pay element
General non-production: Indirect cost Indirect cost
Overtime – O/T Premium
Specific overtime – Basic pay Direct cost Direct cost

element
Specific overtime – O/T Direct cost Direct cost
premium
Incentives and bonuses

4.6 Incentives and bonuses encourage staff to work harder.
Piecework
4.7 The more output you produce the more you will be paid.
4.8 Different rates may apply to different levels of production (differential piecework).
Bonuses
4.9 Bonuses are fairly common in practice. Some examples would be:
(a) Time saved bonus
(b) Discretionary bonus
(c) Group bonus
(d) Profit sharing schemes
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5 Standard hours
5.1 A standard hour is the pre-determined output from one worker for one hour. In other words
a standard hour is a 'quantity of work', not a period of time. Another name for a standard
hour is 'output hour'. Therefore your total standard hours produced are equal to how long,
according to standard, the actual production should have taken.
5.2 Actual units output  Standard time per unit = Standard labour hours
Lecture example 3
An employee makes 200 units of product A, 350 units of product B and 300 units of product C. The
standard time allowed per unit was:
A – 4 minutes
B – 2 minutes
C – 3 minutes
Required
Calculate the standard hours produced by the employee.
Solution
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6 Analysis of labour efficiency

6.1 Three ways of measuring labour performance or activity include the following.
Standard hours to make output
 Efficiency ratio (or productivity ratio) =  100%
Actual hours taken
Actual hours worked
 Capacity ratio =  100%
Hours budgeted
 Production volume ratio (or activity ratio) =  100%
Hours budgeted
6.2 Production Volume = Efficiency  Capacity
Lecture example 4
Barnes Co budgeted to make 13,000 standard units of output during a budget period of 26,000
hours (each unit should take two hours each).
During the period, the company actually made 14,000 units which took 35,000 hours.
Required
Calculate the efficiency, capacity and production volume ratios to one decimal place.
Solution
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Lecture example 5
The standard time allowed for product X is two hours and the standard labour rate is $5.00 per
hour. Last month the actual output of X was 1,000 units and the actual hours worked were 1,850.
Required
Calculate:
(a) The value in standard hours of last month's production
(b) The efficiency ratio as a percentage, to one decimal place
Solution
7 Labour utilisation rates (or ratios)

7.1 You can calculate the efficient use of labour by considering how actual working time is
utilised, that is to say whether the time is 'productive' or 'non-productive'.
7.2 An example is the idle time ratio which shows the proportion of labour hours which were lost
due to idle time.
Idle hours
Idle time ratio =  100%
Total hours
Lecture example 6
From a weekly payroll of 750 workers, the number of hours paid for were 6,000. During the week
machines were idle for 27 hours.
Required
Calculate the idle time ratio.
Solution
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8 Accounting for labour costs

8.1 Payment of labour:
Debit Labour control
Credit Bank
8.2 Charging of direct labour:
Debit Work-in-progress
Credit Labour control
8.3 Charging of indirect labour:
Debit Production overhead control
Credit Labour control
WAGES CONTROL ACCOUNT

(1) Bank etc (2) WIP
(actual wages) X (direct labour) X
(3) Production overheads X
(indirect labour)
Statement of profit or loss  X
X X
8.4 More information regarding the work in progress account and the production overhead
account can be found in Chapter 8 Absorption costing.
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9 Chapter summary
1 Introduction During the course of your studies we are only interested
in the gross labour costs of the organisation.
2 Determining labour Labour can be determined on a time-based system or a
costs piecework system.
3 Recording labour costs Labour charged on an hourly basis will usually be
recorded on some sort of time record.
Labour charged on a piecework system will usually be
recorded on an operation card.
4 Overtime, bonuses and Overtime is the extra amount that accrues when an
absences employee works in excess of the normal hourly
requirements.
Bonuses are offered as an incentive to encourage staff
to work harder.
What is treated as direct costs and what is treated as
indirect costs will depend on the type of labour worker
being considered.
5 Standard hours A standard hour is the predetermined output from one
worker for one hour. It is essentially how much the
worker 'should' produce each hour.
6 Analysis of labour Labour productivity is a measure of the efficiency with
efficiency which output has been produced.
Companies will monitor productivity as part of their cost
control procedures. You need to be able to calculate:
 Efficiency ratios
 Capacity ratios
 Production volume ratios
7 Labour utilisation rates High labour turnover will cause increased cost to a
business.
8 Accounting for labour Labour costs will be split between direct and indirect
costs costs and double entry will be used to record these
costs.
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10 Formulae summary
 Standard labour hours = Actual units of output  standard time per unit
Standard hours to make actual output
 Labour efficiency ratio =  100%
Actual hours worked
Actual hours worked
 Labour capacity ratio =  100%
Budgeted hours
Standard hours to make actual output
 Production volume ratio =  100%
Budgeted hours
Replacements
 Labour turnover rate =  100%
Average number of employees in period
11 Journal summary
 Wages paid
Debit Wages
Credit Bank/PAYE control account/NIC control account
 Direct labour
Debit Production/WIP
Credit Wages control account
 Indirect labour
Debit Production overhead account
Credit Wages control account
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12 Overview summary
Labour costs
Systems of recording and analysing labour

 Time-based system  Controllable causes/
 Piecework system uncontrollable causes
 Bonus/incentive scheme  Replacement costs/
preventative costs

 Production/productivity
– Efficiency ratio
– Capacity ratio
– Production volume ratio
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Chapter 6 Questions
6.1 Mary assembles 227 mobile phones in a production period. Wages are calculated on a
piecework basis at the following rates. What is Mary's wage for the period?
0–100 $5 per unit
101–150 $6 per unit
151–200 $7 per unit
201+ $8 per unit
 $1,366
 $1,435
 $1,476
 $1,816 (2 marks)
6.2 1,000 hours of direct labour is incurred in the production period. If labour is paid at a
standard rate of $7.50 per hour how is the cost of labour taken into production in the
accounting records?
 Debit Production overhead $7,500; Credit Wages control account $7,500
 Debit Work in progress $7,500; Credit Wages control account $7,500
 Debit Wages control account $7,500; Credit Work in progress $7,500
 Impossible to calculate (2 marks)
6.3 Paul, a direct worker, is paid $5 per hour and a rate of time and a half for overtime. Paul
completes 30 hours of overtime in the period, 10 hours resulting from a specific contract and
the remaining 20 hours on general overtime. What is the double entry to record the overtime?
 Debit Work in progress $225; Credit Wages control account $225
 Debit Work in progress $50, Debit Overheads $175; Credit Wages control account
$225
 Debit Work in progress $175, Debit Overheads $50; Credit Wages control account
$225
 Debit Wages control account $225; Credit Work in progress $175,
Credit Overheads $50
(2 marks)
6.4 Heritage Co employed 46 people at the start of the year and 40 people at the end of the
year. During the period 14 people left the company. What is the staff turnover rate
expressed as a percentage?
 11.6%
 32.6%
 37.2%
 18.6% (2 marks)
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The following information relates to questions 6.5, 6.6 and 6.7

A company budgeted to produce 10,000 items at a rate of five hours per unit for January. It
actually made 11,000 items in January consuming 52,500 labour hours.
6.5 What is the labour efficiency ratio (expressed to the nearest whole percentage)?
 105%
 110%
 95%
 91% (2 marks)
6.6 What is the labour capacity ratio (expressed to the nearest whole percentage)? %
(2 marks)
6.7 What is the labour production volume ratio (expressed to the nearest whole percentage)?
 105%
 110%
 95%
 91% (2 marks)
6.8 Green Co operates a premium bonus system by which employees receive a bonus of 60%
of the time saved compared with a standard time allowance (at the normal hourly rate).
Details relating to employee X are shown below:
Employee X
Actual hours worked 45 hours
Hourly rate of pay $12
Output achieved 380 units of product Y
Standard time allowed (per unit of Y) 8 minutes
The bonus payable (to the nearest $) to employee X is $ (2 marks)
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6: LABOUR
Chapter 6 Answers
0–100 $5 per unit 100  $5 = $500

101–150 $6 per unit 50  $6 = $300
151–200 $7 per unit 50  $7 = $350
201+ $8 per unit 27  $8 = $216 Total = $1,366
6.2 The correct answer is: Debit Work in progress $7,500; Credit Wages control account $7,500
Here costs are being transferred from Wages control (credit) into Work in progress (debit), ie
Production.
6.3 The correct answer is: Debit Work in progress $175, Debit Overheads $50; Credit Wages
control account $225
Here costs are being allocated between direct and indirect costs and so are being
transferred from the Wages control account (credit) into Work in progress and Overheads
(debit).
General overtime: Basic 20 hrs @ $5 = $100 – Direct cost; Overtime premium 20 hrs @
$2.50 = $50 – Indirect cost
Specific overtime: Basic 10 hrs @ $5 = $50 – Direct cost; Overtime premium 10 hrs @
$2.50 = $25 – Direct cost
Hence the double entry is Debit Work in progress $175, Debit Overheads $50; Credit
Wages control account $225.
6.4 The correct answer is: 18.6%
Replacements
Staff turnover rate =  100%
Ave. no.of employees in period
Average employees (46 + 40)/2 = 43. Replacements – 14 people left the company during
the year but staff numbers fell by only 6. This implies that 8 people were recruited (replaced)
during the period.
8/43  100% = 18.6%
6.5 The correct answer is: 105%
Standard hours of production
Labour efficiency ratio =
Actual hours of production
Actual activity is 11,000 units at a standard rate of 5 hrs per unit – standard hrs are 55,000
hrs.
Efficiency ratio = 55,000/52,500  100% = 105%
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6: LABOUR
Actual hours of production

Labour capacity ratio =
Budgeted hours of production
Budgeted hrs are 10,000 units at 5 hrs per unit – Budgeted hrs are 50,000 hrs.
Capacity ratio = 52,500/50,000  100% = 105%
Standard hours of production
Production volume ratio = = Efficiency ratio  Capacity ratio
Budgeted hours of production
Actual activity is 11,000 units at a standard rate of 5 hrs per unit – Standard hrs are 55,000
hrs.
Budgeted hrs are 10,000 units at 5 hrs per unit – Budgeted hrs are 50,000 hrs.
Production volume ratio = 55,000/50,000  100% = 110%
6.8 The correct answer is: $41
Standard time for actual output = 8 minutes  380 units
= 3,040 minutes
3,040
= hours
60
= 50.67 hours
Time saved = (50.67– 45) hours = 5.67 hours  60%
= 3.4 hours  $12 = $41
END OF CHAPTER
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Expenses

 Explain the different treatment of direct and indirect expenses.
 Identify how to record both direct and indirect expenses.
 Describe and calculate asset and expense items and illustrate the relevant accounting treatment.
 Calculate and explain depreciation charges using straight-line, reducing balance, machine hour and product units
methods.
Exam Context
Other expenses within a manufacturing firm or a service environment is another key area of the syllabus. You can
expect questions on this area within your exam.
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7: EXPENSES
Overview
Expenses
Direct expenses Indirect expenses
Recording expenses
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7: EXPENSES
1 Cost distinctions
1.1 The total cost of a cost unit is made up of the following three elements of cost:
 Materials
 Labour
 Other expenses
We looked at materials costs and labour costs in some detail in Chapters 5 and 6. Any other
costs that might be incurred by an organisation are generally known as expenses or other
expenses.
1.2 Like materials and labour costs, expenses can be also divided up into different categories.
You should not find too much difficulty in distinguishing between the following:
 Direct expense costs (eg tool hire for a specific job)
 Indirect expense costs (eg factory insurance)
 Fixed expense costs (eg factory insurance)
 Variable expense costs (eg cost per advert)
2 Direct and indirect expenses

2.1 A major distinction that must be made is between direct and indirect expenses.
2.2 Remember that a direct cost is a cost that can be traced in full to the product or service that
is being costed.
2.3 Direct material is all material becoming part of the product (unless used in negligible
amounts and/or having negligible cost).
2.4 Direct wages are all wages paid for labour (either as basic hours or as overtime) expended
on work on the product itself.
2.5 Direct expenses are any expenses which are incurred on a specific product other than
direct material cost and direct wages.
Direct expenses are charged to the product as part of the prime cost. Examples of direct
expenses are as follows:
 The cost of special designs, drawings or layouts
 The hire of tools or equipment for a particular job
Direct expenses are also referred to as chargeable expenses.
Indirect expenses are also known as overheads and are studied in detail in the next
chapter.
3 Recording expenses
3.1 Direct expenses are recorded by coding them to the appropriate job or client.
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7: EXPENSES
3.2 Indirect expenses are initially allocated to appropriate cost centres and then spread out or
apportioned to the cost centres that have benefited from the expense.
3.3 In responsibility accounting, cost centres collect the costs that are the responsibility of the
cost centre manager, and hence may be known as responsibility centres.
4 Asset expenditure and expense items

4.1 Expenditure may also be classified as either an expense item or as asset expenditure.
Asset expenditure is expenditure which results in the acquisition of non-current assets.
Non-current assets are assets acquired to provide benefits in more than one accounting
period. Asset expenditure is charged to the statement of profit or loss via a depreciation
charge over a period of time.
4.2 Expense items are charges incurred for the purpose of the trade of the business, or in
order to maintain the existing earning capacity of non-current assets. They are charged to
the statement or profit or loss in the period to which they relate.
4.3 Depreciation is a method of writing off asset expenditure. There are four methods used:
straight line, reducing balance, machine hour and product units.
(a) The straight line method charges an equal amount of depreciation each period.
(b) The reducing balance method charges the largest amount of depreciation at the
beginning of an asset's life. As the asset grows older the amount charged each period
gets steadily smaller.
(c) The machine hour method charges depreciation in proportion of hours used to
expected usage.
(d) In the product units method the useful life of the asset is expressed in terms of the
total number of units expected to be produced.
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7: EXPENSES
5 Chapter summary
1 Cost distinctions Aside from labour and materials other costs incurred by
the organisation are generally referred to as expenses.
2 Direct and indirect Direct expenses are those incurred on a specific
expenses product that are not considered to be material or labour
costs.
3 Recording expenses Direct expenses are allocated to the appropriate job.
Indirect expenses are allocated to or apportioned to
cost centre which benefits from them.
4 Asset expenditure and Asset expenditure results in acquisition of non-current
expense items assets.
Expense items are incurred for the purpose of trade
and in order to maintain existing earning capacity of
non-current assets.
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7: EXPENSES
6 Overview summary
Expenses
Any other costs incurred by the

organisation that are not materials or
labour are generally known as expenses

Any expense which is incurred on a Indirect expenses are also known as
specific product other than direct overheads
materials or labour
Recording expenses
Direct expenses are
charged directly to the job
Indirect expenses are
allocated to appropriate
cost centres
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7: EXPENSES
Chapter 7 Questions
7.1 Which of the following are indirect expenses?
(i) The cost of overtime worked specifically to complete a one-off project
(ii) The depreciation of a machine on an assembly line
(iii) Raw materials, eg cartons and boxes
(iv) Rental cost of a factory
 (i) and (iv)
 (ii) and (iv)
 (ii) and (iii)
 (iv) only (2 marks)
7.2 A firm pays a 20c per unit royalty to the investor of a device which it manufactures and sells.
The royalty would be classified in the firms accounts as a:
 Selling expense
 Direct expense
 Production overhead
 Administration overhead (2 marks)
7.3 A company makes one delivery per week to all of its customers. The cost of these deliveries
is a:
 Prime cost
 Production overhead
 Selling and distribution cost
 Direct cost (2 marks)
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7: EXPENSES
Chapter 7 Answers
7.1 The correct answer is: (ii) and (iv)
7.2 The correct answer is: Direct expense
7.3 The correct answer is: Selling and distribution cost
END OF CHAPTER
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Checkpoint 1 – Progress Review
To reinforce your learning to date you should now follow the study guidance in the following
pages. On completion, your progress towards full exam preparation will be:
Take some time to reflect on the knowledge and skills you covered during Stage 1. The Course Notes
section for each chapter (starting overleaf) provides helpful guidance (and time commitments) on how
to focus your review on the key learning points in your notes.
Key messages from Stage 1

The first stage of the MA2 course introduces you to the basic ideas of management accounting. You will
cover the topics of how costs are classified and how they behave including details on material and labour
costs. These types of costs will be examined in every examination.
Key knowledge
The specific areas of key knowledge covered in Stage 1 were:
 Introduction to management accounting – management accountants help an organisation to achieve
its objectives by providing 'good' information relating to costing, decision making, planning, control
and performance evaluation.
 Cost classification – how to classify costs in management accounting, eg production/non-production
and direct/indirect costs.
 Cost behaviour – being able to identify how costs are expected to change (particularly when output
changes) is crucial to companies in the real world, and you need to be able to do this quickly and
confidently in your exam. The high–low method for splitting total costs between a fixed and variable
element is very important for this course and later studies.
 Material costs – controlling the costs of inventory is very important to a lot of businesses, and the
techniques you saw in Chapter 5 are the basic approaches that businesses use to be as efficient as
possible in maintaining their inventory levels. The formula for the EOQ will be given to you in the
exam if a question requires it, but you should begin to learn and remember the other formulae as this
is a highly examinable topic.
 Labour costs – hopefully you found this more straightforward than material costing. The concept of
'standard hours' is important in terms of analysing labour productivity.
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CHECKPOINT 1
Key skills
 Calculator skills – you may have been using some functions on your calculator that you've never
used before, or at least not for some time (such as powers, square roots and brackets). If this is the
case, spend some time getting to know your calculator and practising these functions.
 Remembering formulae – the materials and labour chapters introduced some new formulae – some
that you need to learn and some that will be given in the exam. There are a quite a few formulae to
learn for this exam so it would be a good idea to start preparing a list of these. It may seem daunting
having to remember them all but if you start learning them early it will be a lot easier. A good way of
remembering formulae is to understand them as far as possible and then repeat, repeat, repeat! This
is a great technique for getting things into your long-term memory. Practise by writing down all the
new formulae that you have come across so far, and then repeat every day until you get them all
right!
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CHECKPOINT 1
Checkpoint 1 – Study Support
Chapter 1 – Accounting for management 17 minutes
Key areas
 Attributes of good information
 Purpose and role of cost and management accounting within an organisation
Course Notes
 This chapter serves as an introduction to the MA2 exam. 5 minutes
 It could perhaps form the basis of one of the questions in your exam.
 Reread through the chapter summary to make sure that you are happy with the key
concepts.
Question practice
 Complete the questions from the end of chapter questions in the Course Notes for 5 minutes
Chapter 1.
7 minutes
 Required question practice:
From the Practice & Revision Kit try the following questions:
Question 1 Management information and information technology – 1.3, 1.9, 1.11
Chapter 2 – Role of information technology 45 minutes
Key areas
 Understanding the methods of capturing, processing, storing and outputting cost and
 Appreciating the importance of the management information system
Course Notes
 Work carefully through the Course Notes. 20 minutes
Question practice
 Complete the questions from the end of chapter questions in Chapter 2 of the Course 10 minutes
Notes; this will test your understanding of the terminology introduced.
From the Practice & Revision Kit try the following questions: 15 minutes
Question 1 Management information and information technology – 1.2, 1.4, 1.5, 1.8,
1.10, 1.13
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CHECKPOINT 1
Checkpoint 1 – Study Support (cont.)
Chapter 3 – Cost classification 20 minutes
Key areas
 Understanding how to break production and non-production costs down into the
different elements
 Distinguishing between direct and indirect production and non-production costs
Course Notes
 Skim over the chapter and make sure that you are happy with all of the concepts here. 5 minutes
This terminology will be used throughout the rest of the course so it is really useful to
have a good understanding of it at this stage.
Question practice
 Complete the questions from the end of chapter questions in Chapter 3 of the Course 5 minutes
Notes; this will test your understanding of the terminology introduced.
Question 2 Cost classification and cost behaviour – 2.3, 2.5, 2.6, 2.7
Chapter 4 – Cost behaviour 45 minutes
Key areas
 Understanding fixed, stepped fixed, variable and mixed costs
 Ability to use linear functions and equations
 Using the high–low method to estimate fixed costs and variable costs per unit
Course Notes
 Review the chapter and make sure that you understand the graphical representation of 5 minutes
the types of cost behaviour.
 Spend a few minutes learning the formula of a straight line.
 Ensure you understand the lecture examples, particularly the steps of the high–low
method, as this is an important technique that will be used throughout your studies.
Question Practice
 Review questions done and complete any that you have not finished from the Course 10 minutes
Notes end of chapter questions for Chapter 4
Question 2 Cost classification and cost behaviour – 2.9–2.20
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CHECKPOINT 1
Chapter 5 – Materials costs 78 minutes
Key areas
 Materials control procedures and recording techniques
 Economic order quantity (EOQ)
 Inventory valuation techniques
Course Notes
 Rework the lecture examples in the notes to make sure that you are happy with the 10 minutes
steps involved.
 Learn the stock level formula and the formula to calculate the total costs given the 10 minutes
EOQ. Make sure you are happy with the letters used in all formulae.
 Review lecture example 3 to ensure you are happy with the three inventory valuation 5 minutes
techniques.
Question practice
 Complete the questions from the end of chapter questions in the Course Notes for 10 minutes
Chapter 6; this will ensure that you practice using all of the formulae learnt in the
chapter.
43 minutes
Question 3 Materials – 3.1–3.10, 3.17–3.24
Chapter 6 – Labour costs 70 minutes

Key areas
 Identification of direct and indirect labour costs
 Recording labour costs
Course Notes
 Learn the efficiency, capacity and production volume ratios and the labour turnover 10 minutes
rate formula.
 Spend some time learning the classification of indirect and direct labour. 10 minutes
 Ensure that you are happy with the double entries and the wages control account.
Question practice
 Work through the questions from the Course Notes end of chapter questions for 10 minutes
Chapter 6.
 Required question practice: 40 minutes
Question 4 Labour – 4.1–4.17
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CHECKPOINT 1
Chapter 7 – Expenses 45 minutes
Key areas
 Identification of direct and indirect expenses
 Recording direct and indirect expenses
Course Notes
 Review the notes in this chapter to ensure you understand the difference between 5 minutes
direct and indirect expenses which do not fall into labour and material costs.
 Review the method for recording expenses. 5 minutes
Question practice
 Work through the question from the Course Notes end of chapter questions for 10 minutes
Chapter 7.
 Required question practice: 25 minutes
Question 5 expenses – all questions
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Absorption costing

 Explain the different treatment of direct and indirect expenses.
 Describe the procedures involved in determining production overhead absorption rates.
 Allocate and apportion production overheads to cost centres using an appropriate basis.
 Re-apportion service cost centre costs to production cost centres (using the reciprocal method where service
cost centres work for each other).
 Select, apply and discuss appropriate bases for absorption rates.
 Prepare journal and ledger entries for manufacturing overheads incurred and absorbed.
 Calculate and explain the under- and over-absorption of overheads.
Exam Context
Overhead apportionment and absorption is one of the most important topics in your Management Accounting studies
and is almost certain to appear in the exam.
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8: ABSORPTION COSTING
Overview
Absorption costing
Predetermined OAR
Types of overhead
Allocating overheads to units to Calculating a profit or loss

find the full production cost under absorption costing
Three-step approach to
absorption costing
Allocating non-production
overheads to a product
(1) Allocate & (2) Re-apportion (3) Absorb

apportion
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1 Overview
1.1 Businesses need to put a cost on goods/services they produce (ie cost units) for many
reasons. These include:
 Pricing (cost + percentage mark up)
 Inventory valuation
 Profitability analysis
Absorption costing
1.2 Absorption costing is a product costing/inventory valuation method which includes all
production costs in the valuation, and is required for external reporting purposes. An
example is shown below:
Standard cost card
$/unit
Direct materials X
Direct labour X
Prime cost X
Production overheads X
Product cost X
Prime cost
1.3 The direct costs of a cost unit are usually straightforward to ascertain since by definition they
are identified with a cost unit.
Direct materials: x kg of material at $y per kg
Direct labour: a hrs of labour at $b per hour
Overheads
1.4 Since these are not identified with specific cost units, some method must be used to charge
a share of the total production overhead to each cost unit.
Note. In the previous chapter a distinction was made between fixed and variable overheads.
Initially total overheads will be considered as a whole.
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2 Service and production cost centres
Lecture example 1
Required
Suggest examples of (a) production cost centres and (b) service cost centres.
Solution
(a) Production cost centres, through which cost units actually flow
eg
(b) Service cost centres, which support/service the production cost centres
eg
3 Absorption costing steps

Method
3.1 To get the full absorbed production cost there are four steps:
(a) Allocate direct costs to cost units.
(b) Allocate and apportion production overheads to cost centres.
(c) Re-apportion overheads in service cost centres to production cost centres.
(d) Absorb overheads into cost units.
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Diagram
3.2
TOTAL PRODUCTION COSTS
DIRECT COSTS INDIRECT COSTS

(overheads)
(b)
COST CENTERS
Production 1 Production 2 Service

(a)
(c)
Production 1 Production 2
(d)
COST UNIT
4 Allocation and apportionment to cost centres

4.1 The first stage in valuing the overhead cost of a cost unit is to allocate and apportion
overheads between the cost centres. There are no set rules, just pick a basis which would
seem to reflect most fairly the way in which overheads are incurred.
Terminology
4.2 Allocation – whole cost items are charged to a cost centre.
Apportionment – cost items are divided between several cost centres.
Lecture example 2
Required
Identify an appropriate basis for the following costs.
Basis
Overhead Basis
Rent/rates
Depreciation of equipment
Staff welfare
Heat and light
Insurance of equipment
Stores costs
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Lecture example 3
A company has incurred the following overhead costs for a period:
$
Factory rent 20,000
Factory heat 5,000
Processing department – supervisor 15,000
Packing department – supervisor 10,000
Depreciation of equipment 7,000
Factory canteen expenses 18,000
Welfare costs of factory employees 5,000
80,000
Suitable cost centres in the company:
Processing department
Packing department
Canteen
Processing Packing Canteen
dept dept
Cubic space 50,000 m³ 25,000 m³ 5,000 m³
Carrying value of equipment $300,000 $300,000 $100,000
No. of employees 50 40 10
Required
Allocate and apportion the overhead costs incurred to the three cost centres using the most
suitable basis.
Solution
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5 Apportioning service costs to production

departments
5.1 Only production departments manufacture units. It is necessary to have all the overheads
charged to production departments. This becomes slightly more complex when you have
several service cost centres that do work for each other as well as for the production cost
centres.
5.2 There are two methods to resolve this:
(a) Apportion costs of each service department to production departments only, ignoring
any work that the service departments do for each other (example 4(a)) – this is
called the direct method.
(b) Apportion the costs of each service department not only to production but also to
some (but not all) of the service departments that make use of its services – this is
known as the step-down method (example 4(b)).
Lecture example 4
Required
Using the following data re-apportion the overheads of stores and maintenance to production
departments X and Y using the following methods:
(a) Direct method
(b) The step-down method, starting with stores
Production Service centre
X Y Stores Maintenance
$ $ $ $
Allocated overheads 70,000 30,000 20,000 15,000
Estimated work done by

the service centres for
other departments:
Stores 50% 30% – 20%
Maintenance 45% 40% 15% –
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Solution
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6 Absorption of overheads into production (cost units)

Bases
6.1 All of the production overhead costs have now been apportioned to the production cost
centres. We now need to charge these to the cost units passing through the production cost
centres. This is termed 'absorption'. We are going to absorb an element of total production
overhead into each cost unit.
There are several possible bases for absorption, the most common being:
(a) Per unit
(b) Per labour hour
(c) Per machine hour
(d) Percentage of direct labour cost
Budgeted production overhead
OAR (overhead absorption rate) =
Budgeted activity level
Lecture example 5
Choosing bases
Ideally, the basis chosen should be the one which most accurately reflects the way in which the
overheads are in fact being incurred.
Identify under what circumstances the following bases would be appropriate.
(a) Per unit
(b) Per labour hour
(c) Per machine hour
(d) Percentage of direct labour cost
Solution
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Lecture example 6
Calculating absorption rates
Choco Co has two production departments, mixing and stirring, in which it makes a variety of
products. Budgeted overheads are $10,000 and $15,000 respectively, and the following budgeted
information has also been collected.
Mixing Stirring
Direct labour hours 20,000 5,000
Direct machine hours 2,000 60,000
Number of units 10,000 10,000
Required
Calculate appropriate overhead absorption rates for both mixing and stirring departments.
Solution
6.2 Production overheads normally accrue (or increase) on a time basis. Hence time-based
methods (eg labour hours or machine hours) are more appropriate, rather then a basis of
per $ of labour cost.
7 Predetermined overhead absorption rates

7.1 Businesses need to cost their production throughout the year, not at the end of an
accounting period. Therefore they predetermine or estimate their absorption rates
for the year.
Budgeted production overhead
Overhead absorption rate (OAR) =
Budgeted level of activity
Note. Activity level refers to production activity not sales.
Absorption into production

7.2 The amount absorbed into production is:
Actual production activity  OAR
This may differ from actual overhead costs incurred for either or both of the following two
reasons:
(a) Actual expenditure was more or less than budget (expenditure variance)
(b) Actual units produced (ie volume) were more or less than normal (volume variance)
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Lecture example 7
Predetermined overhead absorption rates.
Gurney Halleck Co had the following budgeted and actual figures for units of production and
overheads.
Budgeted Actual
Units of production 20,000 24,000
Overheads $100,000 $117,000
Required
Prepare the production overhead account for Gurney Halleck Co.
Predetermined absorption rate =
Overhead absorbed for period =
Under-/over-absorption =
The amount of under- or over-absorbed overhead would be the balancing figure in the production
overhead account and would be transferred to the statement of profit or loss.
PRODUCTION OVERHEAD ACCOUNT
Remember that the double entry for the overhead accounts are:
Debit Actual cost
Credit Actual activity level  predetermined OAR
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Lecture example 8
Identify possible reasons for under-/over-absorption in Lecture example 7.
Solution
Lecture example 9
You are given the following information for a production department for month 9.
Budgeted Actual
Direct labour hours 57,500 59,250
Machine hours 28,750 34,000
Units produced 1,150,000 950,000
Overheads $575,000 $612,750
Required
(a) Calculate the OAR under labour hours, machine hours and per unit.
(b) Calculate the under- or over-absorbed overhead.
Solution
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Lecture example 10
May Days plc manufacturers children's clothing. The General Manager is concerned about how the
costs of the various garments it produces are calculated. The material cost varies from one
garment to another and the rates of pay in the various departments also vary to reflect the different
skills offered. Both these prime costs are charged direct to individual garments so that any
variation is taken into account. It is the overhead cost which has been concerning May Days plc for
some time. The present overhead system uses one overhead rate for the whole company and is
absorbed as a percentage of direct labour cost. You have been provided with the following
information:
Overhead Numbers % of Materials Machine
cost employed floor area issued hours
$'000 $'000
Production departments
Cutting 187 10 40 200 15,000
Sewing 232 15 30 250 25,000
Finishing 106 8 15 100
Service departments
Stores 28 2 5
Maintenance (machines) 50 3 10 50
Required
Using the information, apportion:
(a) Stores department costs to the Production and Maintenance departments
(b) Maintenance departments costs to the Cutting and Sewing departments only
Calculate to the nearest $.
OVERHEAD ANALYSIS SHEET
TOTAL PRODUCTION SERVICE
Cutting Sewing Finishing Stores Maintenance
$ $ $ $ $ $
Overheads 603,000 187,000 232,000 106,000 28,000 50,000
Apportion
Stores
Apportion
Maintenance
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Lecture example 11
Required
Calculate overhead absorption rates for the three departments using machine hour rates for the
Cutting and Sewing departments and a labour hour rate for the Finishing department, given that
12,000 labour hours will be worked in the Finishing department.
Calculate to two decimal places of the $.
Solution
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8 Chapter summary
1 Overview Overheads are costs incurred in the course of making a
product that can't be directly linked to a unit.
2 Service and production A service cost centre is an area of the business that
cost centres supports production.
A production cost centre is an area of the business
where the units are physically being produced.
3 Absorption costing The objective of absorption costing is to include a share
steps of the overheads in the total cost of the product.
4 Allocation and The first stage in valuing the overhead cost of a cost
apportionment unit is to allocate and apportion overheads between the
cost centres.
5 Apportioning service The second stage is to transfer all service cost centre
costs to production overheads to the production centres, as it is through
departments these cost centres that cost units flow.
6 Absorption of The final stage is to charge the overheads to the cost
overheads into units passing through the production cost centres using
production (cost units) an overhead absorption rate (OAR).
7 Predetermined Under- or over-absorption of overheads occurs due to
overhead absorption the difference between the estimates used in
rates calculating the OAR and the actual expenditure or
activity levels.
9 Formulae summary
Budgeted overhead
 Predetermined overhead absorption rate (OAR) =
Budgeted activity
 Overhead absorbed = actual activity  predetermined OAR
 Actual overheads X
Overhead absorbed (X)
Under-/(over-)absorption X/(X)
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10 Journal summary
 Overheads incurred
Debit Overhead account
Credit Cash/payables
 Overhead absorbed
Debit WIP (Actual activity level  pre-determined OAR)
Credit Overhead account
 Overhead absorption
Debit Overhead account
Credit Statement of profit or loss
 Under-absorption
Debit Statement of profit or loss
Credit Overhead account
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11 Overview summary
Absorption costing
Calculating the cost per unit

 Profitability
 Selling price
Types of overhead Predetermine OAR

 OAR calculated at the start of the
year based on budgeted figures
Production Non-production
Allocating overheads to units to

Calculating a profit or loss
find the full production cost
under absorption costing
(See Chapter 9)
 Predetermined OAR used to
estimate overheads during the
year to calculate a profit or loss
figure
absorption costing
 Getting the production overhead
cost into the cost card
 Can be done for internal reporting
purposes

apportion
 Overheads from  Overheads from production cost
 Overheads to cost service cost centres to centres to individual units using an
centres on some production cost overhead absorption rate (OAR)
fair basis centres on some fair Budgeted overhead
– Production cost basis OAR =
Budgeted activity
centres – Direct method
– Service cost – Reciprocal (1) Calculate OAR using appropriate
centres method activity
(2) Calculate the activity for a single
unit and apply OAR
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Chapter 8 Questions
8.1 A company has two production departments and two service departments with the fixed
overheads shown in the table.
Production Service
Production W X Y Z
Overheads ($'000) 500 600 600 800
Service department Y divides its times between the other departments in the ratio 3:2:1
(for W, X and Z respectively). Department Z spends 40% of its time servicing department W
and 60% servicing department X. If all service departments' overheads are allocated to
production departments, the total fixed overhead cost of department W is:
 $1,200,000
 $1,100,000
 $660,000
 $1,160,000 (2 marks)
8.2 Which of the following statements about overhead absorption rates are true?
(i) They are predetermined in advance for each period.
(ii) They are used to charge overheads to products.
(iii) They are based on actual data for each period.
(iv) They are used to control overhead costs.
 (i), (ii) and (iv) only
 (ii), (iii) and (iv) only
 (iii) and (iv) only (2 marks)
8.3 A Co's budgeted and actual data for the year ended 31 December 20X1 is shown in the
table.
Budgeted Actual
Production (units) 5,000 4,600
Variable costs per unit $6 $4
Fixed production overheads $10,000 $9,500
Sales (units) 4,000 4,000
Sales price per unit $10 $10
Absorption basis for fixed overheads: per unit
The fixed overhead absorbed during 20X1 will be:
 $8,000
 $9,200
 $9,500
 $10,000 (2 marks)
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8.4 Budgeted overheads for a period were $340,000. Actual labour hours and overheads were
21,050 hours and $343,825 respectively. If there was over-absorption of $14,025, how many
labour hours were budgeted?
 20,000 hours
 20,225 hours
 20,816 hours
 21,050 hours (2 marks)
8.5 A company absorbs overheads on machine hours, which were budgeted at 11,250 with
budgeted overheads of $258,750. Actual results were 10,980 hours with overheads of
$254,692. Overheads were:
 Under-absorbed by $2,152
 Over-absorbed by $4,058
 Over-absorbed by $2,152 (2 marks)
8.6 A business calculated its overhead absorption rate to be $32 per machine hour, based on
an estimate that the production overheads of the business would be $216,000 in the coming
year. How many machine hours did the business anticipate working?
 6,750 hours
 216,000 hours
 32 hours
 Don't know, would need more information (2 marks)
8.7 Which of the following entries will record an under-absorption of production overheads in the
overhead account?
 Debit Work in progress Credit Statement of profit or loss
 Debit Overhead Credit Statement of profit or loss
 Debit Statement of profit or loss Credit Work in progress
 Debit Statement of profit or loss Credit Overhead (2 marks)
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8.8 The following extract of information is available concerning the four cost centres of EG Co.
Service cost
Production cost centres centre
Machinery Finishing Packing Canteen
Number of direct employees 7 6 2 –
Number of indirect employees 3 2 1 4
Overhead allocated and
apportioned $28,500 $18,300 $8,960 $8,400
The overhead cost of the canteen is to be re-apportioned to the production cost
centres on the basis of the number of employees in each production cost centre. After
the re-apportionment, the total overhead cost of the packing department, to the nearest $,
will be:
 $1,200
 $9,968
 $10,080
 $10,160 (2 marks)
8.9 A company absorbs overheads on a labour hours basis. Budgeted labour hours were
28,800 and budgeted overheads were $633,600. Actual results were 28,000 hours and
overheads of $676,800.
Overheads were under/over absorbed by $ (2 marks)
8.10 Hayes Co absorbs overheads on the basis of direct labour hours. During September
46,400 hours were worked, while only 45,230 were budgeted. Actual overheads were
$182,500 and overheads were under absorbed by $6,180. What were budgeted overheads
(to the nearest $)?
 $176,320
 $176,994
 $171,874
 $180,522 (2 marks)
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Chapter 8 Answers
8.1 The correct answer is: $1,160,000
W X Y Z
$'000 $'000 $'000 $'000
500 600 600 800
Y (3:2:1) 300 200 (600) 100
900
Z (40:60) 360 540 – (900)
1,160 1,340 – –
8.2 The correct answer is: (i) and (ii) only
Overhead absorption rates (OARs) are determined in advance for each period, usually based
on budgeted data. Therefore statement (i) is correct and (iii) is incorrect. OARs are used to
absorb overheads into product costs therefore (ii) is correct. (iv) is incorrect as overheads are
controlled by budgets and other management information.
OAR = $2/unit ($10,000/5,000). Absorbed overhead = $9,200 (4,600  $2).
8.4 The correct answer is: 20,000 hours

$
Actual overheads 343,825
Over-absorbed overheads 14,025
Overhead recovery for 21,050 hrs 357,850
Therefore overhead absorption rate 357,850/21,050 = $17 per hour.
Budgeted labour hours = Budgeted overheads/Overhead absorption rate =
$340,000/$17 = 20,000 hrs
8.5 The correct answer is: Under-absorbed by $2,152
Overhead absorption rate = Budgeted overheads/

Budgeted machine hours
= $258,750/11,250 machine hours
= $23 per machine hour
Actual hour = 10,980 hours
10,980  $23 = $252,540 absorbed
This is $254,692 – $252,540 = $2,152 under-absorbed
8.6 The correct answer is: 6,750 hours
The budgeted machine hours equals the total overheads divided by the OAR of $32.
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8.7 The correct answer is: Debit Statement of profit or loss Credit Overhead
Example
OVERHEAD ACCOUNT
$ $
Actual 190,000 Absorbed costs 180,000
 SOP/L (under-
absorption) 10,000
190,000 190,000
Number of employees in packing department = 2 direct + 1 indirect = 3

Number of employees in all production departments = 15 direct + 6 indirect = 21
Packing department overhead
$8,400
Canteen cost apportioned to packing department = 3
21
= $1,200
Original overhead allocated and apportioned = $8,960
Total overhead after apportionment of canteen costs = $10,160
8.9 Overheads were under absorbed by $ 60,800
Budgeted overheads
OAR =
Budgeted labour hours
$633,600
=
28,800
$22 per labour hour
$
Overhead absorbed = $22  28,000 616,000
Overhead incurred 676,800
Under-absorbed by 60,800

$
Actual overheads 182,500
Under-absorbed overheads (6,180)
Overhead recovery for 21,050 hrs 176,320
Therefore overhead absorption rate 176,320/46,400 = $3.80 per hour.
Budgeted overheads = Overhead absorption rate  Budget hours
= $3.80  45,230 = $171,874
END OF CHAPTER
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Marginal and absorption
costing

 Explain the importance of and apply the concept of contribution.
 Demonstrate and discuss the effect of absorption and marginal costing on inventory valuation and profit
determination.
 Calculate profit or loss under absorption and marginal costing.
 Reconcile the profits or losses calculated under absorption and marginal costing.
 Describe the advantages and disadvantages of absorption and marginal costing.
Exam Context
Look out for questions in your examination which require you to calculate profit or losses using absorption and marginal
costing and then reconcile the profits calculated under the two methods.
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9: MARGINAL AND ABSORPTION COSTING
Overview
Marginal (MC) and
absorption (AC) costing
Cost card under AC Cost card under MC
Contribution
Profit/loss under AC Profit/loss under MC
Reconciliations
Advantages/disadvantages of
AC and MC
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1 Overview
1.1 Some businesses only want to know the variable cost of the units they make, regarding
fixed costs as period costs. The variable cost is the extra cost each time a unit is made,
fixed costs being effectively incurred before any production is started.
The variable production cost of a unit is made up of:
$
Direct materials X
Direct labour X
Variable production overheads X
Marginal cost of a unit X
Marginal costing
1.2 Variable production costs are included in cost per unit (ie treated as a product cost).
Fixed costs are deducted as a period cost in the statement of profit or loss.
2 Contribution
Introduction
2.1 Contribution is a fundamental concept in marginal costing. Contribution is an
abbreviation of 'contribution towards fixed costs and profit'.
It is the difference between selling price and all variable costs (including non-production
variable costs), usually expressed on a per unit basis.
$ $
Selling price X
Less: variable production costs X
variable non-production costs X (X)
contribution X
Note. Contribution takes account of all variable costs. Marginal cost takes account of
variable production costs only and inventory is valued at marginal cost.
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3 Proforma marginal costing statement of profit or loss

3.1
$ $
Sales X
Less: variable cost of sales
opening inventory X
production costs
variable X
X
Less closing inventory (X)
(X)
X
Less: variable selling, distribution and (X)
administration costs
Contribution
Less: fixed costs X
production X
selling and distribution X
administration X (X)
Profit X
Note. Inventory are valued at variable production costs only.
Lecture example 1
Selling price $25
$
Cost card per unit:
Direct materials 7.00
Direct wages 8.00
Variable production overheads 5.00
Fixed production overheads 0.90
20.90
There is a variable selling cost per unit of $0.50.
Year 1 Year 2
Normal/budgeted production 12,000 12,000
Actual production 14,000 11,500
Actual sales 13,000 12,500
Actual fixed production overheads $11,000 $11,000
Actual fixed selling costs $5,000 $5,000
There is no opening inventory at the beginning of Year 1. All variable costs were as per budget for
the two years.
Required
Set out a statement of profit or loss under absorption and marginal costing for both years 1 and 2.
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Solution
Absorption costing
Year 1
$ $
Sales
Less: cost of sales
opening inventory
production costs
variable costs
fixed overhead absorbed
Less closing inventory
Fixed overhead under-/(over-)absorbed
Net profit
Less selling, administration costs etc
Net profit
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Year 2
$ $
Sales
Less: cost of sales
opening inventory
production costs
variable costs
fixed overhead absorbed
Fixed overhead under-/(over-)absorbed
Net profit
Less selling, administration etc costs
Net profit
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Marginal costing
Year 1
$ $
Sales
opening inventory
production costs
variable
Less variable selling, distribution and

Contribution
Less: fixed costs
production
selling and distribution
administration
Profit
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Year 2
$ $
Sales
opening inventory
production costs
variable
Less variable selling, distribution and

Contribution
Less: fixed costs
production
selling and distribution
administration
Profit
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Lecture example 2
Required
Prepare a reconciliation of absorption and marginal costing profits from Lecture example 1.
Solution
The difference in profit arises from the different inventory valuations which are the result of the
difference in treatment of the fixed production overheads.
Effects
3.2 The delay in charging some production overheads under absorption costing leads to the
following situations.
Lecture example 3
Required
Compare profits under marginal and absorption costing for the following situations.
(a) Production > Sales
(b) Production < Sales
(c) Production = Sales
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Solution
4 Advantages and disadvantages of marginal costing

compared to absorption costing
Advantages
4.1 (a) More appropriate for decision making
(b) Fixed costs are treated in accordance with their nature, ie as period costs
(c) Profit depends on sales as opposed to production activity levels and is hence more
appropriate for performance evaluation
Disadvantages
4.2 (a) Does not comply with reporting standards
(b) Costs must be analysed into fixed and variable parts
(c) Fixed costs cannot be ignored in the long run
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5 Chapter summary
1 Overview The marginal cost is the variable production cost of
one unit.
2 Contribution Contribution is the amount that a unit contributes
towards fixed costs when it is sold. It is calculated as
selling price less all variable costs.
3 Proforma marginal In marginal costing fixed costs are treated as period
costing statement of costs.
profit or loss In absorption costing fixed costs are absorbed into the
units and carried forward with closing inventory.
The different inventory valuations in AC and MC can
lead to different profits being reported. The difference
can be reconciled by multiplying the change in the
inventory by the OAR.
4 Absorption costing vs Each costing method has its own advantages and
marginal costing disadvantages.
6 Formulae summary
 Contribution = SP – ALL VC
 Difference in profit = Change in inventory  OAR
Under AC and MC in units per unit
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7 Overview summary
Marginal (MC) and

 Profitability
 Selling price
 EXCLUDES any overheads

 Includes element of
overheads (Chapter 8)
CONTRIBUTION
 Contribution towards fixed costs

and profit = SP – ALL VC
Including non-production VC
Profit/loss under AC Profit/Loss under MC
Above gross profit = PRODUCTION costs Format Above contribution = VARIABLE costs
Below gross profit = NON-PRODUCTION costs Below contribution = FIXED costs
Value at full production cost ie from cost card Value at marginal cost ie from cost card
Inventory
including overheads excluding overheads
(1) Overheads absorbed

Fixed overheads Include actual fixed overhead
(estimate of overheads)
= OAR  actual activity
(2) Adjustment for under- or over-absorption
Reconciliations
Difference is due to the valuation of inventory

AC MC
 Recognises that selling price must  Highlights contribution so appropriate
cover all costs for decision making
 Complies with reporting standards Advantages/disadvantages of  Treats FC in accordance with their
AC and MC nature
 Profits can be manipulated by
changing production levels  Danger that contribution fails to cover
FC
 Assumes FC are volume related
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Chapter 9 Questions
9.1 If a company increases its inventory during the period, which of the following statements is
true?
 Absorption costing will produce lower profits than marginal costing.
 Absorption costing will produce higher profits than marginal costing.
 Absorption costing profits will be the same as marginal costing profits.
 There is not enough information to know which method has the highest profits.
(2 marks)
9.2 When opening inventories were 8,500 litres and closing inventories 6,750 litres, a firm had a
profit of $62,100 using marginal costing. Assuming that the fixed overhead absorption rate
was $3 per litre, what would be the profit using absorption costing?
 $41,850
 $56,850
 $67,350
 $82,250 (2 marks)
9.3 The cost structure for a product is as follows:
Product Per unit

$
Selling price 30
Variable production costs 9

Fixed production costs 6
Total production costs 15
Non-production overheads
Variable 2
Fixed 3
Total cost 20
What is the contribution per unit?
 $10
 $15
 $19
 $21 (2 marks)
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9.4 A company absorbs overheads on a machine hours which were budgeted at 11,250 with
budgeted overheads of $258,750. Actual results were 10,980 hours with overheads of
$254,692.
Overheads were:
 Over-absorbed by $4,058
 Over-absorbed by $2,152 (2 marks)
9.5 Marginal costing profit will be greater than absorption costing profit when:
 Production = Sales
 Production < Sales
 There is no change in inventory
 Production > Sales (2 marks)
9.6 The following data relates to two output levels of a department.

Machine hours 17,000 18,500
Overheads (total) $246,500 $251,750
The variable overhead rate per hour is $3.50.
The amount of fixed overheads is:
 $5,250
 $50,500
 $187,000
 $246,500 (2 marks)
9.7 In a period, opening inventories were 10,000 units and closing inventories 11,000 units.
Profits, based on marginal costing, were $100,000 and profit under absorption costing was
$105,000. The fixed overhead absorption rate per unit is:
 $0.50
 $5.00
 $4.50
 $5,000 (2 marks)
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Chapter 9 Answers
9.1 The correct answer is: Absorption costing will produce higher profits than marginal costing.
If inventories are rising, closing inventory is greater than opening inventory. Using
absorption costing fixed overheads will be included in the closing inventory valuation.
 Closing inventory value is higher using absorption costing
 Cost of sales is lower using absorption costing
 Profits are higher using absorption costing

$
Opening inventory (8,500)
Closing inventory 6,750
Change in inventory (1,750)
 overhead absorption rate $3

Amount of overhead absorbed, thus reducing profit by this amount $5,250
Profit = 62,100 – 5,250 $56,850
$
Selling price 30
Variable production costs (9)
Variable non-production costs (9)
Contribution per unit 19
9.4 The correct answer is: Under-absorbed by $2,152
OAR $258,750/11,250 = $23

Overheads absorbed $23  10,980 = $252,540
Actual overheads $254,692
$2,152 UNDER
9.5 The correct answer is: Production < Sales
Total overheads = Fixed + variable
For 17,000 units:
$246,000 = Fixed + (17,000  $3.5)
$246,000 = Fixed + $59,500
Therefore: $246,000 – $59,500 = Fixed = $187,000
9.7 The correct answer is: $5.00
The difference in profits is due to fixed overheads in opening/closing inventory. 1,000 extra
units of inventory led to a $5,000 difference in profits. Therefore each unit of inventory has
$5 of fixed overheads.
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END OF CHAPTER
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Cost bookkeeping

 Understand the accounting entries for materials, labour, and overheads both direct and indirect.
 Understand the accounting entries in relation to over-/under-absorption.
Exam Context
Look out for questions in your exam which require you to identify the correct accounting entries or to identify various
balances from accounting entries you have been provided.
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10: COST BOOKKEEPING
Overview
Cost bookkeeping
Materials Production
Labour WIP
overheads
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1 Introduction
1.1 Essentially, you need to know:
(a) How to turn purchases, wages and so on into units of production
(b) How to deal with under/over absorption of overheads
2 Control accounts
2.1 These show the total values. They may be backed up by more detailed computer listings.
(a) Materials control account
(b) Wages control account
(c) Production overhead control account
(d) Work in progress (WIP) control account
3 Basic double entry

First, let's look at how a single purchase of materials works through into the final accounts.
The relevant double entries are as follows.
$ $
(a) Debit Materials X
Credit Cash (or payables) X
being the buying of materials which are put into raw materials inventory
(b) Debit Work in progress X
Credit Materials X
being the issue of materials to production for use in work in progress
(c) Debit Finished goods X
Credit Work in progress X
being the transfer of units that are now finished to finished goods inventory
(d) Debit Cost of sales X
Credit Finished goods X
being the taking of units out of finished goods inventory and selling them
(e) Debit Statement of profit or loss X
Credit Cost of sales X
being the closing off of ledger accounts and the drawing up of financial statements
This entry would only be made at the end of a period.
The process of accounting for labour is the same.
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Lecture example 1
Bodger & Co spends the following in 20X8:
$
Raw materials 5,000
Direct labour 4,000
Required
Show how these costs would be initially recorded in the following accounts:
 Payables control account
 Raw materials control account
 Labour control account
Solution
PAYABLES
$ $
RAW MATERIALS
$ $
LABOUR
$ $
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Lecture example 2
Bodger & Co issues the materials to production for use in work in progress. All of the labour is
employed making units.
Required
Show how the issue of materials and use of labour would be recorded in the following accounts:
 Raw materials control account
 Labour control account
 WIP control account
Solution
RAW MATERIALS CONTROL ACCOUNT
$ $
LABOUR CONTROL ACCOUNT

$ $
WIP
$ $
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4 Production overheads
4.1 The process of accounting for production overheads is slightly different.
The initial entry is the same as we have seen before for the overhead incurred:
$ $
Debit Production overheads X
Credit Cash (or payables) X
4.2 The subsequent entry:
$ $
Debit Work in progress X
Credit Production overheads X
is slightly different. The amount we debit WIP and credit production overheads is the amount
absorbed into production.
This leaves a balance on the production overheads account which is taken to the statement
of profit or loss.
Lecture example 3
Bodger & Co incurs production overheads of $6,000.
The production overhead to be absorbed into WIP is:
$
Manufacturing department 4,000
Finishing department 600
Quality control 500
Required
Show how the production overheads will be recorded in the following accounts:
 Payables control account
 Production overheads control account
 WIP control account
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Solution
PAYABLES
$ $
Raw materials 5,000
Direct labour 4,000
PRODUCTION OVERHEADS
$ $
WIP
$ $
Materials 5,000
Labour 4,000
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5 Chapter summary
1 Introduction Recognise the accounting entries required to turn
individual costs into a cost per unit.
2 Control accounts Control accounts show the total value of the items to
which they relate, ie materials, labour production or
WIP.
3 Basic double entry The relevant entries for a material purchase (and the
process for labour would be the same) all the way
through to the final accounts are:
Debit materials
Credit cash (or payables)
Debit WIP
Credit Materials
Debit finished goods
Credit WIP
Debit COS
Credit Finished goods
Debit Statement of profit or loss
Credit COS
4 Production overheads When the overheads are incurred, they are recorded by
debiting Production overheads and crediting cash (or
payables). The overheads are then absorbed by
debiting WIP and crediting production overheads. Any
balance left in the production account is taken to the
statement of profit or loss.
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6 Overview summary
Cost bookkeeping
Materials Labour Production overheads WIP
Debit Materials Debit Labour Debit Production Debit Finished goods

Credit Cash (payables) Credit Cash overheads Credit WIP
Credit Cash
Debit WIP Debit WIP (direct labour) Debit WIP with Debit Cost of sales
Credit Materials Credit Labour absorbed Credit Finished goods
overheads
Debit Production o/h
(indirect labour) Credit Production
overheads with
Credit Labour Debit SOP/L
absorbed
overheads Credit Cost of sales
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Chapter 10 Questions
10.1 Lessflash Co operates an integrated cost and financial accounting system.
The accounting entries for an issue of direct materials to production would be:
Account debited Account credited
 Work in progress control account Stores control account
 Finished goods account Stores control account
 Stores control account Work in progress control account
 Cost of sales account Work in progress control account
(2 marks)
10.2 A company's accounting system operates so that the cost accounts are independent from
the financial accounts. The two sets of accounts are then reconciled on a regular basis to
keep them continuously in agreement.
Which of the following terms correctly describes this accounting system?
 Independent accounts
 Interlocking accounts
 Reconciled accounts
 Integrated accounts (2 marks)
10.3 In a cost bookkeeping system what would be the entry for the absorption of production
overheads?
Debit Credit
 Cost ledger control account Production overhead account
 Production overhead account Work in progress account
 Work in progress account Cost ledger control account
 Work in progress account Production overhead account
(2 marks)
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Chapter 10 Answers
10.1 The correct answer is: Debit WIP control account Credit Stores control account
All direct costs of production are debited to the WIP control account.
10.2 The correct answer is: Interlocking accounts
The question describes interlocking accounts, where the cost accounts are distinct from the
financial accounts.
With integrated accounts, a single set of accounting records provides both financial and cost
accounts.
10.3 The correct answer is: Debit WIP account Credit Production overhead account
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END OF CHAPTER
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Job, batch and
service costing

 Describe the characteristics of job and batch costing.
 Describe the situations where the use of job or batch costing would be appropriate.
 Establish job costs from given information.
 Identify situations where the use of service operation costing is appropriate.
 Illustrate suitable unit cost measures that may be used in different service/operation situations.
 Carry out service cost analysis in simple service industry situations.
Exam Context
Although a small part of the syllabus, this is a popular topic for questions. Make sure that you are able to deal with basic
calculations.
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11: JOB, BATCH AND SERVICE COSTING
Overview
Job, batch and service

costing
Job and batch costing Service industry
Cost card Service cost units
Service department costing
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1 What is a job?
1.1 It is a cost unit which consists of a single order or contract carried out to the special
requirements of the customer.
1.2 Jobs differ and it is necessary to keep a separate record of each job, and the cost incurred
on that job.
2 Collection of job costs

2.1 Material requisitions are sent to stores requesting necessary material.
Example
2.2
MATERIALS REQUISITION
Material required for: No.

(job or overhead account)
Department: Date:
Quantity Description Code Weight Rate $ Notes

no.
Supervisor:
2.3 The material requisition is used to cost materials allocated to a job. This is recorded on a job
cost sheet or job cost card.
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Example
2.4
JOB COST CARD Job no.

Customer Customer's order no. Start
date
Job description
Delivery
Estimate ref. Invoice no. date
Quoted Invoiced Despatch
price price note no.
Material Labour Overheads
Cost Lab Cost Cost
Bonus
Date Req. Qty. Price Date Analysis Cost Hrs. Rate M/c OAR
no. $ p Ref. Ctre $ p hrs. $ p
Total C/F Total C/F Total C/F
Expenses Job cost summary Actual Estimate
Cost $ p $ p
Date Ref. Description
$ p Direct materials B/F
Direct expenses B/F
Direct labour B/F
= Prime cost
Factory overheads B/F
= Factory cost
Selling & admin. overheads
% on Factory cost
= Total cost
Invoice price
Total C/F Job profit/loss
Comments
Job cost card completed by ..............................................................................
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Labour costs
2.5 A job card or job ticket is completed by the employee, recording start and finish times, and
then passed on to the employee who undertakes the next function and so on.
Example
2.6
JOB CARD
Department .................................................................. Job no. ..............................................................................

Date .............................................................................. Operation no. ....................................................................
Time allowance ............................................................ Time started ......................................................................

....................................................................................... Time finished .....................................................................
....................................................................................... Hours on the job ................................................................
Description of job Hours Rate Cost
Employee no. .................................................................... Certified by ......................................................

Signature ..........................................................................
2.7 Direct materials, direct labour and direct expenses incurred as recorded on job cost are
charged to the job account, which will be a sub-account of WIP control account.
2.8 Job account will contain:
JOB ACCOUNT
$ $
Materials X Finished jobs X
Direct labour X
Direct expenses X
Factor overhead at
predetermined rate X
Other overheads X
S&D Admin X
X X
Notes
1 Other overheads will be charged on completion of the job.
2 The difference between selling price and total cost will be profit (or loss).
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Rectification costs
2.9 On inspection, work could be sub-standard. Rectification costs can be treated in two
different ways, depending upon the circumstances that gave rise to them.
(a) Not a frequent occurrence: charged as a direct cost to the job concerned.
(b) Regarded as normal part of work: treat as a production overhead.
3 Illustration of job costing
Lecture example 1
Bisley Co is a jobbing company. On 1 September 20X3 there was one uncompleted job in the
factory. The job card can be summarised as follows:
Job costing sheet: Job no. 5732
$
Direct materials 2,520
Direct labour (120 hours) 1,400
Production overhead ($4 per hour) 480
Production costs to date 4,400
During September another job was started (5832).
Production costs in September were as follows:
Materials issued to: 5732 9,560
5832 14,800
Material transfers
Job 5732 to 5832 2,480
Material returned to stores
Job 5732 3,480
Direct labour hours recorded
Job 5732 430 hours
Job 5832 280 hours
The cost of labour during September was $12 per hour. Production overheads incurred during the
month were $15,200.
The completed jobs were delivered as soon as they were finished. Invoices amounted to:
Job 5732 20,000
Job 5832 27,500
Administration overheads are added to the cost of sales at the rate of 20% of production costs.
Actual costs incurred in September amounted to $12,800.
Required
You are required to prepare summarised job cards for each job and calculate the profit/(loss) on
each completed job.
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Solution
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4 Batch costing
4.1 This is a cost unit which consists of several separate product units.
4.2 There is rather a grey area between batch and continuous processing as:
 Each batch is separate and identifiable;
but
 Within a particular batch all the individual items are identical as for continuous
processing.
4.3
Batch production
Input = Output
1
Batch 1
1 =
1
1
2
Batch 2
2 =
2
2
Continuous processing
Input = Output
Batch costing
4.4 This is no different from when a cost unit is a job.
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5 Service costing
What are service organisations?
5.1 Service organisations do not make or sell tangible goods. Profit-seeking service
organisations include accountancy firms, law firms, management consultants, transport
companies, banks, insurance companies and hotels. Almost all non profit-making
organisations – hospitals, schools, libraries and so on – are also service organisations.
5.2 Service costing differs from the other costing methods (product costing methods) for a
number of reasons.
(a) With many services, the cost of direct materials consumed will be relatively small
compared to the labour, direct expenses and overheads cost. In product costing the
direct materials are often a greater proportion of the total cost.
(b) The output of most service organisations is difficult to define and hence a unit cost is
difficult to calculate.
(c) The service industry includes such a wide range of organisations which provide such
different services and have such different cost structures that costing will vary
considerably from one to another.
Lecture example 2
Required
Suggest cost units used by companies operating in the following service industries.
Service industries Cost unit
Road, rail and air transport services
Hotels
Education
Hospitals
Catering establishments
Total costs for period

5.3 Cost per service unit =
Number of service units in the period
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6 Charging customers for services

6.1 The procedure for charging customers for services is similar to that which applies in job
costing. A mark up will be added to the cost per unit to give a selling price which will provide
the required level of profit.
6.2 The choice of the cost unit by the organisation is important to ensure that an equitable
charge is made to the users of the service.
6.3 Composite cost units

These are used when a single measure would not be appropriate. For example, when
paying for excess baggage on an airline, the charge might be based on:
(a) How far in km the baggage will be transported
(b) How heavy the baggage is
Both of these will impact the airline's fuel cost so it would be inappropriate to base the
charge on km or weight alone.
7 Chapter summary
1, 2 & 3 What is job costing Job costing is a costing method applied where work is
undertaken to customers' special requirements and
each order is of comparatively short duration.
4 Batch costing Batch costing is similar to job costing in that a
separately identifiable group of units are produced
(often to order) and are treated as a single cost unit
(like a job).
5 Service costing Service costing is used by companies operating in a
service industry. The main difficulty is defining an
appropriate cost unit.
6 Charging customers for This is used to determine costs for 'internal services'
jobs such as canteens or IT support.
8 Formulae summary
Total costs for period

Cost per unit =
Number of service units in the period
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9 Overview summary

costing

Job – single jobs or contracts  Product  not tangible
Batch – lots of identical items that  Costs  higher proportion of
make up one cost unit costs may be indirect costs
 Cost unit  changes

Direct materials X  Quite often difficult to identify and
Direct labour X compare against competitors
Prime cost X within the same industry
Overheads X
Total cost X

 Cost of an internal service
 A business will want to:
Control cost of Control usage of service

department providing in company
service
 Methods of deciding the cost to charge for

an internal service
– Actual cost
– Standard cost
– Opportunity cost
– Variable cost
– Cost + margin
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11.1 For which of the following is it most appropriate to use job order costing?
 A petroleum refinery
 A manufacturer of personal computers
 A manufacturer of ready meals
 A firm of solicitors (2 marks)
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Chapter 11 Answers
11.1 The correct answer is: A firm of solicitors
Job costing is appropriate where each unit of work is tailored to individual customer
requirements.
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END OF CHAPTER
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To reinforce your learning to date you should now follow the study guidance in the
following pages. On completion, your progress towards full exam preparation will be:
Take some time to reflect on the knowledge and skills you covered during Stage 2. The Course
Notes section for each chapter (starting overleaf) provides helpful guidance (and time
commitments) on how to focus your review on the key learning points in your notes.

The second stage of the MA2 course covers accounting for overheads, absorption and marginal
costing, as well as job, batch and service costing. Absorption and marginal costing are both
fundamentally important topics which will be examined in every exam and it is important that you
spend time ensuring you are happy with these topics.
Key knowledge
 Absorption costing – focuses on the distinction between production and non-production
costs. It can seem complicated at first but it will help you to 'keep it simple' in your studies by
remembering that it is just a technique for sharing out fixed production overheads in a 'fair'
way, amongst the units of production. Absorption costing is a three-stage process – Step 1:
Allocation and Apportionment, and Step 2: Re-apportionment. These stages are concerned
with fairly sharing overheads between cost centres before these costs are absorbed into
units. You will need to be comfortable with the reason for this sharing out of costs and with
the techniques used to enable you to be comfortable with Step 3. Step 3, absorption, is
perhaps the most important as it can lead to so many different types of exam questions. You
must know how to calculate an OAR, and calculate under, or over-absorption, as well as
understand why this arises.
 Marginal costing – focuses on the distinction between variable and fixed costs. It is a simpler
technique than absorption costing, but this doesn't mean it's less important! It is hard to think
of a concept that is more integral to management accounting than 'contribution' – so take the
time now to ensure you fully understand how to calculate this and what it represents. It is
also important to understand why different profits can be reported by absorption and
marginal costing, and how to explain or reconcile the difference.
 Job and batch costing – the key here is to remember that each job or batch will be different
depending on the customer's requirements.
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CHECKPOINT 2
 Service costing – the focus here is that the provision of services is significantly different to
manufacturing and therefore requires different considerations when it comes to analysing
and controlling costs. Composite cost units are often used – they help to 'standardise'
different services so that comparison is meaningful and cost control more effective.
Key skills
 Re-arranging formulae – there are quite a few formulae associated with absorption and
marginal costing and you will need to add these to your 'Formulae to Learn' sheet. However
it is not always enough to simply remember a formula; sometimes you will also need to
rearrange them in order to find a missing value.
 If you haven't used formulae recently then spend some time looking at Questions 8.4 in the
Course Notes which both require the re-arrangement of the absorption costing formulae, and
make sure you are comfortable with the method that has been used. This skill is also
required in Chapter 9, where you are sometimes asked to use the formula to reconcile profits
between the two costing methods to find the OAR or stock movement. You can practise this
by doing Questions 9.2 and 9.7 in the Course Notes.
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CHECKPOINT 2
Chapter 8 – Overheads and absorption costing 77 minutes
Key areas
 Allocation and apportionment of overheads to cost centres
 Re-apportionment of overheads from service to production cost centres
using the direct and reciprocal methods
 Allocation of production overheads to cost units
 Calculating under- or over-absorption of overheads
Course Notes
 Review the notes for Steps 1 and 2 of the absorption costing process and 30 minutes
review the Lecture examples. It is important to keep clear in your mind the
final aim of absorption costing which is to assist in estimating the cost of one
unit of production.
 Steps 1 and 2 are to help us estimate how much overhead relates to each
production cost centre before we can absorb this into units in Step 3.
 Make sure you are clear on the difference between the direct and reciprocal
methods.
 Review the diagram in section 3.2 to make sure you understand the steps of
absorption costing.
 Run through the Lecture examples once more with the diagram in front of
you.
 Start learning the overhead absorption rate formula and how you calculate
overheads absorbed and under-/over-absorption.
Question practice
 Attempt all the questions from the Course Notes end of chapter questions. 17 minutes
Question 6 Overheads and absorption costing – 6.2, 6.4, 6.5, 6.13, 6.14,
6.18, 6.20
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CHECKPOINT 2
Chapter 9 – Marginal and absorption costing 42 minutes
Key areas
 Understanding contribution and marginal costing techniques
 Calculating a profit or loss figure under absorption and marginal costing
Course Notes
 Review the profit and loss calculations in Lecture example 1. 10 minutes
 Make sure that you are happy with how to reconcile a profit figure
calculated using absorption costing techniques and one calculated using
marginal costing.
Question practice
 Work through the question from the Course Notes end of chapter questions 10 minutes
for Chapter 9.
Question 7 Absorption and marginal costing – 7.1–7.5, 7.9, 7.11–7.13
Chapter 10 – Cost bookkeeping 39 minutes
Key areas
 Understanding the cost accounting entries for materials, labour and
overheads
 Understanding the treatment for absorbing overheads and dealing with
under- or over-absorption within the cost accounting ledgers
Course Notes
 Make sure that you are happy with the terminology in this chapter. 5 minutes
Question practice
 Work through the questions from the end of chapter questions in Chapter 10 5 minutes
in the Course Notes.
Question 8 – all questions
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CHECKPOINT 2
Checkpoint 2 – Study Support (cont)
Chapter 11 – Job and service costing 29 minutes
Key areas
 Cost records and accounts for job and batch situations
 Cost unit measures in service operations
Course Notes
 Make sure that you are happy with the terminology in this chapter. 5 minutes
Question practice
 Work through the questions from the end of chapter questions in Chapter 11 5 minutes
in the Course Notes.
Question 9 Job, batch and service costing – 9.1–9.6, 9.9, 9.12
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CHECKPOINT 2
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Process costing

 Describe the characteristics of process costing.
 Describe the situations where the use of process costing would be appropriate.
 Explain the concepts of normal and abnormal losses and abnormal gains.
 Calculate the cost per units of process outputs.
 Prepare process accounts involving normal and abnormal losses and abnormal gains.
 Distinguish between by-products and joint products.
 Value by-products and joint products at the point of separation.
 Prepare process accounts in situations where by-products and/or joint products occur.
Exam Context
Process costing has historically been a common examination question. You might be required to do calculations for
completion of a process account. Make sure that you can deal with losses, gains and scrap values.
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12: PROCESS COSTING
Overview
Process costing
General principles of Abnormal loss Abnormal gain

process costing
Normal losses
Without scrap With scrap value

value
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12: PROCESS COSTING
1 General principles
Introduction
1.1 Process costing is not an alternative to absorption costing or marginal costing. Rather, it is a
method for applying these costing systems if goods or services are produced in a series of
processes. The essence of process costing involves the averaging of the total costs of each
process over the total output of that process.
Lecture example 1
Input to Process I during a period was 1,000 units of raw materials, cost $40,000.
Other costs were: labour – $50,000, overheads – $20,000.
All output was transferred to Process II.
Required
Prepare the Process I ledger account.
Solution
PROCESS I
Units $ Units $
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12: PROCESS COSTING
2 Normal loss – no scrap value

Definition
2.1 Normal loss is the loss that is expected from the experience of the process, such as
wastage or evaporation.
Lecture example 2
Input and costs same as Lecture example 1.
Losses normally account for 10% of input.
Output was 900 units.
Required
Prepare the Process I ledger account.
Solution
PROCESS I
Units $ Units $
3 Normal loss – non-zero scrap value

Introduction
3.1 If we are able to sell the normal loss at a price, then we can use the proceeds to reduce the
processing costs.
3.2 Normal loss can be calculated in several ways:
(a) Percentage of input (most common) – this means materials input only, not opening WIP
(b) Percentage of throughput = opening WIP + materials input – closing WIP
(c) Percentage of good output
(d) Percentage of total output = good output + losses
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12: PROCESS COSTING
Lecture example 3
Required
Prepare the Process and Scrap ledger accounts for the following situations using data as in
Lecture example 2.
Solution
(a) Given all scrapped units have a scrap value of $20 each:
PROCESS I
Units $ Units $
SCRAP ACCOUNT
Units $ Units $
(b) Suppose that the scrap merchant pays not $20 per unit as anticipated, but only $19. Then
the losses a/c will look like:
SCRAP ACCOUNT
Units $ Units $
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12: PROCESS COSTING
4 Abnormal losses
4.1 This is as before, but the output to Process II is 880 units not 900 units as expected. (We
call this 'extra' loss over and above what we normally expect an abnormal loss of 20 units.)
Treatment:
Value in the same way as output and include as a miscellaneous expense in the statement
of profit or loss.
Lecture example 4
Required
Prepare appropriate ledger accounts given an abnormal loss of 20 units.
Solution
PROCESS I
Units $ Units $
SCRAP ACCOUNT
Units $ Units $
ABNORMAL LOSSES ACCOUNT

Units $ Units $
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12: PROCESS COSTING
5 Abnormal gains
5.1 This is as before but the output to Process II is 920 units, not 900 units as expected. (We
call this extra output an abnormal gain of 20 units.)
Lecture example 5
Required
Prepare appropriate ledger accounts given an abnormal gain of 20 units.
Solution
PROCESS I
Units $ Units $
SCRAP ACCOUNT
Units $ Units $
ABNORMAL GAINS ACCOUNT

Units $ Units $
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12: PROCESS COSTING
6 Joint products
6.1 Two or more products which are output from the same processing operation, but which are
indistinguishable from each other up to their point of separation.
They each have a substantial sales value either immediately or after further processing.
7 By-product
7.1 These are products produced at the same time and in the same process as the joint
products but are recognised by a relatively low sales value compared to the main product or
joint products.
8 Treatment
By-products
8.1 (a) Do not allocate joint costs to them.
(b) If this is a usual occurrence then calculate net proceeds of by-products and reduce
process costs by this amount.
(c) If this is a one-off occurrence then calculate net proceeds and treat as miscellaneous
income.
Joint products
8.2 Joint products cannot be identified until split-off point.
Therefore costs incurred up to split-off point need to be apportioned on some basis to the
joint products.
Method of apportionment:
(a) Physical units
(b) Relative sales value
(c) Net realisable value (NRV) at split-off point
9 Physical units
Lecture example 6
Process: P1 600 kg
P2 1,200 kg
By-product 200 kg for which we expect to realise $500.
Required
Allocate the joint costs on a physical units basis.
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12: PROCESS COSTING
Solution
PROCESS ACCOUNT
Units $ Units $
Materials 2,000 2,000
Labour 2,000
Overheads 1,000
Uses
9.1 This is a useful method if:
(a) The joint products are in the same form; eg both solids or both liquids
(b) The joint products are components in another product and therefore have no relevant
sales value
10 Net realisable value

Definition
10.1 Net realisable value (NRV) = Sales value less all further costs to completion
(ie further production costs and selling costs)
Lecture example 7
A company produces four products from a process. Common costs are $16,000.
Further
Production Selling price process Selling price
Units $ $ $
A 600 1,000 10
B 400 2,500 20
C 500 7
D 600 10
Required
Allocate the joint costs to the four products according to their net realisable value.
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12: PROCESS COSTING
Solution
Uses
10.2 This is the best method for joint products where some are to be sold immediately and others
only after some modification/further processing.
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12: PROCESS COSTING
11 Further processing decisions
Lecture example 8
Further processing decisions
Final selling Post separation Output Selling price
price costs at separation
X $5 $10,000 2,500 $3
Y $10 $8,000 1,500 $5
Z $15 $12,000 2,000 $8
Joint processing costs $20,000.
Required
Which products should be processed further?
Solution
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12: PROCESS COSTING
12 Chapter summary
1 General principles Process costing can be used in a situation where it is
not possible to identify separate units of production.
2&3 Normal loss Expected losses are called normal losses.
4 Abnormal loss During the process abnormal losses may occur, when
the actual loss differs to the expected loss.
5 Abnormal gain During the process abnormal gains may occur.
6&7 Joint and by-products Joint products are two or more products separated after
a process, each of which has a significant value.
A by-product is an incidental product from a process
which has an insignificant value compared to the main
product.
8 Treatment By-products are not allocated any of the joint costs.
Joint products need to be apportioned a fair share of
the joint costs at the split-off point.
9 & 10 Apportioning joint costs The main methods of apportioning joint costs are by
on physical units basis physical measurement and by net realisable value
or net realisable value method.
basis
11 Further processing Sometimes it is necessary to consider whether products
decisions should be sold immediately or processed further and
sold later for a little more revenue.
13 Formulae summary
Unit calculation:
Input cost – Scrap value of normal loss
Cost per unit (used when no WIP) =
Input units – Normal loss units
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12: PROCESS COSTING
14 Overview summary
Process costing

process costing
 Unexpected losses during  Unexpected gains during
the process the process
Good
Inputs Process 1 Good
output
output Good
output
Normal
Inputs Process 1
loss Inputs Process 1 Normal
Normal losses loss
Abnormal
 Losses expected in the process loss Abnormal
gain
Abnormal losses valued at CPU
Good
Inputs Process 1 output
Abnormal gains valued at CPU
Normal
loss
Without scrap value With scrap value

 No proceeds from  Income generated from
scrapped units scrapping units
Value of output at cost per unit (CPU)

CPU =
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12: PROCESS COSTING
12.1 An abnormal loss would arise when:
(i) Total losses are less than expected
(ii) Total losses are greater than expected
(iii) Total output is less than expected
(iv) Total output is greater than expected
Which of the following is correct?
 (i) only
 (i) and (ii)
 (ii) and (iii)
 (iii) and (iv) (2 marks)
12.2 In process costing a joint product is:

 A product which is later divided into lots of parts
 A product which is produced simultaneously with other products and is of similar
value to at least one of the other products
 A product which is produced simultaneously with other products but is of a greater
value than any of the other products
 A product which is produced jointly with another organisation (2 marks)
12.3 What is a by-product?

 A product produced at the same time as other products which has no resale value
 A product produced at the same time as other products which requires further
processing to put it in a saleable state
 A product produced at the same time as other products which has a relatively low
volume compared to the other products
 A product produced at the same time as other products which has a relatively low
value compared to the other products (2 marks)
12.4 In process costing, if an abnormal loss arises, the process account is generally:
 Debited with the scrap value of the abnormal units
 Debited with the full production cost of the abnormal units
 Credited with the scrap value of the abnormal loss units
 Credited with the full production cost of the abnormal units (2 marks)
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12: PROCESS COSTING
12.5 A company which produces high-class perfumes has a production schedule for April
showing that 5,000 kg of materials were input to the process. These cost an average of
50 cents per kg. Other costs for the month amounted to $1,500. It is generally expected that
20% of materials input will be lost due to spillage and that the waste can be sold for 20 cents
per kg. Output from this process was 3,800 kg for April. What is the total abnormal loss in kg
for April?
 1,200 kg
 4,000 kg
 1,000 kg
 200 kg (2 marks)
12.6 With regard to normal losses, which of the following statements is true?
 Normal losses always occur in a production process.
 The normal loss is the number of rejected outputs from a process.
 An abnormal gain occurs when actual loss is more than normal or expected loss.
 Normal loss units are valued at their scrap value in the process account. (2 marks)
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12: PROCESS COSTING
Chapter 12 Answers
12.1 The correct answer is: (ii) and (iii)
(ii) If more losses have been incurred than expected the loss is abnormally high.
(iii) If output is less than expected, losses must be higher than expected.
12.2 The correct answer is: A product which is produced simultaneously with other products and
is of similar value to at least one of the other products
Joint products are two or more products produced by the same process and separated in
processing, each having a sufficiently high saleable value to merit recognition as a main
product.
A joint product may be subject to further processing, as implied in option A, but this is not
the case for all joint products.
12.3 The correct answer is: A product produced at the same time as other products which has a
relatively low value compared to the other products
A by-product is output of some value produced in manufacturing, which is separate to the

main product.
The first option is incorrect because a by-product has some value.
The second option is incorrect because this description could also apply to a joint product.
The third option is incorrect because the value of the product described could be relatively
high, even though the output volume is relatively low.
12.4 The correct answer is: Credited with the full production cost of the abnormal units
The abnormal loss units are valued at their full production cost and credited to the process
account, so that their occurrence does not affect the cost of good production.
12.5 The correct answer is: 200 kg
Normal loss in the period = 5,000 kg  20% = 1,000 kg

Expected good output = Inputs – Normal loss = 5,000 kg – 1,000 kg = 4,000 kg
Abnormal loss = Expected output – Actual output = 4,000 kg – 3,800 kg = 200 kg
12.6 The correct answer is: Normal loss units are valued at their scrap value in the process
account
Revenue from the sale of normal loss units is used to reduce the total costs of production,
and thus normal loss units are included in the process account at their scrap value.
END OF CHAPTER
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The third stage of the MA2 course finishes off the important topic of process costing.
Key knowledge
 Process costing – at first sight this can seem quite different to anything that you've seen
before. Do not be put off by the use of T-accounts – they are especially useful in process
costing because you need to keep track of units and cash at the same time. It will help you
to remember that this is just another technique for working out the cost of one unit of output
that is used in certain 'process' industries. The definitions of normal loss and abnormal loss
and gain are important.
 Joint products and by-products – in the exam you may be tested on the definitions of these
and/or the different treatments that both require.
Key skills
 How to tackle multiple choice questions – the basic approach to tackling multiple choice
questions is to first read the question and ALL the options; secondly, eliminate any
answers that are definitely incorrect; and thirdly, select what you consider to be the most
appropriate response; and lastly, move on.
 This last stage is particularly important if you are faced with a question where you are
struggling – it is essential that you do not spend excessive time trying to figure out one
question and then not have sufficient time to attempt all the questions on the exam. You
should make your best attempt and move on to work on other questions where you are likely
to have a better chance of coming to the right answer.
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CHECKPOINT 3
Chapter 12 – Process costing 80 minutes
Key areas
 Calculation of the cost per unit when there are losses in the production
process
 The difference between the valuation of normal and abnormal losses
 Allocation of joint costs and dealing with by-products
Course Notes
 Review your notes slowly; rework Lecture examples 3, 4 and 5. 10 minutes
 Learn the full unit calculation and the cost per unit calculation. 5 minutes
 Learn the bookkeeping of normal and abnormal losses. 5 minutes
 Review Chapter 12 to make sure that you are happy with terminology and 10 minutes
the two methods of allocating costs to joint products.
Question practice
 Complete all the questions from the end of chapter questions in Chapter 12 20 minutes
of the Course Notes.
Question 10 Process costing – all questions
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Cost–volume–profit
analysis

 Calculate the contribution per unit and the contribution to sales ratio.
 Explain the concept of breakeven and the margin of safety.
 Use contribution per unit and contribution/sales ratio to calculate breakeven point and margin of safety.
 Analyse the effect on breakeven point and margin of safety of changes in selling price and costs.
 Use contribution per unit and contribution/sales ratio to calculate the sales required to achieve a target profit.
 Interpret breakeven and profit/volume charts for a single product or business.
Exam Context
Cost–volume–profit analysis is one of the key roles that a management accountant may perform and is essential for
planning and control within a business.
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13: COST–VOLUME–PROFIT ANALYSIS
Overview
Identifies the Cost–volume–profit analysis

breakeven point for a
business
Breakeven point Target profit Margin of safety
Breakeven revenue Units %
Breakeven point Contribution

 selling price to sales ratio
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1 Overview
1.1 It is important for management to know and predict how changes in volume (production
output and sales) will impact costs and revenues and hence profitability. Indeed, breakeven
analysis is often referred to as cost–volume–profit (CVP) analysis.
Definition
1.2 Cost–volume–profit analysis is concerned with the relationship between sales volume and
profit level.
1.3 Specifically, cost–volume–profit analysis identifies the breakeven point for a company.
The breakeven point is the sales volume at which the company makes a nil profit ('breaks
even'). If sales exceed the breakeven point the company will make a profit.
2 Breakeven point
Contribution
2.1 Total contribution = Sales volume  Contribution per unit
Re-arrange this equation to give the formula for finding the sales volume:
Sales volume = Total contribution/Contribution per unit
Breakeven formula
2.2 Remember that profit is equal to contribution less fixed costs.
Where profit is nil, fixed costs must be exactly equal to contribution:
Sales volume at breakeven point = Fixed costs/Contribution per unit
Target profit
2.3 This approach can be used to identify the sales volume necessary to achieve any given
profit figure, not just zero:
Sales volume at target profit = (Fixed costs + Target profit)/Contribution per unit
Contribution to sales ratio

2.4 The ratio of contribution to sales (C/S ratio) is an alternative method of finding the
breakeven point. This ratio is a measure of the amount of contribution earned per $1 of
sales revenue. The C/S ratio is often approximately the same as the gross profit margin.
Breakeven revenue = fixed costs/C/S ratio
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Margin of safety
2.5 This is a measure of the amount by which sales must fall before we start making a loss.
A loss is made if sales volume is less than the breakeven point (BEP).
 Margin of safety = Budgeted sales volume less breakeven volume
or, as a percentage:
Budgeted sales volume – Breakeven sales volume

Margin of safety =  100
Budgeted sales volume
Lecture example 1
Pile and Sell Co's output and costs are as follows:
Budgeted output 5,000 batteries
Fixed costs $5,700
Variable costs $6.50 per battery
Selling price $8.00 per battery
Required
Calculate:
(a) Breakeven point and revenue
(b) C/S ratio
(c) Margin of safety
(d) The sales to achieve profit of $10,000
(e) The change in budgeted profit if selling price is increased by 10%. To ensure that sales
volume only falls by 5%, fixed advertising costs of $3,000 need to be incurred.
Solution
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3 Breakeven charts and contribution charts

3.1 A breakeven chart shows the profit or loss at different levels of sales.
It shows, in diagrammatic form, the relationship between sales volume or value, total
revenue and total costs. Breakeven occurs when total costs are equal to total revenue.
The horizontal axis is used for sales volume or value and the vertical axis for money (costs
and revenue).
Three lines are plotted on the graph:
 Firstly the sales revenue line (which will pass through the origin, since when sales
volume is nil, revenue is nil);
 Then the fixed costs line (which will be parallel to the horizontal axis); and
 Finally the total costs line.
Below is the breakeven chart for the data in Lecture example 1.
$
TR
TC
30,400
5,700 FC
Output
3,800
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Profit–volume chart for the data in Lecture example 1
Profit
Budgeted profit
Breakeven Sales volume

3,800 units
5,700
Loss
4 Limitations of CVP analysis

 This approach can only be applied to a company producing a single product or a mix
of products in constant proportions.
 Costs must be able to be split into fixed and variable elements. Stepped costs can not
be included in the analysis.
 It is assumed that selling price per unit and variable cost per unit are constant at all
levels of activity (and, therefore, that the C/S ratio remains constant).
 This implies a linear relationship between profit and sales volume; in practice this is
unlikely to be the case.
 No account is taken of changes in inventory.
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5 Chapter summary
1 Overview Cost–volume–profit (CVP) analysis is concerned with
the relation between sales volume and profit level.
2 Breakeven point The breakeven point illustrates the number of units a
business must sell to ensure it breaks even incurring
no loss but equally no profit.
This can be found using a number of different
formulae which you need to be able to use and
manipulate to get the required answer.
3 Breakeven charts A profit–volume chart shows the profit or loss and
and contribution contribution made by the business at different levels
charts of sales.
A breakeven chart clearly shows the number of units
which need to be sold in order for a company to break
even, along with the breakeven revenue, variable
costs and fixed costs.
4 Limitations of CVP The approach considered in MA2 for calculating and
analysis identifying the breakeven point can only be applied to
a business producing a single product or a mix of
products produced and sold in constant proportions.
6 Formulae summary
Contribution
Total contribution = Sales volume  Contribution per unit
Breakeven point
Fixed costs/Contribution per unit
Breakeven revenue
Breakeven point  Selling price
or
Fixed costs/C/S ratio
Contribution to sales (C/S) ratio
Contribution per unit/Selling price per unit
Target profit
(Fixed costs + Target profit)/Contribution per unit
Margin of safety
Units = Budgeted sales – Breakeven sales
% = ((Budgeted sales – Breakeven sales)/Budgeted sales)  100
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7 Overview summary

breakeven point for
a business
The number of units The number of units

you must sell to you must sell to The amount sales
break even achieved your target can fall by before
profit you start making a
 Fixed costs/ loss
 Fixed costs + Target
Contribution per profit/Contribution per
unit unit

(BER)
 Budgeted sales – BEP/

Budgeted sales = %
 Budgeted sales – BEP = Units
Contribution
BEP  SP =
to sales ratio
BER
Illustrates the
contribution earned per
$1 of sales revenue
 Contribution per unit/Selling price

per unit = C/S ratio
 Fixed costs/ C/S ratio= BER
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The following information relates to questions 13.1 to 13.3
The accountant of Lee plc has calculated the company's breakeven point from the following data:
Selling price per unit $6.00
Variable production cost per unit $1.20
Variable selling cost per unit $0.40
Fixed costs per unit based on a budgeted 10,000 units $4.00
13.1 The company's breakeven point is:

 8,333 units
 9,091 units
 10,000 units
13.2 How many units must be sold if Lee wants to make a profit of $12,000?
 9,286
 10,333
 11,818
 130,000 (2 marks)
13.3 It is now expected that the variable production cost per unit and selling price per unit will
each increase by 10%. These changes will cause the breakeven point to fall by:
 0.8%
 1.6%
 9.1%
 9.8% (2 marks)
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13.4 Budgeted sales of a company's single product in a period are 20,000 units, producing a total
contribution of $180,000 at a selling price of $24 per unit. Fixed costs are $6 per unit based
on budgeted sales quantity.
What is the budgeted variable cost per unit?
 $3
 $9
 $15
 $18 (2 marks)
13.5 A firm makes a single product. Budgets have been prepared for the year ahead and include
production and sales of 60,000 units with a breakeven point of 45,000 units.
What is the margin of safety?
 25%
 33%
 75%
 133% (2 marks)
13.6 ABC Co manufactures a single product, the 'F', data for which is as follows:
Selling price (per unit) $60
Direct material cost (per unit) $14
Direct labour cost (per unit) $12
Variable overhead cost (per unit) $19
Fixed overhead per cost (per unit) $11
What is the contribution/sales ratio for product Q (to the nearest percent)?
 25%
 45%
 48%
 57% (2 marks)
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Chapter 13 Answers
B/E = Fixed costs/contribution per unit

(10,000  $4)/($6 – $1.20 – $0.40)
= 9,091
13.2 The correct answer is: 11,818
Profit = $12,000, B/E = FC + Profit/Contribution per unit

= ($40,000 + $12,000)/$4.40
= 11,818
13.3 The correct answer is: 9.8%
New B/E point = $40,000/($6.60 – $1.32 – $0.40)

= 8,197
% fall = (9,091 – 8,197)/9,091
= 9.8%
24 – (180,000/20,000) = $15
((60,000 – 45,000)/60,000)  100 = 25%
The contribution to sales ratio (C/S ratio) is another term used to describe the profit/volume
ratio (P/V ratio).
C/S ratio = Contribution per unit/Selling price per unit

= ($(60 – 14 – 12 – 19)/$60)  100 = 25%
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END OF CHAPTER
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Decision making

 Explain the importance of the limiting factor.
 Identify the limiting factor given in various situations.
 Formulate and determine the optimal production plan when there is a single resource constraint.
 Solve make/buy-in problems when there is a single resource constraint.
 Explain the concept of relevant costs.
 Apply the concept of relevant costs in business decisions.
Exam Context
Decision making has been a common exam area which appears regularly in the exam. You might be required to
calculate the relevant costs of materials, labour and other expenses or asked to consider a situation where there is a
limiting factor.
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14: DECISION MAKING
Overview
Decision making
Future incremental
cash flows
Materials Labour
Decisions:
 Accept or reject
 Make or buy
Limiting factor
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14: DECISION MAKING
1 Relevant costs/revenues in decision making

Definition
1.1 Future cash flows arising or stopped as a direct result of the decision under review.
Sunk costs
1.2 Definition Sunk costs are costs incurred in the past that cannot be changed.
For example, research costs of $5,000 previously incurred is a sunk cost and therefore not
to be considered in further decision making.
Committed costs
1.3 Definition Committed costs are costs which will be incurred in the future that cannot
be changed.
For example, building rental costs.
Avoidable costs
1.4 Definition Avoidable costs are those costs which can be identified with an
activity/decision and which would be avoided if the activity did not exist.
For example, equipment costs for a project of $7,000 will be avoided if the project does not
go ahead.
Opportunity cost
1.5 Definition Opportunity cost is the benefit foregone by selecting one course of action in
preference to the most profitable alternative.
For example, X plc can undertake one of two projects. Project A would results in profits of
$20,000 and Project B $14,000. X plc would decide to go ahead with Project A and as a
result would lose out on the $14,000 from Project B. Therefore the opportunity cost is
$14,000.
Relevant costs of inputs for a decision

1.6 This is a particular technique for calculating relevant costs for materials.
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14: DECISION MAKING
Relevant costs of inputs for a decision

Relevant cost – materials
In inventory Not in inventory
In continual No other Scarce Just have

use use to buy it
If take from If take from If take from Relevant

inventory inventory inventory cost
Relevant cost Relevant cost Relevant cost
Relevant cost – labour
Labour
Could hire Spare capacity Full capacity

More
Relevant cost = Relevant cost = Relevant cost =
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14: DECISION MAKING
Lecture example 1
A contract requires 400 kg of X and 200 kg of Y.
The following data is available
In inventory Historic cost Current Scrap value
purchase
price
X 300 kg $2/kg $3/kg $2.20
Y 300 kg $0.50/kg $2/kg $1.50
X is no longer used by the company; Y is regularly used for other products/purposes within the
business.
Required
What is the relevant cost of X and Y to be included in the contract cost?
Solution
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14: DECISION MAKING
Lecture example 2
A plc is deciding whether to undertake a new contract.
15 hours of labour are required for the contract. Labour is currently at full capacity producing X.
Cost card for X $/unit

Direct materials (10 kg @ $2) 20
Direct labour (5 hrs @ $6) 30
Variable overheads (60% of direct labour) 18
68
Selling price 90
Contribution 22
Required
What is the cost of using 15 hours of labour for the contract?
Solution
Question types
1.6 There are three decision-making scenarios with which you must become familiar:
(a) Accept or reject a contract
(b) Make or buy
(c) Limiting factor
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14: DECISION MAKING
2 Accept or reject decisions
Lecture example 3
Company Thomas is at full capacity producing Adams; details per unit are as follows:
$
Selling price 20
Costs:
Direct materials 8
Direct labour (2 hours) 4
Fixed overhead (2 hours) 4
16
Details of one-off contract:
 Requires 100 hours of labour
 $500 of special materials to be bought in
 Revenue to be received of $1,000
Required
Should the company accept the contract?
Solution
3 Make or buy decisions
Lecture example 4
Product A can be bought for $23. Alternatively it can be made in two labour hours, requiring $10
per unit of raw materials. Currently labour is at full capacity making product B which makes a
contribution of $9 in 3 labour hours, labour being paid at the rate of $5 per hour. Fixed overheads
are absorbed at the rate of $2.00 per labour hour.
Required
Advise the company whether to make or buy product A.
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14: DECISION MAKING
Solution
4 General factors to consider in decision making

4.1 (a) Are the cash flows known with certainty?
(b) What are the objectives of the company?
(c) Are there any alternative courses of action which have not been considered?
(d) What will be the impact of the decision on:
(i) The workforce;
(ii) Customers; and
(iii) Competitors?
5 Limiting factor decisions

5.1 If there is only one scarce resource then we can use the method of maximising contribution
per unit of that limited resource.
Lecture example 5
A company sells two products, Tom and John, for which the following details are available.
Tom John
$ $
Direct labour (@ $5 per hr) 15 10
Direct materials (@ $2 per kg) 2 5
Variable overheads 2 2
Fixed overheads 3 3
22 20
Selling price $25 $22

Maximum demand per month 10,000 8,000
Required
If only 40,000 labour hours and 35,000 kg of material are available per month, what is the optimal
production plan?
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14: DECISION MAKING
Solution
6 Advantages and limitations of using opportunity

costs for decision making
6.1 Management are made more aware of how well they are using resources, and whether
resources could be used better in other ways.
6.2 It is not always easy to recognise alternative uses for certain resources, nor to put an
accurate value an opportunity cost.
It is only likely to be accurate in situations where resources have alternative uses which can
be valued at an external market price.
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14: DECISION MAKING
7 Chapter summary
1 Relevant costs/ Relevant cash flows are those which are considered to
revenues in decision be future, incremental, cash flows.
making They are not sunk costs.
2 Accept or reject Where a decision to accept or reject a particular
decisions opportunity arises we should only accept it if the
relevant revenues exceed the relevant costs.
3 Make or buy decisions We should only decide to make a product in house
rather than buying it in if the relevant cost of making the
product is cheaper than the current purchase price.
4 General factors to With any decision that needs to be made consideration
consider in decision should be given to certainty of the cash flows, the
making objectives of the business, alternative courses of action,
and the impact on the workforce, customers and
competitors.
5 Limiting factor If there is one scarce resource preventing the business
decisions from producing indefinite amounts of product, then the
method of maximising contribution per unit of limiting
factor should be used when deciding the quantity of
each product which should be produced.
6 Advantages and Although opportunity costing methods are useful for
limitations of using helping management to look at alternative methods for
opportunity costs for using resources, they can be difficult to identify and
decision making value.
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14: DECISION MAKING
8 Overview summary
Decision making
Future incremental
cash flows
Materials Labour
Could hire more staff:
In inventory Not in inventory Current rate of pay
In constant use: Current purchase
Replacement cost price Spare capacity:
No relevant cost
No other use:
Scrap value Full capacity:
Opportunity cost
Scarce:
Opportunity cost Lost contribution
Or
Decisions: Lost revenue
Only accept if you will
ultimately be profitable
 Make or buy
Only make if it is cheaper (a) Identify the limiting
than buying the product factor
(b) Calculate the
contribution
per unit
(c) Calculate the
contribution per
unit of limiting
factor
(d) Grade your
products
Limiting factor (e) Identify the optimal
production plan
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14: DECISION MAKING
14.1 F Co has to incorporate 100 kg of material X into a special order for a customer. Data for
material X is as follows:
Quantity in inventory 75 kg
Original purchase price $2/kg
Current purchase price $3/kg
If not used on the special order all existing inventory of X must be disposed of at a cost to
F Co of $0.50/kg.
What is the relevant cost of material X for the special order?
 $37.50 cost
 $37.50 saving
 $75 cost
 $187.50 cost (2 marks)
14.2 A company manufactures two products, S and T. Both products use the same type of
resources, with the following revenue/cost per unit.
Product S Product T
$ $
Selling price 40 30
Direct materials ($4/kg) (8) (12)
Direct labour ($6/hr) (18) (6)
Fixed overhead ($3/hr) (9) (3)
Profit 5 9
Only 15,000 kg of material are available in the short term, compared with 20,000 labour
hours. Maximum demand for the products are 5,000 units and 2,000 units for S and T
respectively. The fixed overhead absorption rate is based upon the maximum sales demand
levels; none of the fixed overheads are avoidable.
The maximum profit the company can earn is:
 $36,000
 $39,000
 $43,000
 Cannot be determined except by linear programming (2 marks)
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14: DECISION MAKING
14.3 Within decision making, cash flows need to be considered as relevant. Which of the follow
are characteristics associated with relevant costs?
(i) Future
(ii) Unavoidable
(iii) Incremental
(iv) Differential
 (i) and (iii) only
 (i), (iii) and (iv) only
 All of them (2 marks)
14.4 When comparing the costs of different manufacturing firms, it was found that one firm
charged rent as an expense even though the firm owned the building from which it traded.
How should this rental cost be considered?
 An avoidable cost
 A incremental cost
 A fixed cost
 A notional cost (2 marks)
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14: DECISION MAKING
Chapter 14 Answers
14.1 The correct answer is: $37.50 cost
If we need the relevant cost of material in a contract/special order the decision we are
looking at is whether to go ahead with the contract or not.
There is a further question: if we go ahead with the contract, should we use the X we have
in inventory? Compare:
Contract Contract
Using inventory of 75 kg Not using inventory of 75 kg
$ $
Cash flows – Buy (75  $3) (225.50)
– Dispose inventory (75  $0.50) (37.50)
There is a total cost of $262.50; however, there is no cost if we use the inventory we
currently have, therefore we should use the inventory we already have.
Decision – cash flows
Contract: Buy 25 kg  $3 = relevant cost of $75
Saving from not disposing of the material is $37.50 (working above)
Net relevant cost = $37.50
No contract: Cost of disposing the existing material = 75 kg  $0.50 = $37.50

Labour Materials
S 15,000 10,000
T 2,000 6,000
Maximum demand requires 17,000 16,000
Therefore materials is the only limiting factor as we only have 15,000 kg available.
S T
Contribution per unit $14 $12
Contribution per limiting factor of scarce resource ($14/2 kg) $7
($12/3 kg) $4
Based on this, we should produce as much product S as possible as these products
generate the most contribution per kg of material. We should therefore produce 5,000 units
of S which will use 10,000 kg of material and with the remaining 5,000kg of material make
as many product T; ie 1,667 (5,000/3 kg).
Profit = contribution less fixed costs, therefore profit is found as follows:
((5,000  14) + (1,667  12)) – ($45,000 + $6,000) = $39,000
14.3 The correct answer is: (i), (iii) and (iv) only
If a cost is unavoidable then any decision that is made about the future will not affect that
cash flow.
Therefore unavoidable costs are not considered relevant.
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14: DECISION MAKING
14.4 The correct answer is: A notional cost

The use of a charge of notional rent enables a more meaningful comparison of the cost of
different factories.
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14: DECISION MAKING
END OF CHAPTER
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Capital investment
appraisal

 Explain and illustrate the difference between simple and compound interest, and between nominal and effective
interest rates.
 Explain and illustrate compounding and discounting.
 Explain the distinction between cash flow and profit and the relevance of cash flow to investment appraisal.
 Explain and illustrate the net present value (NPV) and internal rate of return (IRR) methods of discounted cash
flow.
 Calculate present value using annuity and perpetuity formulae.
 Calculate NPV, IRR and payback (discounted and non-discounted).
 Interpret the results of NPV, IRR and payback calculations of investment viability.
Exam Context
This chapter helps us to appraise whether the capital investment projects identified should be undertaken. It is an
important chapter and you should expect it to be examined.
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15: CAPITAL INVESTMENT APPRAISAL
Overview
Capital investment appraisal
Payback NPV IRR
Simple Discounted
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1 Introduction
1.1 If you were offered $100 today or $100 in ten years' time, which would you select?
Being a sensible individual you should select $100 now.
The main reasons for this are briefly :
 Money has a time value.
If you selected the $100 now option and invested it, then it should be worth far more
than $100 after ten years.
 There is a risk that the promise of $100 in ten years' time will not be fulfilled.
1.2 To calculate how much a cash flow receivable at some time in the future is worth today, we
use discounting to take account of the time value of money and the risk that the cash will not
be received.
Basic formula
1.3 We can take any future cash flow and discount it back to what it is equivalently worth today
by multiplying it by its discount factor.
A selection of these are given in tables or can be calculated using the following formula:
1
FV  = PV
1 r 
n
Where:
FV = future value; ie the sum you will receive at a given time in the future.
r = periodic interest rate
n = number of periods between now and the future date
PV = present value; ie the value of the future sum you will earn in today’s terms
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Lecture example 1
We require $1,610 at the end of five years from now.
Required
Assuming we could earn 10%, how much should be invested now? (to the nearest $)
Solution
Present value
1.4 $1,000 is the present value (PV) of $1,610 @ 10% in five years.
In purely monetary terms we would be indifferent between receiving $1,000 now or $1,610
in five years.
Compounding
1.5 Compounding looks at how much an investment made now will be worth in the future if you
earn a certain percentage rate of interest and can be calculated using the following formula:
FV = PV  (1 + r)n
Where:
FV = future value; ie the sum you will receive at a given time in the future
r = periodic interest rate
n = number of periods between now and future date
PV = present value; ie the value of the future sum you will earn in today’s terms
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2 Annuities and perpetuities

Definition
2.1 A constant sum of money each year for a given number of years.
Discounting
2.2 One way to find the present value of an annuity is to discount each yearly sum of money
individually.
Lecture example 2
We invest $100 at the end of each of the next three years at 10% per annum.
Required
What is the present value of this investment?
Solution
Cumulative discount factors

2.3 To make the calculations easier we can use cumulative discount factors.
The present value of the $100 annuity above is:
$100  (DF1 + DF2 + DF3) = $100  CDF1–3
where
CDF1–3 = DF1 + DF2 + DF3
DF1–3 is known as the three year cumulative discount factor.
A selection of these are given in tables.
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Lecture example 3
Required
Recalculate the above example using the tables.
Solution
Perpetuities
2.4 A perpetual annuity
a
PV of a perpetuity starting at time 1 = NB. The first flow will be at time 1.
r
1
 discount factor for a perpetuity is
r
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Lecture example 4
Required
If the interest rate is 10%, what would you pay for a perpetuity of $1,000 starting in one year's
time?
Solution
3 Equivalent rates – effective annual interest rate

3.1 An effective annual rate of interest (EAR) is the corresponding annual rate when interest is
compounded at intervals shorter than a year.
The non-annual compounding interest rate can be converted into an annual equivalent using
the following formula.
(1 + R) = (1 + r)n
Where:
R = effective annual rate
r = period rate
n = number of periods in a year
The EAR is also called the APR (annual percentage rate) by banks, building societies and
credit companies.
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4 Investment appraisal methods

4.1 To determine whether a future investment opportunity (project) is worthwhile the following
appraisal methods may be used:
(a) Payback period
(b) Net present value (NPV)
(c) Internal rate of return (IRR)
Example
4.2 Kirby plc is considering a five-year project that requires an initial cash outlay of $550,000 on
equipment. At the end of the project the equipment is expected to have a scrap value of
$25,000.
The equipment will produce annual cash operating revenues of $150,000 for five years.
Kirby has a cost of capital of 10%.
Discount factors at:
10%
Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683
Year 5 0.621
5 Payback period
Definition
5.1 The number of years necessary for the cash flows of the project to pay back the initial
investment.
Payback can be simple or discounted.
Decision rule
Accept all projects with a payback period (PP) of less than the company's required payback
period.
Lecture example 5
This Lecture example is based on Kirby plc, from the Example in section 4.2.
Required
Kirby has a required payback period of five years.
Should Kirby plc go ahead with the project on the basis of:
(a) Simple payback
(b) Discounted payback?
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Solution
5.2 Advantages and disadvantages of payback period

Advantages
(a) Quick, simple calculation
(b) Easily understood concept
(c) Considers liquidity
Disadvantages
(a) How is maximum period set?
(b) Ignores timing of flows within the payback period
(c) Ignores any cash flows after the end of the payback period
(d) Ignores the time value of money
6 Net present value

Definition
6.1 The net present value (NPV) is the net total of the discounted cash flows of the project.
The purpose of discounting is to establish the maximum amount that an investor would be
willing to pay for a given set of future cash flows, given the investor's cost of capital.
Discounting takes into account the time value of money.
Decision rule
Accept all projects with an NPV greater than zero.
Lecture example 6
Calculate the NPV of Kirby's project and advise Kirby whether to proceed.
Required
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Solution
6.2 Advantages and disadvantages of net present value

Advantages
(a) Correctly accounts for the time value of money (discounting of future cash flows gives
greater ‘weight’ to earlier cash flows)
(b) Uses relevant cash flows
(c) Absolute measure
(d) Is consistent with the objective of maximising shareholders' wealth
Disadvantages
(a) Need to estimate cost of capital
(b) Tricky concept
(c) Does not allow for the risk of the project
7 Internal rate of return

Definition
7.1 The internal rate of return (IRR) is the discount rate that gives an NPV of zero.
To calculate the IRR we use the following formula:
IRR = a + NPVa  (b – a)
NPVa – NPVb
Where:
a = lower discount rate
b = higher discount rate
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Decision rule
Accept all projects with an IRR greater than the company's cost of capital or minimum
acceptable rate of return.
Lecture example 7
Required
Calculate the IRR for Kirby.
Solution
7.2 Advantages and disadvantages of internal rate of return

Advantages
(a) Readily understood concept of percentage return
(b) Does not require an exact cost of capital
Disadvantages
(a) Relative return – not absolute
(b) May rank projects incorrectly
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8 Chapter summary
1 Introduction looking at Compensation for the time value of money,
discounting and recognising that money today is worth more than
compounding money in the future, due to inflation, interest and
risk.
Discounting looks at the present value of a future
sum, whereas compounding looks at the future
value of a sum invested today given a certain rate
of interest.
2 Annuities and Annuities are a constant sum of money for a fixed
perpetuities period of time. The present value is calculated
using the cumulative discount tables.
Perpetuities – annuity paid or received forever.
3 Equivalent annual EAR is the annual interest earned when interest is
interest rates (EAR) compounded at intervals of less than a year.
4 Investment appraisal To decide whether a future investment opportunity
methods is worthwhile a number of appraisal methods will
be considered and applied.
5 Payback period (PP) Time taken for cash flows to repay the initial
investment.
6 Net present value (NPV) The net total of the discounted cash flows of the
project.
7 Internal rate of return The discount rate that gives an NPV of zero.
(IRR)
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9 Overview summary
Payback NPV IRR

• Time taken for project • Discount rate that
to payback initial gives NPV = 0
investments Difference between • Accept all prospects
• Accept projects with with IRR >
PBP < target PBP company’s cost
of capital
Simple Discounted
Sum of discounted Amount initially invested

cash flows expected
from investment
• Accept all projects with

positive NPV
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15.1 $1,000 was invested exactly three years ago, at a guaranteed rate of compound interest of
5% per annum. Its value now (to the nearest $) is:
 $1,000
 $1,150
 $1,158
 $1,500 (2 marks)
15.2 The value of $3,000 per year in perpetuity, when the interest rate is 12%, to the nearest
thousand dollar is:
(2 marks)
15.3 An annual rent of $1,000 is to be received for ten successive years. The first payment is due
tomorrow. Assuming the relevant interest rate to be 8%, the present value of this stream of
cash flows is closest to:
 $6,250
 $6,710
 $7,250
 $7,710 (2 marks)
15.4 Which is worth most, at present values, assuming an annual rate of interest of 8%?
 $1,200 in exactly one year from now
 $1,400 in exactly two years from now
 $1,600 in exactly three years from now
 $1,800 in exactly four years from now (2 marks)
15.5 $728 was invested exactly two years ago, at a guaranteed rate of compound interest of
7.2% per annum. Its value in one year’s time (to the nearest $) will be:
 $780
 $781
 $896
 $897 (2 marks)
15.6 A person is to receive a ten-year annuity of $15,000 per year, received at the end of each
year. At what interest rate does this have a present value of $100,650?
 7%
 8%
 9%
 10% (2 marks)
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Chapter 15 Answers
There are ten flows but one is at time 0. We therefore need to look up in annuity table the
present value of $1 per annum received at the end of nine years at an interest rate of 8%.
NPV = $[(1,000  1) + (1,000  6.25)]
= $7,250
15.4 The correct answer is: $1,800 in exactly four years from now
$
PV of $1,200 in one year = $1,200  0.93 = 1,116
PV of $1,400 in two years = $1,400  0.86 = 1,204
PV of $1,600 in three years = $1,600  0.79 = 1,264
PV of $1,800 in four years = $1,800  0.74 = 1,332
FV = PV  (1 + r)n
FV = 728 (1.072)3
= 896.84
PV = annuity  CDF
Re-arrange for CDF
CDF = PV/annuity
= 100,650/15000
= 6.71
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END OF CHAPTER
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Cash management

 Define cash and cash flow.
 Outline the various sources of cash receipts and payments (including regular/exceptional expense/asset receipts
and payments, and drawings).
 Describe the relationship between cash flow accounting and accounting for income and expenditure.
 Explain the importance of cash flow management and its impact on liquidity and company survival. (Note.
Calculation of ratios is not required.)
 Distinguish between the cash flow pattern of different types of organisations.
Exam Context
This chapter helps us to appraise understand the importance of cash management within an organisation. It is an
important chapter and you should expect it to be examined.
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Overview
Cash management
Cash operating cycle Cash budgets Treasury department Techniques in

forecasting
Overtrading Deficits and surplus Time series analysis
Inflation
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1 Introduction
1.1 Cash is ready money, most easily thought of as banknotes and coins and money in a
current bank account. It has been described as the lifeblood of business in a modern
economy.
1.2 Cash will differ from profits because:
 Cash is generated from transactions which have no impact on profit (ie an increase in
a bank overdraft).
 Cash paid for non-current assets creates a book adjustment in the statement of profit
or loss of depreciation.
 The statement of profit or loss reflects actual sales in the year; not all sales will have
been paid for, hence there will be a difference between the cash receipts and sales
made.
 The statement of profit or loss reflects actual purchases in the year, but again not all
purchases will have been paid for by the year end.
2 Achieving cash control

2.1 To achieve control of cash a business needs:
 Organisation
 Information
 Planning and policies
as well as a responsible management team and treasury manager (if an organisation is
large enough).
3 Operating cycle (cash flow cycle)

3.1 The operating cycle is a term used to describe the connection between working capital and
cash movements in and out; ie the continuous process of using money received from sales
to buy more resources in order to make more sales.
3.2 Working capital is the difference between current assets (mainly inventory, receivables and
cash) and current payables (such as trade payables and bank overdrafts).
The operating cycle is usually measured in days or months and is the length of time
between when cash is paid out for raw materials and the time cash is received in from
receivables.
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3.3
Stores time Production time Warehousing time Credit sales time
Raw materials days WIP days Inventory days Receivables days
Credit purchases time
Payables days
CASH PAID CASH RECEIVED
Cash operating cycle
Lecture example 1 Technique demonstration
The following information relates to a business:

Receivables 8 weeks
Raw materials stockholding period 3 weeks
Supplier's credit period 6 weeks
Production period 2 weeks
Finished goods stockholding period 4 weeks
Required
What is the operating cycle of the business?
Solution
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Consequences of changing cash cycle

3.4 Changes in the cash cycle also affect a company's cash flows. A lengthening of the cash
cycle, with more inventory and receivables or fewer payables, will slow down cash receipts.
A shorter cash cycle, with fewer inventories and receivables or more payables, will speed
up a company's cash receipts and should improve its cash balances.
Is there an optimum cash cycle length?

3.5 Management will want to know:
 Whether the cash cycle is too long, and investment in working capital should be
reduced by shortening the cycle; or
 Whether the cash cycle is too short and becoming unsustainable, indicating a need
at some point in the future for an increase in working capital investment.
The answers to these questions will vary according to each company's situation.
4 Consequences of not monitoring working capital

Overtrading
4.1 A company that is expanding rapidly will increase its inventory and receivables. If it seeks to
finance the growth with a mixture of a shorter cash cycle and a bank overdraft, it could
eventually face a serious lack of liquidity.
Companies that finance growth with short term credit are said to overtrade.
4.2 This occurs when a business tries to do too much too quickly with too little long-term
capital.
Causes: Business grows quickly without a corresponding growth in its capital resources.
Business repays a long-term loan without replacing it with another  less
long-term capital to finance its current level of operations.
Problem: Business could easily run into liquidity problems ie not have enough capital to
provide the cash to pay its debts as they fall due.
Symptoms: (a) Rapid rise in sales turnover
(b) Rapid increase in volume of current assets
(c) Only a relatively small increase in proprietor's capital
(d) Lower current ratios
5 Cash budgets
5.1 A cash budget is a detailed forecast of expected cash receipts, payments and cash
balances over a planning period. A budget normally covers one year and is divided into
shorter time periods of a month or a quarter.
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5.2 A cash budget is prepared by taking the budgets for sales, costs of sales and profit, and
converting the income and expenditure items in these budgets into cash flows by allowing
for credit periods, prepayments, accruals etc. Adjustments are then made for:
(a) Cash flow items not appearing in the statement of profit or loss; or
(b) Items in the statement of profit or loss which do not have a cash effect.
Proforma
Jan Feb Mar
$ $ $
Cash receipts:
Cash from receivables X X X
Loan X
X X X
Cash payments:
Payables X X X
Wages X X X
Overheads X X X
Non-current assets X
X X X
Net cash flow X (X) X

Opening balance X X (X)
Closing balance X (X) X
Lecture example 2 Technique demonstration
A company's sales revenue is as follows: December $8,000; January $10,000; February $11,000
40% for cash
60% on credit
A 5% discount is given to customers for payment within current month and on average 25% of
customers take up this option.
All other cash is received in the month following the sale.
Required
Calculate cash receipts in January and February.
Solution
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6 Managing surplus/deficits in the cash budget

6.1 There are many ways in which surplus funds can be invested. However, we can identify two
main types:
(a) Cash-based investments – surplus funds deposited in a bank or building society
account
(b) Securities – a certificate giving evidence of a debt or equity obligation
Marketable securities
6.2 Marketable fixed interest securities are types of investments.
The price of stocks are affected by their coupon rate (ie the interest rate). The other major
influences are:
(a) The length of time to redemption (or maturity); and
(b) The risk associated with the payment of interest and the eventual repayment of
capital. From this viewpoint, UK Government securities are considered risk free but
other fixed interest stocks may not be.
Buying and selling marketable securities

6.3 Buying gilts and shares is generally done through specialist firms of intermediaries known as
brokers.
These brokers buy and sell on their clients' behalf in the various investment markets that are
available.
UK Government securities
6.4 Definitions of gilts vary, but most people use the term to mean marketable UK Government
securities. These stocks, although small in number, dominate the fixed interest market.
Commercial papers and debentures

6.5 Commercial paper is the term for certificates issued by a company promising to pay an
amount to the person bearing the note on a specified date.
6.6 Commercial papers differs from debenture stock, which also are debt stocks issued by a
company.
(a) Debenture stocks are borrowing, secured on a particular asset of the business. The
loan is for the long term.
(b) Commercial papers are unsecured borrowing generally issued for a much shorter
period of time.
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Certificates of deposit
6.7 A certificate of deposit (CD) is a negotiable instrument in bearer form (ie a certificate which
can be bought and sold, and title belongs to the holder) issued by an institution (bank or
building society), certifying that a specified sum has been deposited with the issuing
institution, to be repaid on a specific date. The term may be as short as seven days or as
long as five years. The minimum nominal amount is usually £50,000, or its foreign currency
equivalent.
Money markets
6.8 Markets for the lending and borrowing of short-term finance.
6.9 The main instruments are:
(a) Deposits
(b) Bills
(c) Commercial papers
(d) Certificates of deposit
7 Treasury department
7.1 The roles of the treasure function are:
(a) Corporate financial objectives
(i) Financial aims and strategies
(ii) Financial and treasury policies
(iii) Financial and treasury systems
(b) Liquidity management
(i) Working capital and money transmission management
(ii) Banking relationships and arrangements
(iii) Money management
(c) Funding management
(i) Funding policies and procedures
(ii) Sources of funds
(iii) Types of funds
Funding management is concerned with all forms of borrowing, and alternative
sources of funds such as leasing and factoring. The treasurer needs to know:
(i) Where funds are obtainable
(ii) For how long
(iii) At what interest rate
(iv) Whether security would be required or not
(v) Whether interest rates would be fixed or variable
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(d) Currency management

(i) Exposure policies and procedures
(ii) Exchange dealing, including futures and options
(iii) International monetary economics and exchange regulations
(e) Corporate finance
(i) Equity capital management
(ii) Business acquisitions and sales
(iii) Project finance and joint ventures
(f) Related subjects
(i) Corporate taxation (domestic and foreign tax)
(ii) Risk management and insurance
(iii) Pension fund investment management
8 Techniques in forecasting
8.1 Time series analysis
A time series is a series of figures or values recorded over time. The analysis of time series
allows historical aspects of data to be monitored so that observations can be made as to
how a variable has performed over a period of time.
8.2 Components of a time series (TS)

8.2.1 Trend (T)
(a) General movement of a time series over a long period of time (ie growth, inflation)
(b) Generally expected to be a smooth line/curve
(c) Find by method of moving averages
8.2.2 Seasonal variations (SV)

A recurring pattern in recorded values, due to repetitive events, over a shorter but fixed
period of time (weekly, quarterly).
8.2.3 Cyclical variations (CV)

Recurring patterns over a longer period of time, not generally of a fixed nature
(ie recession/depression/economic growth).
8.2.4 Random variations (RV)
Irregular/unpredictable variations, due to rare/chance occurrences (hurricanes, floods,
nuclear war).
8.2.5 Time series models
The four components of variation are assumed to combine together to give TS.
TS = T + SV + CV + RV
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8.2.6 Moving averages

The main method for calculating a trend from a time series is the technique of moving
averages, which is an average of the results of a fixed number of periods and relates to the
mid-point of the overall period.
The most appropriate number of periods for a moving average will depend on the
circumstances and the nature of the time series. For example, a time series of output over a
period.
Lecture example 3 Finding the trend 1
A company has recorded the following sales figures per quarter over the last three years:
Year Q1 Q2 Q3 Q4
1 18 60 90 102
2 30 72 99 120
3 36 90 114 135
Required
What will be the trend in budgeted sales for the first quarter of year 4?
Solution
Year Quarter Time series 4/Period Trend (T) =

(TS) moving Centred
average average
1 Q1
Q2
Q3
Q4
2 Q1
Q2
Q3
Q4
3 Q1
Q2
Q3
Q4
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8.3 Inflation
8.3.1 Inflation is the increase in prices of goods and services over a period of time. In a cash
budget it may affect the values of:
 Selling prices
 Purchase prices
 Expenses
 Cost of fixed assets
 Labour costs
8.3.2 A business may have information about a one off increase in sales price or an annual
increase in the hourly rate paid to the work force. These increases should be built into the
cash budget.
Index numbers
8.3.3 A price index measures the change in value of an item or group of items over a period of
time, compared to a defined base period.
Current period's figure
Index =  100
Base period
Example
8.3.4 Suppose revenue for a company over the last five years were as follows:
Year Revenue
$'000
20X5 35
20X6 42
20X7 40
20X8 45
20X9 50
The managing director decided to set up a revenue index (ie an index which measures how
revenue has done from year to year), using 20X5 as a base year. The $35,000 of revenue in
20X5 is given the index of 100%.
What are the indices for the other years?
If $35,000 = 100%, then:
20X6 $42,000 = $42,000/$35,000  100 = 120%
The same calculation can be applied to other figures and the table showing sales for the last
five years can be completed taking 20X5 as the base year.
Year Revenue Index
$'000
20X5 35 100
20X6 42 120
20X7 40 114
20X8 45 129
20X9 50 143
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4 Chapter summary
1 Introduction Cash will differ from profits for a number of
reasons, such as profits being impacted by
accruals and prepayments which has no impact on
cash, or cash being generated through the
provision of a loan which will not directly impact
the profit or loss of a business.
2 Achieving cash control To ensure control over the cash within an
organisation the business needs to consider the
organisational structure, information required and
the plans the business has, along with policies for
the careful management of cash.
3 Operating cash cycle The operating cash cycle is a term used to
describe the connection between working capital
of a business along with the cash movements in
and out of the organisation.
4 Consequences of not Overtrading is a consequence of not monitoring
monitoring working the working capital of a business and can cause a
capital business to go into liquidation.
5 Cash budgets A cash budget is a detailed forecast of the
expected cash receipts, payments and cash
balances over a planning period.
6 Managing surplus/ Cash surpluses should be invested to earn a
deficits in a cash budget better return on them and cash deficits should be
identified to plan future finance which will ensure
the business can continue to pay its debts as they
fall due.
7 Treasury department The treasury department is involved in a number
of different roles to help ensure the careful
management of cash within the organisation.
8 Techniques in There are some extra areas to review, including
forecasting time series analysis, which is a method applied to
estimate the value of data at time in the future
taking into account the trend, seasonal variations,
cyclical variations, and random variations of past
data.
Inflation is also reviewed briefly as the increase in
the price of goods and services.
Finally price indices are reviewed which measure
the change in value of an item over a period of
time compared to the base period.
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5 Overview summary
Cash management
Cash operating cycle Cash budgets Treasury Techniques in

department forecasting
The cash operating cycle is Cash budgets
the connection between comprise a The role of the
working capital and cash detailed forecast of treasury department
movements in and out of the cash receipts, includes:
organisation: payments and Time series analysis
RM days balances over a  Corporate financial
Time series is a series
+ planning period. objectives of figures or values
WIP day  Funding recorded over time.
+ management This can be analysed
Inventory days  Liquidity to help estimate future
+ Deficits and management
Cash in values.
Receivables days surplus  Currency
less
– Cash out Cash budgets can management Time series analysis
Payable days identify cash  Corporate finance considers the following
deficits when  Tax/pension/risk components:
finances will need management
to be obtained.  Seasonal variations
 Cyclical variations
Cash budgets can  Random variations
identify surpluses  Trend
Overtrading which can be
Overtrading occurs invested:
when a business
grows rapidly without  Gilts
the corresponding Inflation
 Shares
financial support Inflation is the
 Commercial
increase in the price
paper
of goods and
 Debentures services over a
period of time.
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16.1 Which of the following functions are carried out by a company's treasury department?
(i) Setting financial and treasury policies
(ii) Identifying whether security is required when a loan is being considered
(iii) Helping to identity policies and procedures for currency management
 (i) only
 (ii) and (iii)
 (iii) only
 All of them (2 marks)
16.2 Cash forecasts are likely to show which of the following?

(i) How much cash is required
(ii) Profit
(iii) When cash is required
(iv) The sources of funding available
 (i) only
 (i) and (iii) only
 (iii) and (iv) (2 marks)
16.3 One of the key principles that a business should base its cash management policy on is
liquidity. Which one of the following is an example of this principle?
 Ensuring that the business has investments which are easily convertible into cash
 Managing investments carefully to minimise costs
 Ensuring short-term investments are protected from heavy losses
 Ensuring cash and other liquid assets are secure from theft (2 marks)
16.4 The following extracts are from Sarah Co's financial statements:
Non-current assets $250,000
Inventory $56,000
Receivables $12,000
Overdraft $2,000
Payables $15,000
Accruals $1,500
What is Sarah Co's working capital?
 $49,500
 $51,000
 $53,500
 $299,500 (2 marks)
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16.5 A company's projected revenue for 20X6 is $342,000. It is forecast that 20% of revenue will
occur in January and the rest will be equally spread among the remaining 11 months. All
sales are on credit. Customers' accounts are settled 50% in the month of sale, 45% in the
following month and 5% are written off as bad debts after two months.
What are the budgeted cash collections for March?
 $24,873
 $23,629
 $22,386
 $27,075 (2 marks)
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Chapter 16 Answers
16.1 The correct answer is: All of them
All options form part of the range of roles carried out by the treasury department.
16.2 The correct answer is: (i) and (iii) only
Cash forecasts will not show profit and are unlikely to show the sources of funding that are
available.
16.3 The correct answer is: Ensuring that the business has investments which are easily
convertible into cash.
Working capital is current assets less current liabilities so $56,000 + $12,000 – $2,000 –
$15,000 – $1,500 = $49,500
January revenue = $60,400
February – December = $24,873 pcm
Therefore March receipts = 45% of February revenue + 50% of March
= $23,629
END OF CHAPTER
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Information for
comparison

 Explain the purpose of making comparisons.
 Identify relevant bases for comparison: previous period data, corresponding period data, forecast/budget data.
 Explain and illustrate the concept of flexible budgets.
Exam context
The next section of the notes focus on the area of the syllabus related to providing management information. By making
comparisons between actual data and other data, this will allow management to identify areas of concern and initiate
control action. In the main you are likely to see a few mainly narrative questions from this chapter in the exam.
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17: INFORMATION FOR COMPARISON
Overview
Information for comparison
Traditional variance analysis
Original budget Flexed budget Actual results
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1 Types of comparisons
Comparisons with previous periods
1.1 The most common comparison with a previous period is the comparison of one year's final
figures from the ledger with the previous year. This can be seen in a company's annual
financial statements.
1.2 Management accountants need more frequent information and will often compare data on a
month by month basis. This enables management to identify trends and any potential
problem areas as soon as possible. Comparisons can also be made with corresponding
period data. For example, sales in January this year can be compared to sales in January
last year.
Comparisons with forecasts

1.3 A common type of forecast is a cash flow forecast. This is made so that a company can
anticipate in advance any cash shortfalls or surpluses and arrange the appropriate facilities
with the bank.
1.4 It is important to compare forecasts with actuals in order to assess why they differ and
perhaps consider altering the basis on which the forecasts are set.
Comparisons within an organisation

1.5 Comparisons may be made between different parts of the organisation; for example,
departments or sales area.
Comparisons with other organisations

1.6 Organisations may compare their results with those of their main competitors.
Non-financial comparisons
1.7 Comparisons do not have to be in financial terms; a company may compare units sold year
on year, or levels of customer complaints.
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2 Budgets
2.1 Budgets are an organisation's plan for the forthcoming period, expressed in monetary terms.
2.2 The budgetary control cycle can be illustrated as:
Determine
Control objectives Planning
Compare actual Set/revise budget

performance with
budgeted results
Operate in line with budgets
2.3 Comparing actual performance with the budget is only meaningful if we compare like
with like.
2.4 The original budget flexed to the actual production level, to make a more useful comparison
with our actual data.
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3 Chapter summary
1 Types of comparisons Information can be more meaningful and more
useful when it is compared with other information.
There are various options for comparisons
including prior year, forecasts and non-financial
information.
2 Budgets The fixed budget is prepared at the start of the
year and is based on budgeted volumes.
The flexed budget will provide a more meaningful
comparison to actual results as it has been flexed
for actual volumes.
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4 Overview summary
 Set before start of  Adjust for actual

period production/sales volumes
 Based on  Enables 'like for like'
estimated/budgeted comparison with actuals
production and sales
 More meaningful variance
volumes
analysis
END OF CHAPTER
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Variances

 Explain the forecasting/budgeting process and the concept of feed forward and feedback control.
 Use appropriate income and expenditure data for comparison.
 Calculate variances between actual and historical/forecast data which may or may not be adjusted for volume
change (Note. standard costing is excluded).
 Identify whether variances are favourable or adverse.
 Identify possible causes of variances.
 Explain the concept of exception reporting.
 Explain factors affecting the decision whether to investigate variances.
Exam Context
Variance reporting is the difference between budgeted and actual performance so this chapter is heavily linked to the
last one. You should expect to see a couple of variance calculations in the exam. You may also see narrative questions
relating to the possible cause of variances.
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18: VARIANCES
Overview
Variances
Causes
Direct material Direct labour
Fixed overheads Sales
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1 Variances
1.1 Variance reporting is the reporting of differences between the budgeted results and the
actual results (total variance) or between the flexed budget and the actual results (efficiency
of usage and price variance).
1.2 Variances are:

 Favourable if the business has more money as a result
 Adverse if the business has less money as a result
1.3 Variances can be expressed in $ or in %.

Variance $ = Actual cost – budgeted cost
Actual cost – budgeted cost
Variance % =  100%
budgeted cost
Lecture example 1
A grocery shop has prepared the summary of actual and budgeted costs below.
Required
Calculate the variances in $ and %, and identify whether each variance is adverse or favourable.
Solution
Budgeted Actual Variance Variance Adverse/
$ $ $ % favourable
Fruit purchases 3,000 3,350
Rent 2,500 2,550
Rates 500 560
Heat and light 660 540
Salaries 2,200 1,900
1.4 The problem with comparing the actual results to the budgeted results is that the budgeted
volume may be different from the actual volume and so we are not comparing like for like.
1.5 To make a more useful comparison we can adjust (or flex) the budgeted results for actual
volumes. This new budget is known as the flexed budget.
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Lecture example 2
Required
Using the production cost report below, prepare a flexed budget and calculate the variances
between actual results and the flexed budget.
Solution
Actual Budget Flexed Variance Adverse/
budget favourable
Production (units) 5,000 4,800
$ $ $ $
Direct material 1,874 1,850
Direct labour 825 810
Prime cost 2,699 2,660
Fixed overheads 826 840
Total cost 3,525 3,500
1.6 The flexed budget will enable us to split the total variance into two sub-variances known as
the activity variance and the price/efficiency variance for further analysis.
2 Sales revenue variance calculations

2.1 Total sales revenue variance = Activity variance + Selling price variance
Total sales revenue variance

2.2 $
Actual sales revenue (Actual units  Actual selling price) X
Fixed budgeted sales revenue (Budgeted units  Budgeted selling price) X
Variance X (A/F)
2.3 Exam questions will either ask for the total variance or they will ask you to compare actual
results to the fixed budget.
Activity (volume) variance

2.4 Actual sales units X units
Budgeted sales units X units
Variance X units (A/F)
X budgeted selling price per unit $X
Variance $X
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Selling price variance

2.5 $
Actual sales revenue (actual units  actual selling price) X
Flexed budgeted sales revenue (actual units  budgeted selling price) X
Variance X (A/F)
2.6 Exam questions will either ask for the selling price variance or they will ask you to compare
actual results to the flexed budget.
Lecture example 3
Budgeted selling price $21.00
Budgeted sales units 740
Actual sales units 795
Actual sales revenue $16,200
Required
Calculate the total sales variance, activity variance and selling price variance.
Solution
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3 Cost variance calculations

3.1 Total direct cost variance = Activity variance + Purchase price/Efficiency of usage variance
Total direct cost variance

3.2 $
Actual cost (Actual units  Actual cost) X
Fixed budgeted cost (Budgeted units  Budgeted cost) X
Variance X (A/F)
3.3 Exam questions will either ask for the total variance or they will ask you to compare actual
results to the fixed budget.
Activity (volume) variance

3.4 Actual production volume X units
Budgeted production volume X units
Variance X units (A/F)
X budgeted cost per unit $X
Variance $X
Purchase price/efficiency of usage variance

3.5 $
Actual cost (actual units  actual cost) X
Flexed budgeted cost (actual units  budgeted cost) X
Variance X (A/F)
3.6 Exam questions will either ask for the purchase price/efficiency of usage variance or they
will ask you to compare actual results to the flexed budget.
3.7 Note that for labour costs the purchase price variance is known as the rate of pay variance.
Lecture example 4
Budgeted materials were 800 units at a cost of $20 each. Actual materials costs were $17,600 and
820 units were produced.
Required
Calculate the total cost variance, purchase price variance and activity variance.
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Solution
4 Reasons for variances

4.1 In your exam you may be asked to identify possible causes for variances in narrative
questions as well as how to calculate variances as shown above.
4.2 The following table shows just some of the possible causes of variances although you may
see others in your exam.
Variance Favourable Adverse

Material price Unforeseen discounts Price increases
More care taken in purchasing Careless purchasing
Material usage Higher quality material easier to Defective material
work with Excessive waste
Improved working practices Theft
making more effective use of
Stricter quality control
material
Errors in allocating material to
Errors in allocating material to jobs
jobs
Labour rate Use of apprentices or lower skilled Wage rate increases
workers Use of higher grade labour
Labour usage Use of higher grade labour Wastage of time
More motivated workers Lack of training
Better equipment/materials/ Lower grade labour
methods Poor equipment/materials
Errors in allocating time to jobs Errors in allocating time to jobs
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5 Reporting variances
5.1 Variances are reported to the relevant people to draw attention to areas which are not
running according to plan, so that appropriate action can be taken.
5.2 Larger variances, and any variances showing a worrying trend, require investigation by the
people responsible for that area.
5.3 Reporting only the variances which exceed a certain amount or percentage for further
investigation is called exception reporting.
Lecture example 5
Required
Which of the variances from Lecture example 1 would be included on an exception report which
reports all variances greater than $300 or 10% of budget?
Solution
6 Investigation of variances
6.1 Deciding whether to investigate a variance or not can depend on whether variances are
controllable or non-controllable.
6.2 Controllable variances can be rectified by managers. Managers should take action to rectify
the problems that caused the variances.
6.3 Non-controllable variances are due to external factors beyond the manager's control.
Management may wish to revise their plan for these variances.
6.4 A variance should only be investigated if the cost of investigation will be exceeded by the
benefits to be gained.
6.5 If the manager acts by either correcting an operational problem if the variance is controllable
or adjusting the budget if it is non-controllable, this is a feedback control system.
6.6 If the variance is foreseen and the manager takes corrective action in advance to avoid a
variance, this is a feed-forward control system.
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7 Chapter summary
1 Variances Variance reporting is the reporting of differences
between the actual results and the fixed budget
(total variance) or the difference between the
actual results and the flexed budget (price/efficiency
variance).
2 Sales revenue variance The total sales variance can be divided into the
calculations volume/activity variance, which shows the
difference between actual and budgeted units
sold, and the selling price variance.
3 Cost variance As with sales the total direct cost variance can be
calculations divided into the volume/activity variance, which
shows the difference between actual and
budgeted units produced, and the price/efficiency
variance.
4 Reasons for variances In your exam you need to understand possible
reasons for variances as well as how to calculated
them; for example, different quality of material
resulting in different prices and/or different
efficiency.
5 Reporting variances It would be inefficient to report all variances and so
exception reporting is often used whereby only
significant variances are reported. Significance
can be defined using numerical or percentage
thresholds.
6 Investigating variances Controllability is key when deciding whether to
investigate a variance – if the variance is
controllable this means that the manager is able to
respond to change things and so it should be
investigated. If the variance is non-controllable (for
example allocated fixed overheads) this means
the manager is not able to change things and so
further investigation is unnecessary.
Cost is another issue that should be considered
when deciding whether or not to investigate as this
should never exceed the potential benefit gained
from the investigation.
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8 Overview summary
Variances
Causes
Total variance
 Activity/volume
variance
 Price/efficiency
variance
Total variance
 Activity/volume
variance
 Selling price variance
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18: VARIANCES
18.1 A company had budgeted training costs of $25,000. Actual training costs for the year are
$22,100.
What is the training costs variance?
 11.6% favourable
 11.6% adverse
 13.1% favourable
 13.1% adverse (2 marks)
18.2 A company budgets $6 of material costs for each unit it produces. In a period production
was:
Budget 5,000 units
Actual 4,750 units
Actual material costs for the period are $31,250.
What is the material price variance?
 $2,750 favourable
 $2,750 adverse
 $1,250 favourable
 $1,250 adverse (2 marks)
18.3 Which of the following factors may have resulted in an adverse labour variance?
(i) A pay rise given to all employees that was not expected in the budget
(ii) A higher production volume than expected
(iii) A lack of training for employees so that they took longer to make the units than
expected
 (i) only
 (i) and (ii)
 (i) and (iii)
 (i), (ii) and (iii) (2 marks)
18.4 Feedback control involves:

 Managers taking corrective action in advance of the problem to avoid a variance
 Restating the budget to actual activity levels
 Managers investigating the reason for a variance and acting by either correcting
an operational problem if the variance is controllable or adjusting the budget if it's
non-controllable
 Reporting only variances that exceed a set amount or percentage to the responsible
managers (2 marks)
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18.5 A company has the following results for the last year:
Actual Budget
Rent 10,000 9,100
Wages 132,150 135,000
Electricity 6,250 6,000
Materials 126,300 120,000
If the company's policy is to investigate all variances greater than $500 or 5% of budget,
which of the above cost variances would appear on an exception report?
 Rent only
 Rent and materials
 Rent, wages and materials
 All four of the costs (2 marks)
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Chapter 18 Answers
18.1 The correct answer is: 11.6% favourable
Actual cost – Budgeted cost
Variance =  100%
Budgeted cost
22,100 – 25,000
=  100%
25,000
= 11.6% favourable
18.2 The correct answer is: $2,750 adverse

$
Flexible budget material costs $
4,750 units  $6 28,500
Actual material costs 31,250
Variance (2,750) Adverse
18.3 The correct answer is: (i) and (iii)

Paying staff more than you expect per unit will result in actual costs above budget and an
adverse variance.
Staff taking longer to make the units than expected and therefore working more hours will
result in actual costs above budget and an adverse variance.
Variances are the difference between the flexible budget and the actual results. The flexible
budget is the budget adjusted to actual activity levels. Therefore the higher production
volume than expected will be adjusted for in the flexible budget and won't be a reason for a
variance.
18.4 The correct answer is: Managers investigating the reason for a variance and acting by either
correcting an operational problem if the variance is controllable or adjusting the budget if it's
non-controllable
The first option is feed-forward control

The second option is a flexible budget
The fourth option is exception reporting
18.5 The correct answer is: Rent, wages and materials

Actual Budget Variance Variance Adverse/
$ $ $ % favourable
Rent 10,000 9,100 (900) 9.9 A
Wages 132,150 135,000 2,850 2.1 F
Electricity 6,250 6,000 (250) 4.2 A
Materials 126,300 120,000 (6,300) 5.3 A
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END OF CHAPTER
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Reporting management
information

 Describe methods of analysing, presenting and communicating information.
 Identify suitable formats for communicating management information according to purpose and organisational
guidelines including: informal business reports, letter and email or memo.
 Identify the general principles of distributing reports (eg procedures, timing, recipients) including the reporting of
confidential information.
 Interpret information presented in management reports.
Exam Context
This chapter looks at the different ways of communicating and presenting information. When information should not be
communicated is also discussed. You will be seeing a few narrative questions from this area feature in the exam, where
you may be required to determine the most appropriate form of communication for a given short scenario.
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19: REPORTING MANAGEMENT INFORMATION
Overview
information
Report costing Communication Confidentiality
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1 Planning a report
1.1 Points for consideration
 Who is the user? Will they understand technical terms?
 What type of report would be most useful?
 What does the user need to know and for what purpose?
 How much information is needed, how quickly and at what cost?
 Is information required only, or judgements, recommendations etc?
1.2 In many organisations standard reports are issued regularly. Often companies have
prescribed formats for these reports. They also often use house style for other documents,
ie a particular way of setting out the information. This can make it easier for employees to
read and locate information and it presents a consistent image to people outside the
organisation.
1.3 Managers may also require ad hoc reports to help them with particular problems.
2 Types of communication
Lecture example 1
It is important to choose the right method of communication.
Required
Identify what factors would you consider under the following headings to decide on the right
method of communication?
Solution
(a) Time
(b) Complexity
(c) Distance
(d) Written record
(e) Feedback/interaction
(f) Confidentiality
(g) Recipient
(h) Cost
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Letters
2.1 Use when communicating with someone outside of the organisation
2.2 Must be polite, accurate, clear, logical and concise.
A letter
Trainor Ltd
154 Running Lane
Pewsey
Wiltshire
SN15 OLT
Tel: 01848 500500
Date: 15 August 20X3

Our ref: JLC/Mn
Your ref: TIP/P5
Finance Director
Ward Brothers Co
12 Melbourne Road
Bath
BA5 7ST
Dear Sir or Madam,
Yours faithfully,
J. Webb
J. Webb, Management Accountant
Memos
2.3 An internal form of communication which provides the same function as a letter does
externally.
2.4 Can be used to provide reports, brief messages or notes.
2.5 Less formal and detailed than a letter.
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A memorandum
MEMORANDUM
To: Financial Controller

From: J. Webb, Management Accountant
Date: 15 August 20X3
Subject: July Statement of profit or loss
Emails
2.6 Can be used instead of memos or letters where signatures are unnecessary.
Lecture example 2
Required
Identify the advantages of using email as a communications tool.
Solution
Advantages of emails
(a)
(b)
(c)
(d)
(e)
(f)
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Reports
2.7 A manager may require a formal report if a comprehensive investigation is required.
Lecture example 3
Which method of communication do you think would be most appropriate for the following?
(a) An investigation into the raw material costs for the last six months
(b) Reply to an email
(c) Query to your supervisor on account codes
(d) Complaint to a supplier about quantity and quality of goods received
(e) Query to the payroll department about overtime payment not received
(f) Notification to customers of a change in the company's address
Solution
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3 Confidentiality
3.1 Confidentiality can either be a legal requirement or company policy.
Data Protection Act 2018

3.2 The Data Protection Act 2018 (incorporating the General Data Protection Regulation
(GDPR)) is an attempt to protect the personal data of an individual.
Principles
(a) Lawfulness, fairness and transparency of processing. An organisation or business must
only process personal data in accordance with a contract or applicable law, or with the
consent of the individual.
(b) Purpose limitation. An organisation or business must only process personal data in
accordance with the purposes for which it was collected. Data can't be collected for one
reason and then used for an alternative purpose.
(c) Data minimisation. Only the minimum amount of data should be collected. No additional
data should be collected.
(d) Accuracy. The organisation or business must ensure that the data it processes is both
accurate and up-to-date.
(e) Storage limitation. Data must not be stored for longer than is necessary for the purpose it
was collected.
(f) Integrity and confidentiality. Data must be processed in a way that ensures the security of
that data from unlawful processing, disclosure or loss.
Company policy
3.3 Many companies have a policy manual which dictates confidentiality rules.
3.4 Paper files with restricted access should be stored securely.
3.5 Computer files with restricted access should have passwords. This should not be divulged to
unauthorised personnel.
3.6 The internet can cause confidentiality problems for companies. Many organisations have a
specific internet policy.
3.7 If an employee has access to restricted information they are responsible for protecting it.
3.8 You can keep confidential information you are responsible for protected by locking the
information away when you're not using it and checking with your supervisor before
providing the information to others outside your department.
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4 Charts, graphs and tables

4.1 A visual element can be used to add interest and immediate appeal to written
communication by using layout, colour, spacing, different typefaces, symbolic logos
and so on.
4.2 Visual displays of information often help the user's understanding. Some types of visual
displays are considered below.
Charts
4.3 The bar chart is one of the most common methods of presenting data in a visual display. It
is a chart in which data is shown in the form of a bar (two dimensional, or three dimensional
for extra impact), and is used to demonstrate and compare amounts or numbers of
things.
4.4 Line graphs are often used in commercial contexts, to display a wide variety of information.
They are particularly useful for demonstrating trends: the progress of events or the
fluctuation over time of variables such as profits, prices, sales totals, customer complaints.
Tables
4.5 Tables are a simple way of presenting numerical information. Figures are displayed, and
can be compared with each other. Relevant totals, subtotals and percentages can also be
presented as a summary for analysis.
4.6 A table is two-dimensional (rows and columns), so it can only show two variables: a sales
chart for a year, for example, might have rows for products, and columns for each month of
the year.
SALES FIGURES FOR 20X0
Total
Product Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec £'000
A
B
C
D
Total
4.7 You are likely to be presenting data in tabular form very often; when doing so, you should be
aware of the following guidelines:
 The table should be given a clear title.
 All columns should be clearly labelled.
 Where appropriate, there should be clear sub-totals and a right-hand total column
for comparison.
 A total figure is often advisable at the bottom of each column of figures for
comparison.
 Tables should not be packed with too much data so that the information presented is
difficult to read.
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5 Chapter summary
1 Planning a report Prior to preparing a report various factors should
be considered, including the content, the recipient
and the time available.
2 Types of communication Exam questions may require you to identify the
most appropriate method of communication in a
given situation. It is important that you are aware
of scenarios where one type of communication
may be preferred over another.
3 Confidentiality Information that is confidential must be dealt with
and stored appropriately.
The Data Protection Act is in place to protect the
rights of individuals whose data is being held by
other individuals/organisations.
4 Charts, graphs and Charts, graphs and tables are very useful tools in
tables communicating information to assist with making
the information easier to communicate and
understand.
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6 Overview summary
information
Formal  Factors to consider  Data Protection Act 2018

 Title  Methods
 Terms of reference  Visual element
 Executive summary
 Findings/conclusion
 Recommendations
 Bibliography
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19.1 Which of the following methods of communication would be most suitable for notifying
customers about increases in price?
 Email
 Telephone call
 Standard letter
 Memo (2 marks)
19.2 In choosing an appropriate method of communication, which of the following should be

considered?
(i) Complexity of the message
(ii) Confidentiality of the message
(iii) The cost of the communication method
(iv) The speed of delivery required
 (ii) only
 (ii), (iii) and (iv) only
 (i), (ii), (iii) and (iv) (2 marks)
19.3 Which of the following communication methods would be most suitable for an investigation
into the sales performance of a newly launched product?
 Formal report
 Email
 Telephone calls
 Memo (2 marks)
19.4 The Data Protection Act 2018 aims to:

 Prevent personal data about individuals being held by companies
 Protect the personal data of individuals
 Prevent companies from holding personal data about individuals for more than
six months
 Prevent individuals from seeing their own personal data (2 marks)
19.5 Which of the following visual displays is most appropriate for demonstrating trends in
information?
 Bar chart
 Table
 Line graph
 Pie chart (2 marks)
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Chapter 19 Answers
19.1 The correct answer is: Standard letter
A standard letter will be quicker than a telephone call to each customer, and will leave the
customer with a permanent record of the price increases.
A memo is for internal use only and an email would not be formal enough for this type of
communication.
19.2 The correct answer is: (i), (ii), (iii) and (iv)
All of the factors listed are considerations in determining the most appropriate method of
communication.
19.3 The correct answer is: Formal report
For the level of detail required in an investigation a formal report would be the most
appropriate method.
The report may be sent in an email or with a covering memo when it is distributed.
19.4 The correct answer is: Protect the personal data of individuals
This is the aim of the Data Protection Act. It is not aiming to prevent companies holding
personal information about individuals, but to control how this information is collected, held
and used. The Data Protection Act gives individuals the right to see the personal information
held about them.
19.5 The correct answer is: Line graph

Trends are most clearly demonstrated with a line graph.
END OF CHAPTER
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The fourth stage of MA2 reviews cost–volume–profit analysis, decision making, methods of project
appraisal, cash management and a good look at variances and the reporting of management
information. These are all important areas of the MA2 syllabus and it is important that you get to
grips with each area in preparation for your exam.
Key knowledge
 Cost–profit–volume analysis – there are a number of different calculations which you are
required to learn in this area of the syllabus so remember to add them to your formula sheet.
The idea behind this chapter is for an organisation to consider a number of different methods
for identifying the number of units they must sell in order to break even. Selling more than
this will yield a profit; however, selling less than this amount will result in a loss.
 Decision making – decision making of any sort in an organisation will require consideration
for relevant cash flows. A cash flow is relevant if it is a future incremental cash flow. Sunk,
committed and allocated fixed costs should not be considered for short-term decisions.
 Capital investment appraisal – the numerical techniques in this chapter are highly
examinable and question practice will be imperative to ensure you understand how to apply
these techniques. You should be happy with the calculations involved in deriving the
payback period, net present value (NPV) and internal rate of return (IRR).
 Cash management – cash management again involves a number of methods which
identifying cash surpluses, deficits and methods of obtaining or investing cash. Remember
to review the role of the treasury department within the management of cash.
 Variances and reporting information – the final chapters look at the methods of reporting
information including variances as a means of comparing the budgeted results to the actual
results in a meaningful way so that action may be taken. You will see variances throughout
your management accounting studies so it is important that you are comfortable with the
calculations as well as the possible reasons for variances.
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CHECKPOINT 4
Key skills
 Discounting is an important concept in project appraisal. You need to ensure that you are
happy with the mechanics of this, through practising the examples again if necessary.
 Some of the areas within each topic is written. In multiple choice questions it is therefore
very important that you read the question and all of the options carefully, using a methodical
approach to select the correct one. It is easy to jump straight into one that is almost right!
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CHECKPOINT 4
Chapter 13 – Cost–profit–volume analysis 46 minutes
Key areas
 Explanation of the concept of the breakeven point, breakeven revenue,
margin of safety and contribution to sales ratio
 Analysis of the effect on the breakeven point, breakeven revenue, margin of
safety and contribution to sales ratio if there are changes in the selling price
or costs
 Interpretation of breakeven and profit volume charts
Course Notes
 Review Lecture example 1 again to ensure your understanding of each of the 10 minutes
calculations which you may be required to attempt.
Question Practice
 Required question practice 36 minutes
Question 11 Cost–volume–profit (CVP) analysis – 11.1–11.15
Chapter 14 – Decision making 44 minutes
Key areas
 Any decision that needs to be made in an organisation will involve
consideration of future incremental cash flows – the relevant cash flows
which influence the decision being made.
Course Notes
 Review the chapter to make sure that you are happy with what relevant cash 15 minutes
flows are and how they will be used to help in various decision making
scenarios.
Question practice
From the Practice and Revision Kit try the following questions: 29 minutes
Question 12 Decision making – 12.1–12.8, 12.11, 12.14, 12.17, 12.21
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CHECKPOINT 4
Chapter 15 – Capital investment appraisal 91 minutes
Key areas
 Compounding and discounting techniques
 Payback period
 Net present value
 Internal rate of return
Course Notes
 Review the chapter, ensuring that you are familiar with the techniques for 45 minutes
compounding and discounting. Work through the Lecture examples again as
necessary.
Question practice
 Complete the questions from the end of chapter questions in Chapter 15 of 15 minutes
the Course Notes.
Question 13 Capital investment appraisal – 13.1–13.9, 13.19–13.22
Chapter 16 – Cash management 39 minutes
Key areas
 It is important to understand the cash operating cycle within a business,
along with the consequences of not monitoring the working capital
requirements of the business.
 Ensure you can prepare cash budgets, and have a basic understanding of
how any cash surplus can be invested.
 Review the role of the treasury department within cash management.
Read through and ensure your understanding of the supplementary notes
covering time series analysis.
Course Notes
 A review of the Course Notes to check your understanding of the principles 15 minutes
and a recap of Lecture examples 1 and 2 is necessary to ensure you are
equipped to answer written questions as well as numerical questions.
Question practice
Question 14 Cash management – 14.1–14.10
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CHECKPOINT 4
Chapters 17, 18 & 19 – Information for comparison, 56 minutes

variances and reporting information
Key areas
 Chapter 17 introduces the idea of comparing information with a particular
focus on the fixed and flexible budgets
 Chapter 18 looks at variance calculations, possible reasons for variance
calculations and how these can be reported to management to respond
 Chapter 19 covers suitable formats for communicating management
information
Course Notes
 A review of the Course Notes in each of these three chapters is necessary 30 minutes
to check your understanding of the principles.
 Rework Lecture examples in Chapter 18 to reinforce the variance
calculations.
 Work through all questions at the end of each chapter to reinforce your
understanding.
Question practice
Question 3 Information for comparison – 3.6–3.10 and 3.14–3.19
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CHECKPOINT 4
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Answers to
Lecture examples
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20: ANSWERS TO LECTURE EXAMPLES
Chapter 1
Answer to Lecture example 1
Financial information: Financial statements, management accounts, aged receivables ledger,
bank statements, ratio analysis
Non-financial information: Customer complaints, reports on material wastage, labour
efficiency, competitors' products, newspaper reports
Chapter 2
There are no Lecture examples in this chapter.
Chapter 3
Business Appropriate cost unit
Car manufacturer One car
Ball bearing manufacturer A batch/kg of ball bearings
Builder One house/roof/office
Management consultant One hour/job/visit

Direct costs include direct materials and direct labour.

Overhead costs include supervisor salaries, rent, rates, light and heat, cleaning, and
maintenance.

Non-manufacturing costs would include selling and distribution and administration costs.

 Manufacturing costs
Direct costs – chocolate, toffee/filling, production line wages, cost of wrapper
Indirect costs/overheads – factory supervisor, rent and rates of factory, depreciation of
equipment
 Non-manufacturing costs – advertising and marketing, distribution of chocolate bars to
customers, head office administration
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Chapter 4
(a) Fixed cost
Total
cost
$
FC
Output (units)
(b) Variable cost

Total VC
cost
$
Output (units)

Units $
High output 8,000 Total cost 115,000
Low output 6,000 Total cost 97,000
2,000 18,000
Variable cost per unit: $18,000/2,000 = $9.00
Substituting in high–low volume cost:
High Low
$ $
Total cost 115,000 97,000
Variable cost (8,000  $9) 72,000 (6,000  $9) 54,000
Fixed costs (balance) 43,000 43,000
 output of 7,500 units
$
Fixed costs 43,000
Variable costs (7,500  $9) 67,500
Estimated total cost 110,500
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Units $
High output 3,000 Total cost 220
Low output 2,100 Total cost 184
900 36
Variable cost per unit: $36/900 = $0.04
Substituting:
$
Total cost of 3,000 units (high) 220
Variable cost (3,000  $0.04) 120
Fixed costs (balance) 100
Total cost in June

$
Fixed costs 100
Variable cost (2,750  $0.04) 110
Total cost 210

Materials
$
High output 20,000 units High cost 200,000
Low output 18,000 units Low cost 180,000
Difference 2,000 units 20,000
$20,000
2,000 units
Substitute in high: Total variable costs = 20,000 units  $10 = $200,000

Hence materials are all variable.
Labour
$
$32,000
Variable cost per unit = $16 per unit
2,000 units
Fixed costs = Total cost – Variable cost = $340,000 – $320,000 = $20,000
Power and maintenance
$
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$2,000
2,000 units

Fixed costs = Total costs – Variable costs = $35,000 – $20,000 = $15,000
Rent, insurance and depreciation
All fixed costs – no variable costs
Budget at 23,000 units
$
Materials 23,000 units  $10 230,000
Labour 23,000 units  $16 + $20,000 388,000
Power 23,000 units  $1 + $15,000 38,000
Rent $98,000 98,000
Total cost 754,000

(a) To help set selling prices
(b) To aid decision making
(c) To help with planning and budgeting
(d) As a means of controlling costs
(e) For inclusion in reports to various parties
Chapter 5
(a) To avoid production stoppages due to a shortage of materials
(b) To take advantage of quantity discounts
(c) To avoid the detrimental effect of price fluctuations
(d) To provide a buffer or fail-safe in time of general shortage or heavy demand

(a) FIFO assumes that materials are issued out of inventory in the order in which they
were delivered into inventory. Issues are priced at the cost of the earliest delivery
remaining in inventory.
(b) LIFO assumes that materials are issued out of inventory in the reverse order to which
they were delivered. The most recent deliveries are issued before earlier ones, and are
priced accordingly.
(c) The cumulative weighted average pricing method calculates a weighted average price
for all units in inventory.
Issues are priced at this average cost, and the balance of inventory remaining would
have the same unit valuation.
The average price is determined by dividing the total cost by the total number of units
and is calculated whenever a new delivery of materials into store is received.
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(a) FIFO
b/fwd 1 Jan 1 Feb 1 Mar
Production (litres) 6,000 4,000 8,000 7,000

@ $0.70 @ $0.75 @ $0.82 @ $0.88
Sales 25 Jan (6,000) (1,000)

20 Feb (3,000) (3,000)
15 Mar (5,000) (3,000)
Closing inventory – – – 4,000
Production cost per litre $0.88 .
 Inventory valuation $3,520.00
Under FIFO, inventory will always comprise the last units purchased or made.
Alternative calculation:
Litres
Litres available to sell
(6,000 + 4,000 + 8,000 + 7,000) 25,000
Litres sold
(7,000 + 6,000 + 8,000) 21,000
Litres of closing inventory 4,000

Closing inventory must therefore comprise the last 4,000 litres made.
$6,160 $3,520
ie 4,000  =
7,000
(b) LIFO
b/fwd 1 Jan 1 Feb 1 Mar
Production 6,000 4,000 8,000 7,000

@ $0.70 @ $0.75 @ $0.82 @ $0.88
Sales 25 Jan (3,000) (4,000)

20 Feb (6,000)
15 Mar (1,000) (7,000)
Closing inventory 3,000 – 1,000 –
Production cost per litre $0.70 $0.82
 Inventory valuation $2,100.00 $820.00
Total = $2,920
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(c) Weighted average

Litres Cost Cost per
litre
$ $
b/fwd 1.1.X3 6,000 4,200
1 January production 4,000 3,000
10,000 7,200 0.720
25 January sales (7,000) (5,040) 0.720
b/fwd 1.2.X3 3,000 2,160
1 February production 8,000 6,560
11,000 8,720 0.793
20 February sales (6,000) (4,758) 0.793
b/fwd 1.3.X3 5,000 3,962
1 March production 7,000 6,160
12,000 10,122 0.844
15 March sales (8,000) (6,752) 0.844
Closing inventory 4,000 3,370

Re-order level = Max usage  Max lead time = 5,000  4 weeks = 20,000 units

(a) Holding costs – rent of the warehouse, insurance costs, material handling cost, cost of
pilferage, obsolescence, theft
(b) Ordering costs – clerical costs of purchasing department, documentation, telephone
costs, postage, transport costs

Order quantity No. of orders Ordering Average Total ordering
Units per year costs holding costs & holding
per year per year costs
per year
$ $ $
1,500 20 375.00 375.00 750.00
1,200 25 468.75 300.00 768.75
750 40 750.00 187.50 937.50
600 50 937.50 150.00 1,087.50
400 75 1,406.25 100.00 1,506.25
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Purchase price = $80/unit
Fixed cost/order = $50/order
Cost of capital = 10% p.a.
Monthly demand = 600 units
D = 600  12 = 7,200 (D = annual demand)
Ch = 10%  $80 = $8
Co = $50
2  50  7,200
EOQ =
8
= 300 units
Chapter 6
(a) According to the amount of time worked (time-based system)
(b) According to the amount and/or quantity of work done (piecework or performance
related system)

$
Basic pay = 8 hrs @ $15 120.00 (direct cost)
Overtime premium = ¼ @ $15 3.75 (indirect cost)
123.75

A: 200 units  4 minutes = 800 minutes
B: 350 units  2 minutes = 700 minutes
C: 300 units  3 minutes = 900 minutes
2,400 minutes/60 minutes = 40 standard hours

(14,000 2) hours
Efficiency ratio =  100% = 80%
35,000 hours
35,000 hours
Capacity ratio =  100% = 134.6%
26,000 hours
(14,000 2) hours
Production volume ratio =  100% = 107.7%
26,000 hours
E  C = PV – ie 80%  134.6% = 107.7%
The production volume ratio of 107.7% (more output than budgeted and more standard hours
produced than budgeted) is explained by the 134.6% capacity working, offset to a certain
extent by the poor efficiency of 80%.
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Standard hours produced = 1,000 units  2 hours = 2,000 standard hours
Efficiency ratio =  100%
Actual hours taken
2,000
=  100%
1,850
= 108.1%

27 hours
Idle time ratio =  100% = 0.45%
6,000 hours
Chapter 7
Chapter 8
(a) Spraying, Cutting
(b) Stores, Maintenance, Inspection

Basis
 Floor area
 Carrying value or cost of equipment
 Number of employees
 Volume of space occupied/floor area
 Value of materials/equipment insured
 Number of store requisitions

Allocation and apportionment
Processing Packing Canteen
department department
$ $ $
Canteen – – 18,000
Supervisor A 15,000 – –
Supervisor B – 10,000 –
Rent (50:25:5) 12,500 6,250 1,250
Heat (50:25:5) 3,125 1,563 312
Depreciation (3:3:1) 3,000 3,000 1,000
Welfare (5:4:1) 2,500 2,000 500
36,125 22,813 21,062
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Re-apportionment – inter-service centre work
(a) Direct method
Production depts Service depts
$ $ $ $
Overheads 70,000 30,000 20,000 15,000
Stores (50:30) 12,500 7,500 (20,000) –
Maintenance (45:40) 7,941 7,059 – (15,000)
90,441 44,559 Nil Nil
(b) Step-down method
Production depts Service depts
$ $ $ $
Allocated overhead 70,000 30,000 20,000 15,000
Apportion stores
(50:30:20) 10,000 6,000 (20,000) 4,000
– 19,000
Apportion maintenance
(45/85:40/85) 10,059 8,941 – (19,000)
90,059 44,941 – –

Use when:
(a) Units are identical
(b) The production process is labour intensive
(c) Then the production process is machine intensive
(d) The labour cost constitutes a major part of direct production costs or the question
specifically asks this to be used as the basis

As the units are not identical, the units basis of absorption is not appropriate.
Mixing department is labour intensive; therefore a suitable OAR is as follows:
$10,000
OAR = = 50c per labour hour
20,000 labour hours
Stirring department is machine intensive; therefore a suitable OAR is as follows:
$15,000
OAR = = 25c per machine hour
60,000 machine hours
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Predetermined overhead
$100,000
Absorption rate = = $5/unit
20,000 units
Overheads absorbed = 24,000 (actual units produced)  $5/unit = $120,000
Under-over-absorption = 117,000 – 120,000 = $3,000 over-absorbed
PRODUCTION OVERHEAD ACCOUNT
$ $
Actual cost 117,000 WIP – absorbed (24,000  5) 120,000
Statement of profit or loss –
over-absorbed 3,000
120,000 120,000

(a) Expenditure variance
Actual expenditure = $117,000
Budget expenditure = $100,000
 $17,000 under-absorbed/overspent
(b) Volume variance
Actual production = 24,000 units
Budget production = 20,000 units
 4,000 units over produced, in financial terms 4,000  $5 = $20,000 over-absorbed
Overall
$
Expenditure variance 17,000 (A)
Volume variance 20,000 (F)
Over-absorption 3,000 (F)

Labour Machine Unit
hours hours
OAR $10 per lab hr $20 per mach hr $0.50 per unit
Absorbed overheads $592,500 $680,000 $475,000
Budgeted overheads $575,000 $575,000 $575,000
Actual overheads $612,750 $612,750 $612,750
(Under-)/over-absorption ($20,250) $67,250 ($137,750)
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OVERHEAD ANALYSIS SHEET
TOTAL PRODUCTION SERVICE
Cutting Sewing Finishing Stores Maintenance
$ $ $ $ $ $
Overheads 603,000 187,000 232,000 106,000 28,000 50,000
Apportion (material
Stores issues) 9,333 11,667 4,667 (28,000) 2,333
Apportion (machine
Maintenance hours) 19,625 32,708 (52,333)
603,000 215,958 276,375 110,667

Cutting Sewing Finishing
OARs = 215,958 276,375 110,667
15,000 25,000 12,000
= $14.40 $11.06 $9.22
Chapter 9
Absorption costing
Year 1 Year 2
$ $ $ $
Sales 325,000 312,500
Opening inventory – 20,900
Add production cost:
Variable 280,000 230,000
Fixed 12,600 10,350
292,600 261,250
(at $20.90) (20,900) –
271,700 261,250
Under-/over-absorption (1,600) 650
270,100 261,900
Gross profit 54,900 50,600
Less expenses
Variable 6,500 6,250
Fixed 5,000 5,000
11,500 11,250
Net profit 43,400 39,350
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Marginal costing
Year 1 Year 2
$ $ $ $
Sales 325,000 312,500
Less cost of sales
Opening inventory
(1,000  $20) – 20,000
Production costs
– variable
(14,000  $20) 280,000
(11,500  $20) 230,000
280,000 250,000
(1,000  $20) (20,000) –
(260,000) (250,000)
65,000 62,500
Less variable selling costs (6,500) (6,250)
CONTRIBUTION 58,500 56,250
Less fixed costs

Production 11,000 11,000
Selling 5,000 5,000
(16,000) (16,000)
Profit 42,500 40,250

Reconciliation of absorption and marginal costing profits
Year 1 Year 2
$ $
Absorption costing 43,400 39,350
Marginal costing 42,500 40,250
900 (900)
Difference: absorption costing doesn't charge all fixed overheads in period that they are paid.
Some are c/f in inventory to be charged next period when the inventory is sold.
PROFIT RECONCILIATION STATEMENT
Year 1 Year 2
$ $
Absorption costing profit 43,400 39,350
Add fixed overheads b/f in opening inventory – 900
Less fixed overheads c/f in closing inventory (900) –
Marginal costing profit 42,500 40,250

Effects
(a) AC profit > MC profit
(b) AC profit < MC profit
(c) AC profit = MC profit
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Chapter 10
PAYABLES
$ $
Raw materials 5,000
Direct labour 4,000
RAW MATERIALS
$ $
Payables 5,000
LABOUR
$ $
Payables 4,000

RAW MATERIALS CONTROL ACCOUNT
$ $
Payables 5,000 Raw materials to WIP 5,000
5,000 5,000
LABOUR CONTROL ACCOUNT

$ $
Payables 4,000 Labour to WIP 4,000
4,000 4,000
WIP
$ $
Materials 5,000
Labour 4,000
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PAYABLES
$ $
Raw materials 5,000
Direct labour 4,000
Production overheads 6,000
PRODUCTION OVERHEADS
$ $
Payables 6,000 Overheads absorbed:
Manufacturing dept 4,000
Finishing dept 600
Quality control 500
SOP/L () 900
6,000 6,000
WIP
$ $
Materials 5,000
Labour 4,000
Production overheads 5,100
Chapter 11
Job 5732 Job 5832
$ $
Materials (W1) 6,120 17,280
Labour (W2) 6,560 3,360
Production overhead (W3) 2,200 1,120
Factory cost 14,880 21,760
Administration (20%) 2,976 4,352
17,856 26,112
Invoice value 20,000 27,500
Profit on job 2,144 1,388
Workings
1 Materials Job 5732 2,520 + 9,560 – 2,480 – 3,480 = 6,120
Job 5832 14,800 + 2,480 = 17,280
Note. Actual costs of administration are irrelevant as is the actual figure given for production
overheads.
2 Labour Job 5732 (430 hrs  $12/hr) + $1,400 b/f = $6,560
Job 5832 (280 hrs  $12/hr) = $3,360
3 Overheads Job 5732 (430 hrs  $4/hr) + $480 b/f = $2,200
Job 5832 (280 hrs  $4/hr) = $1,120
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Road, rail and air transport services per mile travelled/coach/passengers/tickets

Hotels per room/person/meal served
Education per classroom/tutor/student
Hospitals per bed/patient/doctor
Cater establishments per meal serviced/waiter/guest
Chapter 12
PROCESS I
Units $ Units $
Raw materials 1,000 40,000 To Process II 1,000 110,000
Labour 50,000
Overheads 20,000
1,000 110,000 1,000 110,000
Cost $110,000
Cost/unit =   $110/unit
Output 1,000

PROCESS I
Units $ Units $
Raw materials 1,000 40,000 Normal loss 100 –
Labour 50,000 To Process II 900 110,000
Overheads 20,000
1,000 110,000 1,000 110,000
Costs $110,000
Cost/unit = = = $122.22 / unit
Normal output 900

(a)
PROCESS I
Units $ Units $
Raw materials 1,000 40,000 Normal loss 100 2,000
Overheads 20,000
1,000 110,000 1,000 110,000
Cost – Scrap value of normal loss 110,000 – 2,000
Cost/unit = = =$120 / unit
Normal output 900
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SCRAP ACCOUNT
Units $ Units $
Normal loss 100 2,000 Cash 100 2,000
(b)
SCRAP ACCOUNT
Units $ Units $
Normal loss 100 2,000 Cash 100 1,900
SOP/L 100
100 2,000 100 2,000

PROCESS I
Units $ Units $
Overheads 20,000 Abnormal loss 20 2,400
1,000 110,000 1,000 110,000
Cost – Scrap value of normal loss
Cost/unit =
Normal output
$110,000  $2,000 $110,000  $2,000
= or
880  20 1,000  100
= $120/unit
SCRAP ACCOUNT
Units $ Units $
Normal loss 100 2,000 Cash 120 2,400
Abnormal loss 20 400
120 2,400 120 2,400
ABNORMAL LOSSES ACCOUNT

Units $ Units $
Abnormal loss 20 2,400 Scrap 20 400
SOP/L – 2,000
20 2,400 20 2,400

PROCESS I
Units $ Units $
Overheads 100 20,000
Abnormal gain 20 2,400
1,020 112,400 1,020 112,400
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SCRAP ACCOUNT
Units $ Units $
Normal loss 100 2,000 Abnormal gain 20 400
Cash 80 1,600
100 2,000 100 2,000
ABNORMAL GAINS ACCOUNT

Units $ Units $
Scrap 20 400 Abnormal gain 20 2,400
Statement of profit or
loss 2,000
20 2,400 20 2,400
Cost – scrap value of normal loss
Cost/unit =
normal output
$110,000  $2,000 $110,000  $2,000
= or
920  20 1,000  100
= $120/unit

600
P1 :  4,500  $1,500
1,800
1,200
P2 :  4,500  $3,000
1,800
PROCESS ACCOUNT
Units $ Units $
Material 2,000 2,000 Output P1 600 1,500
Labour 2,000 P2 1,200 3,000
Overheads 1,000 By-product 200 500
2,000 5,000 2,000 5,000

Further Joint
S.V. processing NRV % costs
$ $ $ $
A 6,000 (1,000) 5,000 25.0 4,000
B 8,000 (2,500) 5,500 27.5 4,400
C 3,500 – 3,500 17.5 2,800
D 6,000 – 6,000 30.0 4,800
20,000 16,000
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$
X Increase in S.V. = $2  2,500 5,000
Less further costs (10,000)
(5,000)
Y Increase in S.V. = $5  1,500 7,500

(500)
Z Increase in S.V. = $7  2,000 14,000

2,000
 Only process Z further
Chapter 13
Fixed costs 5,700
(a) BEP = = = 3,800 units
Cont' n/unit 8  6.50
Breakeven revenue = 3,800  $8 = $30,400
Contribution per unit
(b) C/S ratio =
Sales revenue per unit
8  6.50
=
8
= 0.1875
5,000  3,800
(c) Margin of safety =  100
5,000
= 24%
Fixed costs  Target profit
(d) BEP to achieve $10,000 profit =
Contribution/unit
5,700  10,000
=
8  6.50
= 10,467 units
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(e) New selling price = $8.80  New contribution/unit = $2.30

New sales volume = 5,000 units  0.95 = 4,750 units
$
Old contribution (5,000  $1.50) 7,500
Fixed costs (5,700)
 Old profit 1,800
$
New contribution (4,750  $2.30) 10,925
Fixed costs (5,700 + 3,000) (8,700)
2,225
ie gain of $425
Chapter 14
Historic cost can be ignored as it is a sunk cost.
X
Since X is no longer used by the company, the inventory of X will be used rather than buying
in new supplies of X. (Note. The next best alternative to using the inventory is to scrap it for
$2.20/kg.)
So relevant cost of X:
$
300 kg inventory: lost scrap value (300  $2.20) 660
100 kg buy in (100  $3) 300
960
Y
If the inventory of Y is used it will have to be replaced when it is needed elsewhere in the
business.
So relevant cost of Y:
$
200 kg at current replacement cost (200  $2) 400
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Labour is currently working at full capacity 
15 hrs
if 15 hours are used in the contract = 3 units of X will not be made
5 hrs
Cash flows under each option
Undertake contract Make 3X
$ $
Direct labour (15 hrs @ $6) (90) Contribution
Variable overheads (60%  90%) (54) (3  $22) 66
(144)
 Relevant cost of using labour = $(144) – $66
= $(210)
Alternative approach
The cash flows which will change if the contract goes ahead are:
$
Lost revenue from X (3  $90) 270
Saved costs from X materials (3  $20) (60)
Relevant cost of 15 hrs of labour 210
Notes
1 The labour and overhead costs will be incurred whichever decision is made and can
therefore be ignored.
2 This does not equal 'lost contribution' of making 3 Xs ( = 3  $22 = $66).
$
Why? Contribution = Revenue 90 All lost
Less costs (68) Not all saved
22
 Alternative presentation
$
Lost contribution (3  $22) 66
Less: costs not saved
labour (3  $30) 90
variable overheads (3  $18) 54
210
Relevant cost of 15 hrs of labour
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Accept or reject decisions
$ $
Revenue 1,000
Costs:
Materials 500
Labour (100 @ $2) 200
400
Lost contribution  8 100 
2 
1,100
(100)  Reject

Make or buy decisions
Cost of buying $23
Cost of making $
Materials 10
Labour (2 @ $5) 10
6
Lost contribution  9  2 
3 
26
 Buy

Firstly, must determine limiting factor:
Labour Materials
hours kg
Tom 30,000 10,000
John 16,000 20,000
46,000 30,000
Amount available 40,000 35,000
 Labour hours is limiting factor
Tom John
Contribution per unit $6.00 $5.00
Hours taken 3 2
Contribution per labour hour $2.00 $2.50
 Ranking (2) (1)
Optimal production plan:
Units Hours used Contribution
$
John 8,000 16,000 40,000
Tom 8,000 24,000  48,000
40,000 88,000
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Chapter 15
$1,610  5 year DF @ 10%
$1,610  0.621 = $1,000 (to nearest $)

$
$100  1 year DF @ 10% = $100  0.909 = 90.90
$100  2 year DF @ 10% = $100  0.826 = 82.60
$100  3 year DF @ 10% = $100  0.751 = 75.10
2.486 248.60

$100  3 year CDF @ 10% = $100  2.486 = $248.60

1
$1,000  = $10,000
0.1

Simple payback
Year cash flow Cumulative cash flow
$ $
0 (550,000) (550,000)
1 150,000 (400,000)
2 150,000 (250,000)
3 150,000 (100,000) Payback between 3 and 4 years
4 150,000 50,000
5 175,000 225,000
If cash flows arise at the year end, the payback period is 4 years.
If cash flows accrue evenly over the year the payback period is 3 years and 8 months:
 100 
 12 
 150 
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Discounted payback
Time Cash flow Discount Discounted Cumulative
factor @ cash flow DCF
10%
$ $ $
0 (550,000) 1 (550,000) (550,000)
1 150,000 0.909 136,350 (413,650)
2 0.826 123,900 (289,750)
3 0.751 112,650 (177,100)
4 0.683 102,450 (74,650)
5 175,000 0.621 108,675 34,025
Payback between 4 and 5 years
If cash flows arise at the year end the payback period is five years.
If cash flows accrue evenly over the year the payback period is four years and eight months:
 75 
  12 
 109 
Therefore, Kirby should go ahead with the project.

Time Cash flow Discount factor PV
@ 10%
$ $
0 (550,000) 1 (550,000)
1 150,000 0.909 136,350
2 150,000 0.826 123,900
3 150,000 0.751 112,650
4 150,000 0.683 102,450
5 175,000 0.621 108,675
NPV = 34,025
Kirby should proceed with the project because it has a positive NPV.

Time Cash flow Discount factor PV
@ 15%
$
0 (550,000) 1 (550,000)
1–4 150,000 2.855 428,250
5 175,000 0.497 86,975
NPV = (34,775)
34,025
IRR = 10 + (  5)
68,800
= 12.47%
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Chapter 16
Raw materials inventory holding period 3
+ Production period 2
+ Finished goods inventory holding period 4
+ Receivables collection period 8
17
– Payables payment period (6)
Cash operating cycle 11

December January February
$ $ $
Sales 8,000 10,000 11,000.0
Cash sales 4,000 4,400.0

Receipts from customers
From previous month 3,600 4,500.0
This month 1,425 1,567.5
Total cash receipts 9,025 10,467.5

Year Quarter Time series 4/Period Trend (T) =
(TS) moving Centred
average average
1 Q1 18
Q2 60 67.50
Q3 90 70.50 69.000
Q4 102 73.50 72.000
2 Q1 30 75.75 74.625
Q2 72 80.25 78.000
Q3 99 81.75 81.000
Q4 120 86.25 84.000
3 Q1 36 90.00 88.125
Q2 90 93.75 91.875
Q3 114
Q4 135
91.875–69 = 22.875/7= 3.267857 average movement in the trend
TS at year 3 Q2 91.875 + (3  3.267857) = TS at Year 4 Q1 101.67
Chapter 17
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Chapter 18
Adverse/
Budgeted Actual Variance Variance favourable
$ $ $ %
Fruit purchases 3,000 3,350 (350) 11.7 A
Rent 2,500 2,550 (50) 2.0 A
Rates 500 560 (60) 12 A
Heat and light 660 540 120 18.2 F
Salaries 2,200 1,900 300 13.6 F
Actual Budget Flexed Variance Adverse/

budget favourable
Production (units) 5,000 4,800 5,000
$ $ $ $
Direct material 1,874 1,850 1,927 53 F
Direct labour 825 810 844 19 F
Prime cost 2,699 2,660 2,771 72 F
Fixed overheads 826 840 840 14 F
Total cost 3,525 3,500 3,611 86 F

Total sales variance $
Actual sales revenue 16,200
Budgeted sale revenue (740  21) 15,540
Variance 660 (F)
Volume/activity variance $
Actual sales units 795
Budgeted sales units 740
Variance (units) 55
X budgeted selling price  $21
Variance ($) 1,155 (F)
Selling price variance $

Actual sales revenue 16,200
Flexed budgeted revenue (795  21) 16,695
Variance 495 (A)
Note. 660(F) = 1,155(F) – 495(A)
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Total cost variance $
Actual materials cost 17,600
Budgeted cost (800  20) 16,000
Variance 1,600 (A)
Purchase price variance $

Actual materials cost 17,600
Flexed budgeted cost (820  20) 16,400
Variance 1,200 (A)
Note. 1,600(A) = 400(A) + 1,200(A)
Activity variance
Actual units produced 820
Budgeted units 800
Variance (units) 20
X budgeted cost per unit  $20
Variance ($) 400 (A)

Fruit purchases
Heat and light
Rates
Salaries
Chapter 19
Factor Consideration
Time How long will be needed to prepare the message, and how long will it take
to transmit it in the chosen form? This must be weighed against the
urgency with which the message must be sent.
Complexity The method used for relaying a complex piece of information must be
chosen carefully. A written document may make it easier for the reader to
take their time over digesting the information. On the other hand, a
conversation would allow for instant clarification where necessary.
Distance How far is the message required to travel? Must it be transmitted to an
office on a different floor of the building, or across town, or to the other end
of the country?
Written record A written record may be needed as proof, confirming a transaction, or for
legal purposes, or as an aid to memory. It can be duplicated and sent to
many recipients. It can be stored and later retrieved for reference and
analysis as required.
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Factor Consideration
Feedback/ How quickly is the feedback required? If an instant response is needed
interaction then a conversation may be appropriate. How many responses are
required? If there are many responses needed then talking to each
individual may take too long.
Confidentiality Telephone calls may be overheard; internal memos may be read by
colleagues or by internal mail staff; highly personal letters may be read by
the recipient's secretary.
On the other hand a message may need to be spread widely and quickly to
all staff; the notice board, a group email, a public announcement or the
company newsletter may be more appropriate.
Recipient It may be necessary to be reserved and tactful, warm and friendly, or
impersonal, depending upon the desired effect upon the recipient. If you
are trying to impress, a high quality document may be needed.
Cost Cost must be considered in relation to all of the above factors. The aim is
to achieve the best possible result at the least possible expense.

Advantages of emails:
(a) Speed
(b) Economy
(c) Efficiency
(d) Security
(e) Documents can be attached
(f) Read receipts can be used

(a) Report
(b) Email
(c) Memo, email, telephone call
(d) Letter
(e) Telephone call, email, face to face
(f) Letter
END OF ANSWERS TO LECTURE EXAMPLES
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Appendix A:
Overview summaries
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APPENDIX A
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APPENDIX A
Chapter 1: Overview summary

 Establish objectives
 Strategies to achieve
objectives
Role of the management accounting function
 Assist management in running the business
– Costing
– Decision making
– Planning
– Controlling  Comparison of actual and
– Performance evaluation planned performance
Information for decision making

 Aid informed decision making
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APPENDIX A

technology
Capturing and processing cost and

 Keyboard and mouse
 VDU
 Scanning
The role of information technology  Barcodes
 Speed  Optical mark reader
 Accuracy  EFTPOS
 Volume and complexity
 Access to information
Storing cost and management

accounting data
 Disks
 Tape storage
Management information systems  CD-ROM
 Used to drive a database system  DVD
 A system making use of available  Memory stick
resources to provide managers with
the information they need
Outputting cost and management

accounting data
 Printers
 VDU
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APPENDIX A
Cost classification
Cost unit
Unit of product or
service in relation to
which costs may be
ascertained Classification by function

 Associated with production of  All other costs in a business
goods and services
Materials Materials
 Cost of material used  Cost of material
in production Further classification used elsewhere
by nature in the business
Labour
Labour
 Cost of workforce
 Cost of work
used in production
force used
elsewhere in
the business
Overheads
 Cost of overhead
required to support
production Overheads
 Cost of
overhead
Indirect
Direct required to
 Incurred as a result of
 Directly traced support
making a product but
to product function
not directly traceable
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APPENDIX A
Cost behaviour
Group costs together according to how they

behave when output volume changes

(VC) (FC)
 Varies directly with the volume of  Unaffected by changes in volumes  Fixed within certain levels of output
output of output
$ $ $
Output Output Output
Mixed cost
 Contains a fixed and variable element
$
Total cost =
FC + (VC/unit  Output)
Output
Cost estimation
 Businesses need to estimate costs in the future
 To do so they need to break down a historic cost
into a VC and FC element
High–low method
(1) Select highest and lowest activity (output) and associated total cost
(2) Find the change in activity and cost
Change in cost
(3) Calculate VC/unit
Change in activity
(4) Substitute back into: TC = FC + VC/unit  output
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APPENDIX A
Materials
 Purchase requisition form Objective – to maintain  FIFO – assume materials
 Purchase order form accurate records of inventory are issued in order they
 Goods received note levels
were delivered
 LIFO – assume materials
issued in reverse order in
which they were delivered
 WA – calculate weighted
average price for all
inventory
EOQ
Theoretical model: Re-order level
 Quantity of units to order Minimum level
within each other to Maximum level
Theoretical ways of
minimise costs
managing stock levels
 Purchase costs (=P  D) LEARN:
 Order costs (=Co  D/Q) Inventory levels
 Holding costs (=Ch  Q/2)
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APPENDIX A
Labour costs
Systems of recording and analysing labour

 Time-based system  Controllable causes/
 Piecework system uncontrollable causes
 Bonus/incentive scheme  Replacement costs/
preventative costs

 Production/productivity
– Efficiency ratio
– Capacity ratio
– Production volume ratio
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APPENDIX A
Expenses
Any other costs incurred by the

organisation that are not materials or
labour are generally known as expenses

Any expense which is incurred on a Indirect expenses are also known as
specific product other than direct overheads
materials or labour
Recording expenses
Direct expenses are
charged directly to the job
Indirect expenses are
allocated to appropriate
cost centres
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APPENDIX A
Absorption costing

 Profitability
 Selling price
Types of overhead Predetermine OAR

 OAR calculated at the start of the
year based on budgeted figures
Production Non-production
Allocating overheads to units to

Calculating a profit or loss
find the full production cost
under absorption costing
(See Chapter 9)
 Predetermined OAR used to
estimate overheads during the
year to calculate a profit or loss
figure
absorption costing
 Getting the production overhead
cost into the cost card
 Can be done for internal reporting
purposes

apportion
 Overheads from  Overheads from production cost
 Overheads to cost service cost centres to centres to individual units using an
centres on some production cost overhead absorption rate (OAR)
fair basis centres on some fair Budgeted overhead
– Production cost basis OAR =
Budgeted activity
centres – Direct method
– Service cost – Reciprocal (1) Calculate OAR using appropriate
centres method activity
(2) Calculate the activity for a single
unit and apply OAR
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APPENDIX A

Marginal (MC) and

 Profitability
 Selling price
 EXCLUDES any overheads

 Includes element of
overheads (Chapter 8)
CONTRIBUTION
 Contribution towards fixed costs

and profit = SP – ALL VC
Including non-production VC
Profit/loss under AC Profit/Loss under MC
Above gross profit = PRODUCTION costs Format Above contribution = VARIABLE costs
Below gross profit = NON-PRODUCTION costs Below contribution = FIXED costs
Value at full production cost ie from cost card Value at marginal cost ie from cost card
Inventory
including overheads excluding overheads
(1) Overheads absorbed

Fixed overheads Include actual fixed overhead
(estimate of overheads)
= OAR  actual activity
(2) Adjustment for under- or over-absorption
Reconciliations
Difference is due to the valuation of inventory

AC MC
 Recognises that selling price must  Highlights contribution so appropriate
cover all costs for decision making
 Complies with reporting standards  Treats FC in accordance with their
 Profits can be manipulated by Advantages/disadvantages of nature
changing production levels AC and MC  Danger that contribution fails to cover
 Assumes FC are volume related FC
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APPENDIX A
Cost bookkeeping
Materials Labour Production overheads WIP
Debit Materials Debit Labour Debit Production Debit Finished goods

Credit Cash (payables) Credit Cash overheads Credit WIP
Credit Cash
Debit WIP (direct labour) Debit WIP with Debit Cost of sales
Debit WIP
Credit Labour absorbed Credit Finished goods
Credit Materials
Debit Production o/h overheads
(indirect labour) Credit Production
Credit Labour overheads with Debit Statement of
absorbed profit or loss
overheads
Credit Cost of sales
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APPENDIX A

costing

Job – single jobs or contracts  Product  not tangible
Batch – lots of identical items that  Costs  higher proportion of
make up one cost unit costs may be indirect costs
 Cost unit  changes

Direct materials X  Quite often difficult to identify and
Direct labour X compare against competitors
Prime cost X within the same industry
Overheads X
Total cost X

 Cost of an internal service
 A business will want to:
Control cost of Control usage of service

department providing in company
service
 Methods of deciding the cost to charge for

an internal service
– Actual cost
– Standard cost
– Opportunity cost
– Variable cost
– Cost + margin
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APPENDIX A
Process costing

process costing
 Unexpected losses during  Unexpected gains during
the process the process
Good
Inputs Process 1 Good
output output Good
output
Normal
Inputs Process 1
loss Inputs Process 1 Normal
Normal losses loss
Abnormal
 Losses expected in the process loss Abnormal
gain
Abnormal losses valued at CPU
Good
Inputs Process 1 output
Abnormal gains valued at CPU
Normal
loss
Without scrap value With scrap value

 No proceeds from  Income generated from
scrapped units scrapping units
Value of output at cost per unit (CPU)

CPU =
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APPENDIX A

breakeven point for
a business
The number of units The number of units

you must sell to you must sell to The amount sales
break even achieved your target can fall by before
profit you start making a
 Fixed costs/ loss
 Fixed costs + Target
Contribution per profit/Contribution per
unit unit

(BER)
 Budgeted sales – BEP/

Budgeted sales = %
 Budgeted sales – BEP = Units
Contribution
BEP  SP =
to sales ratio
BER
Illustrates the
contribution earned per
$1 of sales revenue
 Contribution per unit/Selling price

per unit = C/S ratio
 Fixed costs/ C/S ratio= BER
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APPENDIX A
Decision making
Future incremental
cash flows
Materials Labour
Could hire more staff:
In inventory Not in inventory Current rate of pay
In constant use: Current purchase
Replacement cost price Spare capacity:
No relevant cost
No other use:
Scrap value Full capacity:
Opportunity cost
Scarce:
Opportunity cost Lost contribution
Or
Decisions: Lost revenue
Only accept if you will
ultimately be profitable
 Make or buy
Only make if it is cheaper (a) Identify the limiting
than buying the product factor
(b) Calculate the
contribution
per unit
(c) Calculate the
contribution per
unit of limiting
factor
(d) Grade your
products
Limiting factor (e) Identify the optimal
production plan
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APPENDIX A
Payback NPV IRR

• Time taken for project • Discount rate that
to payback initial gives NPV = 0
investments • Accept all prospects
• Accept projects with Difference between with IRR >
PBP < target PBP company's cost
of capital
Simple Discounted
Sum of discounted Amount initially invested

cash flows expected
from investment
• Accept all projects with

positive NPV
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APPENDIX A
Cash management
Cash operating cycle Cash budgets Treasury Techniques in

department forecasting
The cash operating cycle Cash budgets
is the connection between comprise a The role of the
working capital and cash detailed forecast of treasury department
movements in and out of cash receipts, includes:
the organisation: payments and Time series analysis
RM days balances over a  Corporate financial
Time series is a series
+ planning period. objectives of figures or values
WIP day  Funding recorded over time.
+ management This can be analysed
Inventory days  Liquidity to help estimate future
+ Deficits and management
Cash in values.
Receivables days surplus  Currency
less
– Cash out Cash budgets can management Time series analysis
Payable days identify cash  Corporate finance considers the following
deficits when  Tax/pension/risk components:
finances will need management
to be obtained.  Seasonal variations
 Cyclical variations
Cash budgets can  Random variations
identify surpluses  Trend
Overtrading which can be
Overtrading occurs invested:
when a business
grows rapidly without  Gilts
the corresponding Inflation
 Shares
financial support Inflation is the
 Commercial
increase in the price
paper
of goods and
 Debentures services over a
period of time.
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APPENDIX A
 Set before start of  Adjust for actual

period production/sales volumes
 Based on  Enables 'like for like'
estimated/budgeted comparison with actuals
production and sales
 More meaningful variance
volumes
analysis
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APPENDIX A
Variances
Causes
Total variance
 Activity/volume
variance
 Price/efficiency
variance
Total variance
 Activity/volume
variance
 Selling price variance
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APPENDIX A
information
Formal  Factors to consider  Data Protection Act 2018

 Title  Methods
 Terms of reference  Visual element
 Executive summary
 Findings/conclusion
 Recommendations
 Bibliography
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APPENDIX A
END OF APPENDIX A
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Appendix B: Formula &
Mathematical tables
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APPENDIX B
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APPENDIX B
Formula sheet
ACCA's website says for MA2:
'Maths tables (net present value and annuity tables) will not be provided with each exam paper but
specific discount factors and annuity factors will be given where a question requires one. Similarly,
specific formula such as EOQ, will be given where a question requires one.'
2C 0 D
Economic order quantity =
Ch
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APPENDIX B
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APPENDIX B
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APPENDIX B
END OF APPENDIX B
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Tel: +44 (0)20 8740 2211
Fax: +44 (0)20 8740 1184
www.bpp.com/learningmedia
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Managing Costs and Finance

ISBN: 1781 4728 0025 9

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Checkpoint 1 – Additional study guidance .................................................................................. 119

Checkpoint 2 – Additional study guidance ................................................................................... 189

Checkpoint 3 – Additional study guidance ................................................................................... 211

Checkpoint 4 – Additional study guidance ................................................................................... 305

Prepare for and book your CBE!

Introduction to MA2 Managing Costs and Finance

Overall aim of the syllabus

Links with other exams

SBL APM ACCA

Assessment methods and format of the exam

Format of the exam Marks

Study Programme Aims

A1 Management information requirements Chapter 1

B1 Accounting for materials Chapter 5

C1 Absorption costing Chapter 8

D1 Cost–volume–profit analysis Chapter 13

E1 Nature of cash and cash flow Chapter 16

Analysis of the pilot exam

Formula given in exam

This section explains and demonstrates the key skills

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BPP Tutor Toolkit copy

Key skills required to pass

1 Learning and 2 Logical

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Skill 1 – Learning and applying the syllabus theory

1 What do I need to know to do well in the exam?

2 Learning the theory

Here are two examples from a past exam:

Which of the following are objectives of cash budgeting?

(1) To anticipate cash shortages and surpluses

(2) To enable necessary funds to be made available

(3) To monitor trade receivables

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A company has two production cost centres, Cutting and Finishing.

Cutting: $210,000 60,000 machine hours 4,000 labour hours

A Both cost centres should be based on machine hours

B Both cost centres should be based on labour hours

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A company planned to produce 4,000 units of Product X during a

Which of the following statements is true?

A Fixed overheads were under-absorbed by $840

B Fixed overheads were over-absorbed by $840

C Fixed overheads were over-absorbed by $1,000

D Fixed overheads were under-absorbed by $1,840

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Which of the following is correct with regard to the above graph?

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Skill 2 – Logical approaches to objective test questions

1 What to do if you know the answer to a multiple choice question

2 What to do if more than one multiple choice answer appears plausible

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STEP Eliminate the incorrect answer(s)

STEP Assess the remaining answers