ACCA FIA - Management Accounting (MA) - Teaching Slides - 2019

Foundations in Accountancy /
ACCA
Management Accounting (FMA/MA)
For exams from 1 September 2019 to 31 August 2020
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Key to icons
Syllabus Case study
Technical content Real world example
Question to consider Diagram
Answer Key model
Past exam question Tackling the exam
Answer to past exam Summary

question
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Syllabus
A The nature, source and purpose of management information
B Data analysis and statistical techniques
C Cost accounting techniques
D Budgeting
E Standard costing
F Performance measurement
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Exam format
This syllabus is assessed by a two-hour examination.
Section A: Thirty five two-mark objective test questions: 70 marks
Section B: Three ten-mark multi-task questions: 30 marks
Total: 100 marks
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Exam format
The question types in the exam are:

• Multiple choice – choose one answer from 4 options
• Multiple response – select more than one response by clicking the
appropriate tick boxes
• Multiple response matching – select a response to a number of
related statements by choosing one option from a number of drop
down menus
• Number entry – key in a numerical response to a question
• Multiple task questions – a series of short questions related to one
scenario. Question formats could include: number entry, drop
down lists, multiple choice, multiple response and hotspots.
It is important to practise all types of questions.
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Tackling the exam
The syllabus for this exam is very broad, which means you need to ensure
that you have a good knowledge of all areas. You can do this by:
• Ensuring that you study all areas of the syllabus

• Practising questions to time (1.2 minutes per mark)
• Practising mixed banks of questions
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Resources available
In addition to your Study Text and Practice & Revision Kit you should ensure
that you make use of the following resources:
• Examining team's articles – Student Accountant archives

• Examining team's reports – ACCA website, explaining common pitfalls
and mistakes made by students
The specimen exam can be found on the ACCA website.
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Chapter 1 • Information
• Planning, control and decision
making
Accounting for
• Financial accounting and
management management accounting
• Cost accounting
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Syllabus learning outcomes
• Distinguish between data and information.

• Identify and explain the attributes of good information.
• Outline the managerial processes of planning, decision making
and control.
• Explain the difference between strategic, tactical and operational
planning.
• Describe the purpose and role of cost and management
accounting within an organisation.
• Compare and contrast financial accounting with cost and
management accounting.
• Explain the limitations of management information in providing
guidance for managerial decision making.
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Overview
Accounting for
management
Role of management Data and Information for

accounting function information planning
Comparison with Qualities

financial accounting Information for
control
Information for
decision making
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Tackling the exam
Example
Question
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Information 1
The successful management of any organisation depends on

information.
For example management need information for:
• Setting prices
• Deciding on whether to purchase or lease machinery
• Deciding how many units to produce
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Information 2
Information is used in any type of organisation:
• Non-profit seeking organisations such as charities, clubs and local

authorities need information for reporting on their activities and
determining prices or subscriptions.
• Multinational businesses need information for reporting on their
activities.
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Information 3
Information is sometimes referred to as processed data.

The syllabus requires you to know the difference between information
and data.
Data is the raw material for processing.
For example, data may relate to facts, events and transactions.
Researchers conducting questionnaire surveys obtain data which are
processed and analysed to produce a report.
The resulting report is information.
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Information 4
Qualities of good information

• Relevance.
Information must be relevant to the purpose for which a manager
wants to use it.
• Completeness.
An information user should have all of the information that they
need to do their job properly.
• Accuracy.
Information should obviously be accurate because using incorrect
information could have serious consequences.
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Information 5
• Clarity.
Information must be clear to the user.
• Confidence.
Information must be trusted by the managers who are expected to
use it.
• Communication.
Individuals given authority to do certain tasks must be given the
information they need to do them.
• Volume.
There are physical and mental limitations to what a person can
read, absorb and understand properly.
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Information 6
• Timing.
Information should be available when it is needed.
• Channel of communication.
Some information is best communicated informally by telephone or
word-of-mouth and some is better in a formal method, in writing.
• Cost.
Benefits of information must outweigh the cost of collecting it.
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Question to consider
What information may the managers of a business need?
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Answer
External information Internal information
Competitors – Service offered Management accounts

– Prices charged – Performance against budget
Customers – Other services they – Trade receivables reports
might use Budgets (eg cash, production, sales)
– Satisfaction Staff availability
– Jobs to tender for
Suppliers – Continuation of trade
Possibility of opening new
office/dept
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Information 7
Most organisations need:
• Financial information
• Non-financial information
• A combination of financial and non-financial information
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Information 8
Non-financial information is becoming more important to managers.
For example, suppose a business decides to provide a staff canteen.
Non-financial information examples:
• Managers need to know how staff morale is affected by the

canteen
• Whether the bread from a supplier is fresh
• Why canteen staff are requesting a new dishwasher
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Planning, control and decision making
Management require information to help them to plan and control

operations and to make informed decisions.
• Planning
• Control
• Decision making
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Planning
Organisations should never be surprised by developments which

occur gradually because they should have implemented a planning
process.
Planning involves:
• Establishing objectives
• Selecting appropriate strategies to achieve those objectives
Planning forces management to think ahead systematically in both

the short term and the long term.
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Planning – establishing objectives
An objective is an aim or a goal of an organisation.
A strategy is a possible course of action that might enable an

organisation to achieve its objectives.
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The objectives of a firm may be:
Profit making firm Non profit making firm

• •
• •
• •
• •
• •
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Answer
Profit making firm Non profit making firm

• Maximise profits/shareholder • Provide goods/services
wealth
• Minimise costs • Minimise costs
• Maximise revenue • Use resources efficiently
• Increase market share • Satisfaction of donor
• Providing best quality
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Planning 1
Long-term strategic planning (also known as corporate planning),

involves selecting appropriate strategies to prepare a long-term plan
to attain the objectives.
Time span – depends on organisation but could be 2, 5, 7 or 10 years
Formulating the plan is a detailed and lengthy process.
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Planning 2
Long-term plans are broken down into a series of short-term plans

usually covering one year.
They usually relate to sections, functions or departments.
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The planning process 1
The planning process
THE Assess the Assess the Assess the Assess

ASSESSMENT external organisation future expectations
STAGE environment
THE Evaluate corporate

OBJECTIVE objectives LONG-
STAGE TERM
STRATEGY
PLANNING
THE Consider alternative

EVALUATION ways of achieving
STAGE objectives
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The planning process 2
STRATEGY
PLANNING
THE Consider alternative
EVALUATION ways of achieving
STAGE objectives
THE
CORPORATE Agree a corporate
PLAN plan
Production Resource Product Research and

planning planning planning development
planning
SHORT-
TERM
PLANNING
Detailed operational plans which implement the corporate plan
on a monthly, quarterly or annual basis. Operational plans
include short-term budgets, standards and objectives.
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Control
There are two stages in the control process.
1 The performance of the organisation is regularly compared with

the actual performance. Any deviations from plan can be
identified and corrective action taken.
2 The corporate plan is reviewed in light of any changes in factors
on which the plan was based. Plan is modified if necessary to
prevent damage to future success of the business.
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Decision making
Decision making involves making a choice between alternatives.
The management accountant must provide information so that

management can reach an informed decision.
It is therefore vital the management accountant understands the

decision-making process so that appropriate information can be
supplied.
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Decision-making process
Step 1 Identify goals, objectives or problems.
Identify alternative solutions/opportunities which

Step 2
might contribute towards achieving them.
Collect and analyse relevant data about each

Step 3 alternative.
PLANNING
Make the choice/decision. State the expected

outcome and check that the expected outcome
Step 4 is in keeping with the overall goals or
objectives.
Step 5 Implement the decision.
Step 6 Obtain data about actual results.
Compare actual results with the expected

CONTROL
Step 7
outcome. Evaluate achievements.
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Anthony's view of management activity 1
Anthony divides management activities into:
• Strategic planning;
• Management control; and
• Operational control.
Strategic planning involves selecting appropriate strategies so as to

prepare a long-term plan to attain the objectives.
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Strategic plans are those which set or change the objectives or

strategic targets of an organisation.
Examples include:
• Selection of products and markets

• Required levels of company profitability
• Purchase and disposal of subsidiary companies
• Purchase and disposal of major non-current assets
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Tactical (or management) control: 'the process by which managers

assure that resources are obtained and used effectively and
efficiently in the accomplishment of the organisation's objectives.'
R N Anthony
Resources refers to people, materials, machines, money.
Efficiency means optimum output is achieved from the input
resources used.
Effectiveness in the use of resources means that outputs obtained
are in line with the intended objectives.
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Strategy feeds into tactical and operational plans. Eg

Increase sales by 5% per annum for at least five years
─ Strategic plan
Planning direct sales resources, advertising, sales promotion (to help

increase sales by 5%)
─ Tactical plan
Sales territory specifies the weekly sales targets for each sales
representative
─ Operational plan
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Management control systems 1
A management control system is a system which measures and

corrects the performance of activities of subordinates in order to
make sure that the objectives of an organisation are being met and
the plans devised to attain them are being carried out.
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Management control systems 2
Basic elements of a management control system:
• Planning: deciding what to do and identifying the desired results

• Recording the plan which should incorporate standards of
efficiency or targets
• Carrying out the plan and measuring actual results achieved
• Evaluating the comparison and deciding whether further action is
necessary
• Where corrective action is necessary, this should be
implemented
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Strategic information
• Derived from internal and external sources

• Summarised at a high level
• Relevant to the long term
• Deals with the whole organisation
• Often prepared on an 'ad hoc' basis
• Is both quantitative and qualitative
• Cannot provide complete certainty, given future cannot be
predicted
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Tactical information
• Primarily generated internally

• Summarised at a lower level
• Relevant to short and medium term
• Describes or analyses activities or departments
• Prepared routinely and regularly
• Based on quantitative measures
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Operational information
• Derived almost entirely from internal sources

• Highly detailed, being the processing of raw data
• Relates to the immediate term
• Prepared constantly or very frequently
• Task specific and largely quantitative
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Financial and management accounts 1
Management information provides a common source from which

information is drawn for two groups of people.
Financial accounts are prepared for individuals external to an

organisation.
Management accounts are prepared for internal managers of an

organisation.
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Financial and management accounts 2
The data used to prepare financial accounts and management

accounts are the same.
The differences between the financial accounts and the management

accounts arise because the data is analysed differently.
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Financial accounting 1
Financial accounting systems ensure that the assets and liabilities

of a business are properly accounted for.
Financial accounts provide information about profits etc to external

parties.
These external parties include shareholders, customers,

suppliers, tax authorities and employees.
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Financial accounting 2
The financial accounts show performance of a defined period.
There are legal and accounting requirements for limited

companies in preparing financial accounts.
Financial accounts are largely monetary and show a historic picture

of past operations.
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Management accounting 1
Management accounting systems provide information specifically

for the use of managers within an organisation.
Management accounts assist in planning and controlling an

organisation's activities and help the decision-making process.
There are no legal requirements to prepare management accounts

or any set format.
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Management accounting 2
Management accounts can focus on specific areas of an

organisation's activities.
Management accounts incorporate non-monetary measures and

can be used as a future planning tool.
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Complete the following table to compare financial and management

accounting:
Financial accounting Management accounting
Legal requirement
Users
Level of precision
Rules
Reporting
Scope
Frequency
Format
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Answer
Financial accounting Management accounting
Legal requirement ✓ X
Users External and internal Internal
Precision True and fair As accurate as possible for the

users needs
Rules Generally accepted accounting No rules govern them but some

principles established techniques used
Reporting Past data Past and present data to make

decisions about future
Scope Whole organisation Segments/divisions or whatever

is needed by the business
Frequency Annual As required
Format Governed by Companies Act No set format
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Cost accounts
Cost accounting is part of management accounting.

Cost accounting provides a bank of data for the management
accountant to use.
Concerned with:
• Preparing statements (eg budgets, costing)

• Cost data collection
• Applying costs to inventory, products and services
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Cost accounting information and decisions
All decision making is concerned with the future and so there will
always be some degree of uncertainty.
Information for decision making should therefore incorporate

uncertainty in some way.
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Chapter summary 1
1. Introduction to management accounting

▪ Purpose is to assist management in running their business to
achieve an overall objective.
2. Data and information

▪ Information is data that has been processed to be meaningful to
the person who receives it.
3. Planning, control and decision making

▪ Information is used in a business for planning, control and decision
making.
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Chapter summary 2
4. Role of management accountant

▪ Includes costing, decision making, planning, control and
performance evaluation.
5. Management accounting and financial accounting

▪ Financial accounting systems ensure that the assets and liabilities
of a business are properly accounted for. Management accounting
systems provide information specifically for managers.
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Chapter 2a
• Types of data
Sources of data • Sources of data

• Secondary data
• Big data
• Sampling
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• Describe sources of information from within and outside the

organisation.
• Explain the uses and limitations of published information/data.
• Describe the impact of general economic environment on costs/
revenues.
• Describe the main uses of big data and analytics for organisations.
• Explain sampling techniques.
• Choose an appropriate sampling method in a specific situation.
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Overview
Effect of general
economic environment on
costs/revenues
Sources of data
Data Sampling
Primary vs secondary Internal vs external Random Non-random
Random Systematic Stratified Multistage
Quota Cluster
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Tackling the exam
Example
Question
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Types of data 1
Data may be classified as follows:
• Primary and secondary data

• Discrete and continuous data
• Sample and population data
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Types of data 2
• Primary data are data collected especially for a specific purpose. Raw
data are primary data which have not been processed at all.
• Secondary data are data which have already been collected

elsewhere, for some other purpose.
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Types of data 3
Quantitative (measurable) data may be classified as being discrete or

continuous:
• Discrete data are data which can only take on a finite or countable
number of values within a given range.
• Eg the number of goals scored by Manchester United against Chelsea

in a league final: Manchester United could score 0, 1, 2, 3 or even 4
goals (discrete variables = 0, 1, 2, 3, 4), but they cannot score 1½ or
2½ goals.
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Types of data 4
• Continuous data are data which can take on any value. They are
measured rather than counted.
• Continuous data include the heights of all the members of your

family, as these can take on any value.
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Types of data 5
• Sample data are data arising as a result of investigating a sample. A

sample is a selection from the population.
• Population data are data arising as a result of investigating the

population. A population is the group of people or objects of interest to
the data collector.
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Types of data 6
DATA
QUANTITATIVE QUALITATIVE
(variables that can (attributes that
be measured) cannot be
measured)
DISCRETE CONTINUOUS
(countable number) (any value) PRIMARY SECONDARY
PRIMARY OR SECONDARY
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Sources of data 1
• Data may be obtained from an internal source or an external source.
Internal sources examples:
• Sales ledger
• Purchase ledger
• General ledger
To maintain the integrity of the accounting records, an organisation will

have systems and controls over transactions.
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Sources of data 2
Other internal sources examples:
• Data relating to personnel will be linked to the payroll system.

• Additional data may be obtained from this source if, say, a project is
being costed and it is necessary to ascertain the availability and rate
of pay of different levels of staff, or the need for and cost of
recruiting staff from outside the organisation.
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Sources of data 3
Other internal sources examples:
• Much data will be produced by a production department about

machine capacity, fuel consumption, movement of people, materials,
and work in progress, set up times, maintenance requirements.
• A large part of the traditional work of cost accounting involves
ascribing costs to the physical information produced by this source.
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Sources of data 4
External data examples:
• Invoices
• Letters and emails
• Advertisements
• Other items received from from customers and suppliers
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Secondary data 1
You will remember that primary data are data collected especially for a
specific purpose.
The advantage of such data is that the investigator knows where the
data came from and is aware of any inadequacies or limitations in the
data.
Its disadvantage is that it can be very expensive to collect primary data.
Management accountants often collect primary data when they carry out
investigations. Eg analysing invoices to establish the direct cost of a
product.
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Secondary data 2
Secondary data sources may be satisfactory in certain situations but it is

essential that there is good reason to believe that the secondary data
used is accurate and reliable.
Main sources of secondary data are:
• Governments
• Banks
• Newspapers
• Trade journals
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Secondary data 3
Government statistics
• Official statistics are supplied by many governments.

• Population data is published by many governments around the world,
and includes population numbers, births, deaths, marriages.
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Secondary data 4
Banks
• The Bank of England issues a quarterly magazine which includes data

on banks in the UK, the money supply and government borrowing and
financial transactions.
Financial newspapers
• Financial newspapers contain detailed business data and information.

• Financial newspapers include the Financial Times, the Wall Street
Journal, the Singapore Business Times and the Nikkei Weekly. Such
newspapers provide data on foreign exchange rates, interest rates,
gilts and other share prices.
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Secondary data 5
Trade journals
• Most industries are served by one or more trade journal. Journals

contain data on new developments in the industry, articles about
competitors' products, details of industry costs and prices.
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Secondary data 6
Internet
• The internet is a global network connecting millions of computers.

• The internet allows any computer with a telecommunications link to
send and receive information to and from any other suitably
equipped computer.
• A website is a collection of images and text that provide information
which may be viewed on the World Wide Web.
• Most organisations now have a website and many are able to process
transactions (known as electronic commerce or e-commerce).
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Secondary data 7
Internet (continued)
• Remember, when you are looking at information on the internet it is

not necessarily good information, just because it is 'published'.
• Anybody can put information on the internet. The reliability and
reputation of the provider is important.
• For example, The Financial Times site, FT.com, is a respected source
of financial information.
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Economic environment
General economic environment will affect the costs and revenues of a

business.
The forecast state of the economy will influence the planning process
for organisations which operate within it. In times of boom and increased
demand and consumption, the overall planning problem will be to
identify the demand. Conversely, in times of recession, the emphasis will
be on cost-effectiveness, continuing profitability, survival and competition.
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Consider an accountancy training business and state how it might be

affected by a recession (ie the general economic environment).
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Answer
Change Impact
Decline in GDP Less money in the economy meaning less
disposable income may create fall in
demand for courses.
The firm operate in a city which has a A higher proportion of students coming
high promotion of financial service firms from an area less affected by the
which seem to be bucking the overall recession may stave off the expected fall
recession well (eg of a local economic in demand due to the national recession.
trend)
Increased inflation High inflation in prices of utilities and food

costs mean that students will have less
disposable income and therefore may not
be able to afford fees.
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Answer (cont'd)
Change Impact
Low interest rates Will make it easier for the business to
raise debt finance to finance its business.
From the point of view of the students low
interest rates should keep down mortgage
repayments and thus combat the high
price inflation to help maintain disposable
income levels.
Increases in tax rates Will reduce the profits made by the

business which could cause a reduction in
either the dividends paid to investors or a
reduction in re investment within the
business.
Reductions in government spending Any contracts with government agencies

could be at risk due to local cutbacks.
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Big Data 1
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Big Data 2
Benefits of Big Data analytics
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Sampling 1
If all members of a population are examined, the survey is called a

census.
If it is not possible to survey the entire population, a sample is selected.
The results from the sample are used to estimate the results of the
whole.
Once a certain sample size has been reached very little accuracy is
gained by examining more items.
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Sampling 2
Disadvantages of a census
• The high cost of a census may exceed the value of the results
obtained.
• It might be out of date by the time you complete it.
Advantages of a sample
• It can be shown mathematically that once a certain sample size has
been reached, very little accuracy is gained by examining more items.
The larger the size of the sample, however, the more accurate the
results.
• It is possible to ask more questions with a sample.
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Sampling 3
A random sample is selected so that every item in the population has an

equal chance of being included.
This will require a sampling frame.
A sampling frame is a numbered list of all items in a population.
From this list a random sample can be selected using random number
tables.
Random sampling may be expensive, can produce an unrepresentative
sample or a sampling frame may not exist.
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Sampling 4
As random sampling can be expensive or impossible then there are

various methods of quasi-random sampling.
Stratified random sampling is where the population is divided into

categories from which random samples are taken.
• This method means that a representative sample is selected which
reflects the population.
• Inferences can be made about each category.
• However the method requires prior knowledge of each population
item.
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Sampling 5
Systematic sampling is another method of quasi-random sampling.

• This involves selecting every nth item after a random start
• Systematic sampling is easy to use and reasonably random
• However a biased sample might be chosen if the population has a
regular pattern coinciding with the sampling interval
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Sampling 6
Multistage sampling is where the population is divided into

subpopulations from which a small random sample is selected.
• Each sub-population is then divided further and then a small sample is
again selected at random.
• This process can take place as many times as necessary.
• This method does not require a sampling frame of the entire
population and is relatively cheap.
• However it is not truly random and there is a possibility of bias.
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Sampling 7
When a sampling frame cannot be established then non-random

sampling methods must be used.
Quota sampling involves stratifying the population and restricting the

sample to a fixed number in each stratum.
• This method is cheap and administratively easy and often used by
market researchers.
• Much larger samples can be studied and no sampling frame is
required.
• However it could result in a certain bias.
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Sampling 8
Another form of non-random sampling is cluster sampling.

• This involves selecting one definable subsection of the population as
the sample that is taken to be representative.
• It is inexpensive to operate.
• It is a good alternative to multistage sampling if a sampling frame does
not exist.
• However there is potential for considerable bias.
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Chapter summary 1
1. Data
▪ Data is term for facts, figures, information and measurements. If
collected for a specific purpose it is known as primary data and if
collected for another purpose it is known as secondary.
2. Sources of data
▪ Data can be internal (accounting records, payroll information, product
information, published accounts or historic records) or external (market
research, interviews, questionnaires, data from government, banks,
newspapers or the internet).
3. Impact of general economic environment on costs/revenues

▪ The economic environment will impact the costs and revenues of a
business.
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Chapter summary 2
4. Sampling
▪ A sample is where data is only collected from a sample of the
population whereas a census collects information from the whole
population.
5. Random sampling
▪ The sample is selected in such a way that each item has an equal
chance of being selected. Often done using random numbers. Quasi
random sampling can also be used.
6. Non-random sampling
▪ Where a random sample cannot be used non-random sampling can be
a solution. Both quota and cluster sampling can be used.
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Chapter 2b
Presenting • Writing a report
information • Tables and diagrams
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• Prepare written reports representing management information in

suitable formats according to purpose.
• Present information using tables, charts and graphs (bar charts, line
graphs, pie charts and scatter graphs).
• Interpret information (including the above tables, charts and graphs)
presented in management reports.
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Overview
Presenting
information
Presenting and
Report interpreting data
Plan the Style of Tables Charts

report report
Short Short Memorandum Bar charts Pie charts Scatter

informal formal graphs
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Introduction
As we saw in Chapter 1, the management accountant is involved in the

presentation, dissemination and interpretation of information.
In this chapter we will be looking at the ways in which information can be
presented, disseminated and interpreted.
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Writing a report 1
The purpose of reports, their subject matter, contents, and style vary
widely, but there are certain generally accepted principles.
The purpose of a report must be clear and it is important that thought is
put into planning and giving structure to a report.
Stylistic qualities of reports include objectivity and balance and ease of
understanding.
In a full report there is a generally accepted way of laying it out.
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Writing a report 2
• Title – short but making it clear what the report is about

• Identification – report writer, report recipient and date
• Contents page – a contents list with page references may be
necessary if the report is long
• Terms of reference – purpose of the report, and any restrictions on its
scope. Timescale if important
• Summary of recommendations – in a long, formal report a summary
of findings is included at this stage
• Sources of information – these should be acknowledged. If primary
research is carried out, its nature should be explained
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Writing a report 3
• Sections – sections or sub-headings, paragraphs numbered and

concerned with one basic idea
• Appendices – calculations, detailed explanations, charts or tables
should be put into appendices and cross-referenced
• Conclusion – in a shorter report the conclusion and any
recommendations would tend to be here
• Prominence of important items – the most significant items in a
report should be given prominence
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The purpose of reports and their subject matter vary widely, but there are
certain generally accepted principles of report writing that can be applied
to most types of report.
Discuss the desired features of a report.
(a) Title
(b) Identification
(c) Sources of information
(d) Sections
(e) Appendices
(f) Summary of recommendations
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Answer
(a) Title. The report should have a title, and the title should be explicit
and brief.
(b) Identification of report writer, report user and date.
(c) Sources of information. If the report draws on the other sources for
its information, these sources should be acknowledged in the report.
(d) Sections. The main body of the report should be divided into
sections.
(e) Appendices. To keep the main body of the report short enough to
hold the reader's interest, detailed explanations, charts and tables of
figures should be put into appendices. The main body of the report
should make cross-references to the appendices in appropriate
places.
(f) Summary of recommendations. A report will usually contain
conclusions or recommendations about the course of action to be
taken by the report user.
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Tables and diagrams 1
A table is a matrix of information in rows and columns, with rows and

columns having titles.
A table is two-dimensional, set out in rows and columns, therefore it can
only represent two variables.
The table should be given a clear title.
All rows and columns should be clearly labelled.
The units being used must be clearly identified ie $ or kg etc.
Where appropriate there should be clear subtotals.
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A total column may be presented (usually the right hand column).

A total figure is often advisable at the bottom of each column of
figures.
Information presented should be easy to read.
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A bar chart is a method of presenting information in which quantities are

shown in the form of vertical bars on a chart.
The length of the bars is proportional to quantities/amounts.
There are three types of bar charts:
• Simple bar charts

• Component bar charts, including percentage component bar charts
• Multiple (or compound) bar charts
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A simple bar chart is one in which the height of each bar indicates the
size of the corresponding information.
• By comparing the heights of bars on the chart the size of each piece of
information can be compared.
• Example:
Year Sales
$'000
1 20,000
2 21,000
3 23,500
4 22,750
5 20,000
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Simple bar chart

Company sales
25000
20000
Sales 15000
$'000 Year
Sales $'000
10000
5000
0
1 2 3 4 5
Year
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A component bar chart is a bar chart that gives a breakdown of each

total into its components
• Example:
North South East West

$'000 $'000 $'000 $'000
Year 1 20,000 18,000 10,000 5,000
Year 2 24,000 20,000 12,000 6,000
Year 3 34,000 20,000 14,000 7,000
78,000 58,000 36,000 18,000
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Component bar chart

Company sales by region Years 1 to 3
80,000
70,000
60,000
Sales 50,000
$'000 West
40,000 East
South
30,000 North
20,000
10,000
0
Year 1 Year 2 Year 3
Year
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In a percentage component bar chart each bar is the same height

representing 100%.
• The heights of sections of a bar vary according to the relative sizes of
the components.
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Percentage component bar chart

100%
90%
Sales 80%
% 70%
60% West
50% East
South
40%
North
30%
20%
10%
0%
Year
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A multiple bar chart is one in which two or more separate bars are used
to present sub divisions of information.
• These are also known as compound bar charts.
• Multiple bar charts do not show a grand total whereas component bar
charts do.
• Multiple bar charts illustrate the comparative sizes of the components
more clearly than component bar charts.
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Multiple bar chart

40,000
35,000
30,000
Sales 25,000
North
$'000 20,000 South
East
15,000
West
10,000
5,000
0
Year
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A pie chart is a chart which is used to show pictorially the relative size of
component elements of a total.
• Pie charts have sectors of varying sizes.
• Working out sector sizes involves converting parts of the total into
equivalent degrees of a circle.
• A complete 'pie' = 360: the number of degrees in a circle
Year 1 Sales
$'000
North 20,000
South 18,000
East 10,000
West 5,000
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Pie chart
Company sales by region for Year 1
Year 1 Sales $'000
North
South
East
West
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Advantages of pie charts:
• They give a simple pictorial display of the relative sizes of elements of

a total.
• They show clearly when one element is much bigger than others.
• They can clearly show differences in the elements of two different
totals.
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Disadvantages of pie charts:
• They only show the relative sizes of elements.

• They involve calculating degrees of a circle and drawing sectors
accurately, and this can be time consuming unless computer software
is used.
• It is often difficult to compare sector sizes easily.
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Scatter diagrams are graphs which are used to exhibit data (rather than
equations) in order to compare the way in which two variables vary with
each other.
• The x axis of a scatter diagram is used to represent the independent
variable and the y axis represents the dependent variable.
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Scatter diagram example
Units 7,000 12,000 14,000 11,000 10,500 5,000

Cost $ 20,000 35,000 45,000 30,000 31,500 13,000
Units 8,000 13,000 14,000 9,000 11,500 12,000

Cost $ 21,000 41,000 40,000 28,000 35,000 36,000
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Scatter diagram
Cost $
50,000
45,000
40,000
35,000
Cost $
30,000
25,000
Cost $
20,000
15,000
10,000
5,000
0
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000
Output (units)
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Tackling the exam
Make sure that you read the following article on presenting information
from the ACCA website:
www.accaglobal.com/uk/en/student/exam-support-resources/foundation-
level-study-resources/ma1/technical-articles1/effective-presentation.html
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Chapter summary
1. Reports
▪ Types of report
— Short formal report
— Short informal report
— Memorandum report
2. Tables and diagrams

▪ A table is a matrix of data in rows and columns.
▪ Charts are a more visual display than tables.
▪ Bar charts are charts consisting of a set of non-joining bars with the
height proportional to the class frequency.
▪ A pie chart shows the relative size of the components of a total.
▪ A scatter diagram is a graph used to exhibit data.
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• Total product/service costs
Chapter 3a
• Direct costs and indirect costs
• Functional costs
Cost classification
• Fixed costs and variable costs
• Production and non-production
costs
• Cost codes
• Cost units, cost objects and
responsibility centres
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Syllabus learning outcomes 1
• Distinguish between cost, profit, investment and revenue centres.

• Describe the differing needs for information of cost, profit, investment
and revenue centre managers.
• Explain and illustrate production and non-production costs.
• Describe the different elements of production cost – materials, labour
and overheads.
• Describe the different elements of non-production cost –
administrative, selling, distribution and finance.
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• Explain the importance of the distinction between production and

non-production costs when valuing output and inventories.
• Explain and illustrate with examples classifications used in the
analysis of the product/service costs including function, direct and
indirect, fixed and variable, stepped fixed and semi-variable costs.
• Distinguish between direct and indirect costs in manufacturing and
non-manufacturing organisations.
• Identify examples of direct and indirect costs in manufacturing and
non-manufacturing organisations.
• Explain and illustrate the concepts of cost objects, cost units and cost
centres.
• Explain and illustrate the use of codes in categorising transactions.
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Overview
Cost classification
Cost object
Codes
Classification by
Cost unit
function
Cost centre
Production Non-production
costs costs
Materials Materials
Further
Labour classification by Labour
nature
Overheads Overheads
Direct cost Indirect cost
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Introduction 1
We explained in Chapter 1 that accountants need information to assist

with:
• Planning (eg the provision of forecast costs at different activity levels)

• Control (eg the provision of actual costs and budgeted costs for
comparison)
• Decision making (eg the provision of information about actual unit
costs for the period just ended, for pricing decisions)
However, before the accountant can plan, control or make decisions, all
costs must be accurately classified.
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Introduction 2
Cost classification is one of the key areas of the syllabus and you can
therefore expect to see it in the exam that you will be facing.
If you continue to progress through the ACCA exams you will come
across cost classification frequently in your studies.
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Total product/service cost
Eventual aim of costing is to determine the cost of producing a product or

service.
The total cost of making a product or providing a service consists of the
following:
• Cost of materials
• Cost of the wages and salaries (labour costs)
• Cost of other expenses
─ Rent and rates
─ Electricity and gas bills
─ Depreciation
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Direct costs and indirect costs 1
A direct cost is a cost that can be traced in full to the product, service
or department that is being costed.
Direct costs are made up of:
• Direct materials;
• Direct labour; and
• Direct expenses.
Total direct costs are known as prime cost.
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Direct material costs are the costs of materials that are known to have
been used in making and selling a product (or even providing a service).
• Component parts, specially purchased for a particular job, order or

process
• Part-finished work which is transferred from department 1 to
department 2 becomes finished work of department 1 and a direct
material cost in department 2
• Primary packing materials like cartons and boxes
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Direct labour costs are the specific costs of the workforce used to make
a product or provide a service.
Examples of groups of labour receiving payment as direct wages are as
follows:
• Workers engaged in altering the condition or composition of the

product
• Inspectors, analysts and testers specifically required for such
production
• Foremen, shop clerks and anyone else whose wages are specifically
identified
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Other direct expenses are those expenses that have been incurred in
full as a direct consequence of making a product, or providing a service,
or running a department.
Examples of direct expenses are as follows:
• The hire of tools or equipment for a particular job

• Maintenance costs of tools, fixtures
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An indirect cost is a cost which cannot be traced directly to the

product, service or department.
• Indirect costs are also known as overheads.
• Examples are indirect materials, indirect labour, indirect expenses,
administration overhead, selling/distribution overhead.
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• A production overhead includes all indirect material costs, indirect

wages and indirect expenses incurred in the factory from receipt of the
order until its completion
• Indirect materials which cannot be traced in the finished product.
Consumable stores, eg material used in negligible amounts
• Indirect wages, meaning all wages not charged directly to a product.
Wages of non-productive personnel in the production department, eg
foremen
• Indirect expenses (other than material and labour) not charged
directly to production. Eg rent, rates and insurance of a factory,
depreciation, fuel, power, maintenance of plant, machinery and
buildings
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Identify and group the costs involved in the production of a music CD.
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Answer
Total production costs
Direct Indirect
Materials Labour Expenses Material Labour Expenses

• CD • Factory • Royalties • Oil/grease • Supervisor • Rent
• Box staff for • Rates
machine • Insurance
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Administration overhead is all indirect material costs, wages and

expenses incurred in the direction, control and administration of an
undertaking.
Examples of administration overhead are as follows:
• Depreciation of office buildings and equipment

• Office salaries, including salaries of directors, secretaries and
accountants
• Rent, rates, insurance, lighting, cleaning, telephone charges
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Selling overhead is all indirect materials costs, wages and expenses

incurred in promoting sales and retaining customers.
Examples of selling overhead are as follows:
• Printing and stationery, such as catalogues and price lists

• Salaries and commission of salesmen, representatives and sales
department staff
• Advertising and sales promotion, market research
• Rent, rates and insurance of sales offices and showrooms, bad debts
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Distribution overhead is all indirect material costs, wages and

expenses incurred in making the packed product ready for despatch and
delivering it to the customer.
Examples of distribution overhead are as follows:
• Cost of packing cases

• Wages of packers, drivers and despatch clerks
• Insurance charges, rent, rates, depreciation of warehouses
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Functional costs 1
In a 'traditional' costing system for a manufacturing organisation, costs

are classified by function as follows:
• Production or manufacturing costs – costs associated with the

factory
• Administration costs – costs associated with general office
departments
• Marketing, or selling and distribution costs – costs associated with
sales, marketing, warehousing and transport departments
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Functional costs 2
• Research costs – the costs of searching for new or improved

products
• Development costs – the costs incurred between the decision to
produce a new or improved product and the commencement of full
manufacture of the product
• Financing costs are costs incurred to finance the business such as
loan interest
• Expenses that do not fall fully into one of these classifications might be
categorised as general overheads
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Fixed costs and variable costs 1
A fixed cost is a cost which is unaffected by changes in the level of

activity.
For example:
• Rent of a building
• Business rates
• Salary of a director
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Fixed costs and variable costs 2
A variable cost is a cost which tends to vary with the level of activity.
For example:
• Direct materials
• Direct labour
• Sales commission
• Costs may also be semi-fixed or semi-variable, such as a telephone
bill which has a fixed standing charge and a variable cost per calls
made
We will return to fixed and variable costs in Chapter 3b.
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Production and non-production costs 1
Pool of total costs
Production costs Non-production costs

Costs associated with All other costs incurred in
the production of the business
goods and services,
from the supply of raw
materials up to the
end of the production
process
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Production and non-production costs 2
Product costs are costs identified with a finished product and are part of
the inventory value.
• When the goods are sold these costs become expenses (cost of
goods sold).
Non-product or period costs are costs that are deducted as expenses

during a period.
• These costs are never part of the inventory value.
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Give some examples of production and non-production costs.
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Answer
Production costs Non production costs

• Raw materials • Sales staff
• Production staff • Distribution staff
• Depreciation on assets • Admin department
• Factory rent • Finance department
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Cost codes 1
Classified costs are coded so that each cost is identifiable by its code.
Advantages of a coding system:
• A code is usually briefer than a description, thereby saving clerical

time in a manual system and storage space in a computerised system.
• A code is more precise than a description and therefore reduces
ambiguity.
• Coding facilitates data processing.
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Cost codes 2
Each individual cost should be identifiable by its code. This is possible by

building up the individual characteristics of the cost into the code.
The characteristics which are normally identified are as follows:
• The nature of the cost (materials, labour, overhead), which is known

as a subjective classification
• The type of cost (direct, indirect)
• The cost centre to which the cost should be allocated or cost unit
which should be charged, which is known as an objective
classification
• The department which the particular cost centre is in
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Cost units and cost objects 1
A cost unit is a unit of product or service to which costs can be related.

For example:
• Patient bed per night (in a hospital)

• Barrel (in the brewing industry)
• Room (in a hotel)
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Cost units and cost objects 2
A cost object is any activity for which a separate measurement of cost is

desired.
For example:
• The cost of a product

• The cost of a service
• The cost of operating a department
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Responsibility centres 1
• A responsibility centre is a department/function whose performance

is the direct responsibility of a specific manager.
• A cost centre is a collecting place for costs before they are analysed
further.
• A revenue centre is a collecting place for revenues before they are
analysed further.
─ A revenue manager should have control over how revenues are
raised.
─ A revenue manager is not accountable for costs.
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• A profit centre is a collecting place for costs and revenues.

─ Managers are accountable for both costs and revenues.
─ They should therefore have control over how revenue is raised and
how costs are incurred.
• An investment centre is responsible for costs and revenues as well
as for capital investment and financing.
─ Managers have the same sorts of responsibilities as a profit centre
manager, but they have additional responsibility for investment.
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Suggest some examples of production cost centres and service cost

centres within a clothes manufacturing factory, a food production
business and a CD manufacturer.
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Answer
Production cost centres Machining Clothes

Finishing manufacturing
Mixing
Food production
Stirring
Pressing
CD production
Packing
Service cost centre Canteen
Maintenance
Stores
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Chapter summary 1
1. Introduction
▪ 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 non-production costs

▪ Costs can be split by their function into production and non production
costs.
▪ Production costs can be split further by their nature into material,
labour and overhead costs.
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Chapter summary 2
3. Direct and indirect costs

▪ Direct costs are costs that can be directly traced to a cost unit.
▪ Indirect costs are costs incurred in production that cannot be directly
linked to a cost unit.
4. Cost objects, cost units and cost centres

▪ Costs can be calculated and analysed at different levels within an
organisation's structure.
5. Codes
▪ A coding system can save time and reduce ambiguity when recording
items of expenditure.
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Chapter 3b
• Introduction to cost behaviour
Cost behaviour • Cost behaviour patterns

• Cost estimation
• Linear equations
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• Describe and illustrate graphically different types of cost behaviour.

• Explain and illustrate with examples classifications used in the
analysis of the product/service costs including by function, direct and
indirect, fixed and variable and stepped fixed and semi-variable costs.
• Explain the structure of linear functions and equations.
• Use high/low analysis to separate the fixed and variable elements of
total costs including situations involving semi-variable and stepped
fixed costs and changes in the variable cost per unit.
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Overview
Cost behaviour
Variable cost Fixed cost Stepped

(VC) (FC) fixed cost
Mixed cost
Cost estimation
High/low method
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Tackling the exam
Example
Question
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Introduction to cost behaviour
So far we have introduced you to the subject of management

information and explained in general terms what it is and what it does.
In Chapter 3a we considered the principal methods of classifying
costs. In particular, we introduced the concept of the division of costs
into those that vary directly with changes in activity levels (variable
costs) and those that do not (fixed costs).
This chapter examines further this two-way split of cost behaviour
and explains one method of splitting semi-variable costs into these two
elements, the high/low method.
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Cost behaviour patterns 1
Cost behaviour is the way in which costs are affected by changes in

the volume of output.
Management decisions are often based on the ways in which costs
behave.
Examples:
• What should the planned activity level be for the next period?
• Should the selling price be reduced in order to sell more units?
• Should a particular component be manufactured internally or
bought in?
• Should a contract be undertaken?
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The most important factor in determining the costs is the level of activity
or volume of output.
As the level of activity rises many costs will also rise.
Level of activity can refer to value/number of items sold, number of
units produced or number of invoices issued.
Basic principle of cost behaviour is that as the level of activity rises,
costs will usually rise.
Knowledge of cost behaviour is essential for the tasks of budgeting,
decision making and control accounting.
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A fixed cost is a cost which tends to be unaffected by increases or

decreases in the level of activity.
• Examples might include rent of a single factory building or straight line
depreciation of a machine.
A step cost is a cost which is fixed in nature but only within certain levels
of activity.
• Examples might include supervisors' salary costs or factory rent if new
space has to be rented.
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A variable cost is a cost which varies directly with the level of activity.
• Examples might be cost of raw materials, direct labour costs, sales
commission.
A mixed/semi-variable/semi-fixed cost contains both fixed and variable

elements.
• Only the variable element is affected by changes in the level of activity.
• Examples might include the electricity bill or salesman's total salary.
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What do you think the graphs would look like for the following?
(Assume the x axis is the volume of output and the y axis is the total cost.)
(a) Fixed cost
(b) Stepped fixed cost
(c) Variable cost (VC)
(d) Mixed cost (semi-variable cost)
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Answer
(a) Fixed cost
Total
cost
Volume of output
eg rent, rates, insurance
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Answer (cont'd)
(b) Stepped fixed cost
Total
cost
Volume of output
eg rent if further production space is required
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Answer (cont'd)
(c) Variable cost
Total
cost
Volume of output
eg material, labour
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Answer (cont'd)
(d) Mixed cost
Total
cost
Volume of output
eg telephone bill, labour on minimum wage
or total cost
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When shown on a graph fixed costs and variable costs are straight lines.
This is known as a linear cost.
However some variable costs show as a curve on a graph and these are
known as non-linear or curvilinear variable costs.
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An example might be savings of scale where as activity levels increase

the variable costs become relatively smaller.
$
Cost
Volume of output
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Also as an example is a piecework scheme if the rates paid per unit

increase at progressively higher output levels.
$
Cost
Volume of output
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Assumptions about cost behaviour:
• Within the normal or relevant range of output, costs are often

assumed to be either fixed, variable or semi-variable (mixed).
• Departmental costs within an organisation are assumed to be mixed
costs, with a fixed and a variable element.
• Departmental costs are assumed to rise in a straight line as the
volume of activity increases. In other words, these costs are said to be
linear.
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Cost estimation 1
• A semi-variable cost has a fixed cost element and a variable cost

element.
• Using the high-low method it is possible to identify the fixed and
variable costs involved.
• There are a number of steps involved in these calculations.
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Cost estimation 2
• Step 1 – find highest and lowest activity levels over the past few
periods (usually months)
• Step 2 – adjust related costs for inflation if necessary
• Step 3 – find total cost and total units of activity at highest and
lowest levels
• Step 4 – calculate variable cost per unit – this is the increase in total
cost divided by the increase in units
• Step 5 – substitute variable cost per unit into either highest or lowest
activity level to find total fixed cost
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Cost estimation 3
Example:
• Estimate the variable and fixed cost using the high-low method
Month Output Cost

May 4,500 $2,000
June 5,500 $2,500
July 2,000 $1,600
August 7,000 $3,500
September 10,000 $4,000
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Cost estimation 4
Example:
• Highest activity level = 10,000 units at a cost of $4,000
• Lowest activity level = 2,000 units at a cost of $1,600
• Variable cost per unit = $(4,000 – 1,600) = $2,400 = $0.30
(10,000 – 2,000) 8,000
• Fixed cost = $4,000 – $(10,000 × 0.3) = $1,000 or

• Fixed cost = $1,600 – $(2,000 × 0.3) = $1,000
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The total costs of a business for differing levels of output are as follows:
Output Total costs

(units) ($'000)
500 70
200 30
300 50
800 90
1,000 110
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Question to consider (cont'd)
Required
What are the fixed and variable elements of the total cost using the
High/Low method?
A Y = $30,000 + $100x
B Y = $30,000 + $110x
C Y = $10,000 + $110x
D Y = $10,000 + $100x
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Answer
Units Costs
$
Highest 1,000 110,000
Lowest 200 30,000
800 80,000
 variable cost per unit = $80,000 = $100

800
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Answer (cont'd)
Fixed cost element:
TC = FC + VC/unit × output
Substitute at the highest level:
$110,000 = FC + $100 × 1,000

FC = $10,000
∴ Y = $10,000 + $100x
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Using the information calculated in the previous example, answer the

following:
If production next year is expected to be 780 units what would the total
cost be?
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Answer
y = 10,000 + 100x
y = 10,000 + 100 × 780
TC = $88,000
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The following data has been collected from a business:
Units produced 5,000 7,500 10,000

Total costs $54,500 $76,500 $90,000
Total costs are made up of two elements, a stepped fixed cost that
changes when the units exceed 7,000 and some variable costs, which
remain constant.
Required
What are the total fixed cost at production levels below and above 7,000
units? What is the VC per unit?
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Answer
High/low method above volume of 7,000 units.
Output Total costs

$
Highest 7,500 76,500
Lowest 10,000 90,000
2,500 13,500
VC/unit = $13,500
2,500
= $5.40/unit
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Answer (cont'd)
Note. This is constant at all volumes of output
Substitute at lowest (or highest) level:
$76,500 = FC + $5.40 × 7,500

FC = $36,000 above output of 7,000 units.
So at 5,000 units
$54,500 = FC + $5.40 × 5,000
FC = $27,500 below output of 7,000 units
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Tackling the exam
Make sure that you are comfortable with the high/low method.
It is a very important tool for answering exam questions!
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Past exam question
The following question is taken from the December 2011 exam:

• The following shows the total overhead costs for given levels of a
company's total output.
• A step up in fixed costs of $500 occurs at an output level of 3,500
units.
Cost $ Output in units

4,000 1,000
7,000 2,000
10,000 3,000
9,500 4,000
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Past exam question (cont'd)
What would be the variable overhead cost per unit (to the nearest $0.01)
using the high-low technique?
A $1.67 per unit

B $1.83 per unit
C $2.75 per unit
D $3.00 per unit (2 marks)
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Answer to past exam question
ACCA examining team's comments
The high-low technique estimates variable cost per unit by looking at the
change in costs between the highest and lowest levels of output. The
correct answer is A. This can be calculated by finding the change in cost
between the highest and lowest output levels not explained by the step in
fixed costs ($9,500 – $4,000 – $500 = $5,000), and dividing by the
change in output between the highest and lowest output levels ($5,000 /
(4,000 units – 1,000 units) = $1.67 per unit).
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Linear equations 1
We have already mentioned that a linear equation is a straight line.

The syllabus states that you need to know the structure of linear
functions and equations so we will look at these in more detail.
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Linear equations 2
A linear equation has the general form:

y = a + bx
Where:
y is the dependent variable whose value depends upon the value of x
x is the independent variable whose value helps to determine the
corresponding value of y
a is a constant, that is, a fixed amount
b is also a constant, being the coefficient of x (that is the number by
which the value of x should be multiplied to derive the value of y)
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Linear equations 3
A linear equation is a straight line and has the general form y = a + bx

where
350
y = dependent variable 300
x = independent variable 250 x
a = constant (eg fixed cost) 200 x
50 variable
called the intercept b= =
150 x 20 element
50
b = constant (eg variable cost) 100 x
2
called the gradient 50
1 2 3 4 5 6 7 8
a = 50 = fixed cost
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Linear equations 4
How to draw a graph
Example:
• Plot the graphs for the following relationships

• (a) y = 4x + 5
• (b) y = 10 – x
• In each case consider the range of values from x = 0 to x = 10
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Linear equations 5
The first step is to draw up a table for each equation.
x y x y
0 5 0 10
2 13 2 8
4 21 4 6
6 29 6 4
8 37 8 2
10 45 10 0
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Linear equations 6
Graph of y = 4x + 5
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Linear equations 7
Graph of y = 10 – x
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Linear equations 8
• The graph of a linear equation is determined by two things, the

gradient (or slope) of the straight line and the point at which the
straight line crosses the y axis.
• The point at which the straight line crosses the y axis is known as the
intercept.
• The intercept of y = 4x + 5 is (0, 5) and the intercept of y = 10 – x is (0,
10).
• The intercept is the same as the constant represented by a in the
general form of the equation y = a + bx.
• a is the value y takes when x = 0, in other words a constant, and so is
represented on a graph by the point (0, a).
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Linear equations 9
• The gradient of the graph of a linear equation is:

(y2 – y1)/(x2 – x1) where (x1, y1) and (x1, x2) are two points on the
straight line.
• The slope of y = 4x + 5 = (21 – 13)/(4 – 2) = 8/2 = 4 where (x1, y1) =
(2, 13) and (x2, y2) = (4,21)
• The slope of y = 10 – x = (6 – 8)/(4 – 2) = –2/2 = –1
• Note that the gradient of y = 4x + 5 is positive whereas the gradient of
y = 10 – x is negative.
• A positive gradient slopes upwards from left to right whereas a
negative gradient slopes downwards from left to right. The greater the
value of the gradient, the steeper the slope.
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Linear equations 10
• The gradient can be found by looking at the equation.

• It is represented by the coefficient of x (b in the general form of the
equation).
• The slope of the graph y = 7x – 3 is therefore 7 and the slope of the
graph y = 3,597 – 263 x is –263.
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Chapter summary 1
1. Cost behaviour and output

▪ 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 step 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.
2. Cost estimation
▪ The fixed and variable element of a mixed cost can be determined by
the high/low method.
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Chapter summary 2
3. Linear equations
▪ A linear equation is a straight line and has the general form
y = a + bx
▪ Where y is the dependent variable whose value depends on the value
of x
▪ x is the independent variable
▪ a is a constant (fixed cost)
▪ b is a constant (variable cost)
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Chapter 4a • Correlation
• Linear regression
Forecasting • High low method
• Time series
• Index numbers
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• Explain the advantages and disadvantages of using the high/low

method to estimate the fixed and variable element of costing.
• Construct scatter diagrams and lines of best fit.
• Calculate and interpret correlation coefficient and coefficient of
determination.
• Establish a linear function using regression analysis and interpret the
results.
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• Use linear regression coefficients to make forecasts of costs and

revenues.
• Adjust historical and forecast data for price movements.
• Explain the advantages and disadvantages of linear regression
analysis.
• Describe the product life cycle and explain its importance in
forecasting.
• Explain the principle of time series analysis.
• Calculate moving averages.
• Calculation of trend, including the use of regression coefficients.
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• Use trend and seasonal variation (additive and multiplicative) to make

budget forecasts.
• Explain the advantages and disadvantages of time series analysis.
• Explain the purpose of index numbers.
• Calculate simple index numbers for one or more variable.
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Overview
Forecasting
Cost prediction Time series
High/low Scatter Linear

Additive Multiplicative
method graphs regression
Correlation Coefficient &

coefficient (r) determination (r2)
Index number Product life cycle
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Tackling the exam
Example
Question
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Correlation 1
Correlation
• Understanding how one variable influences another is a fundamental

part of planning.
• For example, sales directors would like to know how advertising
affects sales.
• Doctors would like to know the efficacy of particular treatments.
• Organisations need to know how costs are affected by activity levels.
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Correlation 2
Correlation
• Regression analysis attempts to discover the nature of association

between variables in the form of an equation.
• It may then be possible to use the equation to predict the
consequences of decisions or events.
• Broadly we can identify four types of association:
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Correlation 3
Positive linear correlation
• Positive means as one variable increases, so does the other.

• Linear means that the relationship between the variables can be
described by a straight line.
• Correlation is the degree of association between the variables.
Weight
Height
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Correlation 4
Negative linear correlation
• Negative means as one variable increases, the other decreases.

• Linear means that the relationship between the variables can be
described by a straight line.
• Correlation is the degree of association between the variables.
Demand
Price
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Correlation 5
Curvilinear correlation
• Curvilinear means that the relationship between the variables can be

described by a curved line.
• Curve fitting is not on your syllabus.
Rate of
marriage
Age
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Correlation 6
No correlation
• If the variables have no apparent association then there would be no

correlation.
• It would be a waste of time using regression analysis as the variables
are unconnected.
Salary Note that this is

a scattergraph
Day of birth (1 – 31)
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Correlation 7
Let's concentrate on costs and output, eg electricity costs and output.

We would expect some evidence of positive linear correlation but cost
will also be influenced by:
• The price per unit of electricity

• The weather
• Output
Be aware that other influences can complicate how costs vary with
output.
Look at the following table showing output and costs.
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Correlation 8
$ Units made
January 10,000 11,000
February 15,000 20,000
March 12,000 13,000
April 9,000 10,000
May 10,000 11,000
June 11,000 12,000
July 14,000 18,000
August 13,000 17,000
September 12,000 13,000
October 11,000 11,000
November 11,000 12,000
December 12,000 14,000
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Correlation 9
As expected, production and costs are positively correlated because they

move in the same direction.
However the relationship is not 'perfect'.
For example, 11,000 units were made in both May and October yet the
costs are different.
Perhaps there were extra heating costs in October.
Despite these imperfections, we will be looking for a simple linear
relationship between two variables.
A linear relationship is one which is described by a straight line of general
formula
y = a + bx where a is the intercept and b is the gradient
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Correlation 10
We could plot the cost against the output on a scattergraph and then joint
up the points to form a 'line of best fit'.
The trouble is that because the points do not lie on a perfect straight line,
different people will draw different lines.
This will imply different values for a and b in the equation y = a + bx
Remember a is the intercept – the fixed cost.
And b is the gradient – the variable cost per unit.
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Linear regression 1
We can instead use a method called the method of least squares to find
a line of best fit which misses the points by the least amount.
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Linear regression 2
First we need to establish which is the dependent and which is the

independent variable.
• To decide which is which, think 'what causes what?' or 'what comes
first?'
• Does output cause the costs or does cost cause the output?
• Whatever does the causing is the independent variable.
• Whatever is caused is the dependent variable.
• In this case, electricity costs are caused by and dependent on the
output.
• Output is the independent variable.
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Linear regression 3
We use two formulae (note that  means 'the sum of')


• For the line y = a + bx
n  xy − ( x)( y)
• b=
n  x2 − ( x)2
• a= y − bx
• Where x and y are the arithmetic means of x and y
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Find the line of best fit. $ Units made
January 10,000 11,000
February 17,000 20,000
March 12,000 9,000
April 9,000 10,000
May 10,000 11,000
June 12,000 12,000
July 16,000 18,000
August 13,000 17,000
September 12,000 13,000
October 20,000 25,000
November 11,000 12,000
December 14,000 14,000
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Answer
Units made $
First work out
January 11,000 10,000
February 20,000 17,000
 x,  y March
April
9,000
10,000
12,000
9,000
May 11,000 10,000
June 12,000 12,000
July 18,000 16,000
August 17,000 13,000
September 13,000 12,000
October 25,000 20,000
November 12,000 11,000
December 14,000 14,000
 x = 172,000  y = 156,000
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Answer (cont'd)
Units made (x) $ xy
January 11,000 10,000 110,000,000
February 20,000 17,000 340,000,000
March 9,000 12,000 108,000,000
April 10,000 9,000 90,000,000
May 11,000 10,000 110,000,000
June 12,000 12,000 144,000,000
July 18,000 16,000 288,000,000
August 17,000 13,000 221,000,000
September 13,000 12,000 156,000,000
October 25,000 20,000 500,000,000
November 12,000 11,000 132,000,000
December 14,000 14,000 196,000,000
 x = 172,000  y = 156,000  xy = 2,395,000,000
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Answer (cont'd)
Units made (x) $ x2
January 11,000 10,000 121,000,000
February 20,000 17,000 400,000,000
March 9,000 12,000 81,000,000
April 10,000 9,000 100,000,000
May 11,000 10,000 121,000,000
June 12,000 12,000 144,000,000
July 18,000 16,000 324,000,000
August 17,000 13,000 289,000,000
September 13,000 12,000 169,000,000
October 25,000 20,000 625,000,000
November 12,000 11,000 144,000,000
December 14,000 14,000 196,000,000
 x = 172,000  y = 156,000  x2 = 2,714,000,000
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Answer (cont'd)
(  x )(  y ) = 156,000  172,000 = 26,832 million
n x2 = 12  2,714 million = 32,568 million
( x )2 = 172,0002 = 29,584 million

28,740 – 26,832
b= = 0.64
32,568 – 29,584
a = 13,000 – (0.64  14,333) = 3,827 (All figures are in millions.)
 y = 3,827 + 0.64x
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Linear regression 4
• Strength of relationship can be assessed using the correlation

coefficient ['r'] or
• The coefficient of determination: r2
• r2 measures the proportion of determinant variable ('y' axis) which can
be explained by other variable ('x' axis)
• If r = 0.992, then r2 = 0.984

• -> 98.4% of the variation in 'y' can be explained by variations in 'x'
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Linear regression 5
Correlation coefficient (r) indicates the strength of the linear relationship

between x and y.
(n XY ) − ( X  Y )
r=
 nX 2 − (X )2   nY 2 − (Y ) 2 
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Linear regression 6
The correlation coefficient, r must always fall between –1 and +1. If you
get a value outside this range you have made a mistake.
• r = +1 means that the variables are perfectly positively correlated

• r = –1 means that the variables are perfectly negatively correlated
• r=0 means that the variables are uncorrelated
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Linear regression 7
Limitations of linear regression analysis
• Assumes a linear relationship between the dependent and

independent variables
• Assumes the dependent variable depends only upon one variable
• However when forecasting sales it may also depend on competitors'
actions, state of the economy etc as well as time
• Assumes that what has happened in the past provides a reliable guide
for the future
• Only valid within the range of data used to determine the equation in
the first place
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High-low method
Cost forecasting with the high-low method
• Select the periods with the highest and lowest activity levels
• High activity level cost – low activity level cost = the variable cost of
the difference in activity levels
• Calculate the variable cost per unit (difference in variable costs ÷
difference in activity levels)
• Calculate fixed cost (total cost at either output level – variable cost for
output level chosen)
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Time series 1
• Time series = number of observations taken regularly over a period of

time
• Eg sales over time
• Eg heating costs over time
• Eg exchange rates over time
There is often a pattern which can be analysed into several components.
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Time series 2
• Seasonal variations – variations with a repeat period of less than or

equal to one year
• Trend – long-term underlying movement (eg a gentle increase)
• Random variations – difficult to predict
• Cyclical variations – long-term, slow variations such as trade cycles
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Time series 3
A trend can be found by using moving averages:

Finding the trend (T) using moving averages
Example of an odd number of periods

Moving total Moving av. of
Year Sales of 3 yrs' sales 3 yrs' sales ( 3)
TREND
20X0 390
20X1 380 1,230* 410
20X2 460 1,290** 430
20X3 450
* (390 + 380 + 460)
**(380 + 460 + 450)
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Time series 4
Example of an even number of periods

Moving total Moving average Mid-point of 2
of 4 yrs' of 4 yrs' moving average
Year Sales sales sales TREND
20X1 600
20X2 840
2,580* 645.0
20X3 420 650.00
2,620** 655.0
20X4 720
20X5 640
*(600 + 840 + 420 + 720) **(840 + 420 + 720 + 640)
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Time series 5
Once the trend has been determined using moving averages then the
trend can be compared to actual figures for the period.
The difference between trend and actual is known as the seasonal
variation.
This can be calculated by using either the additive model or the
multiplicative model.
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Time series 6
Additive model (Y = T + S)
• S = actual – trend (S = Y – T)
Multiplicative/proportional model
• (Y = T × S)
• S = actual ÷ trend (S = Y/T)
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Time series 7
Example of trend calculation

Seasonal variation
Wk 1 Actual Trend Add model Prop model
M 80 92.70 –12.70 0.863
T 104 93.12 +10.88 1.117
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Time series 8
Once the individual seasonal variations have been calculated for each
period then they must be averaged to find an overall figure.
Additive model
M T
Wk 1 –12.70 +10.88
Wk 2 –12.80 +14.78
Total –25.50 +25.66
Average –12.75 +12.83
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Time series 9
Proportional model
M T
Wk 1 0.863 1.117
Wk 2 0.865 1.155
Total 1.728 2.272
Average 0.864 1.136
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Time series 10
Finally, adjust the total variations to ensure that they equal zero:
Additive model: to zero
Mon Tues Wed Thurs Fri Total
Average –12.75 +12.83 +0.91 +27.49 –32.43 –3.95
Adjustment (3.95/5) +0.79 +0.79 +0.79 +0.79 +0.79 +3.95
Final estimate –11.96 13.62 1.70 28.28 –31.64 0.00
Round to –12 14 2 28 –32
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Time series 11
Proportional model: to number of items in cycle
Mon Tues Wed Thurs Fri Total
Average 0.8640 1.1360 1.0095 1.2890 0.6600 4.9585
Adjustment 0.0083 0.0083 0.0083 0.0083 0.0083 0.0415

(5 – 4.9585)/5
Final estimate 0.8723 1.1443 1.0178 1.2973 0.6683 5.0000
Round to 0.87 1.14 1.02 1.3 0.67
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Time series 12
The purpose of time series analysis is to use past data to forecast

future figures.
In order to do that we need to take the forecast trend and adjust for the
seasonal variation.
• Deseasonalised or seasonally adjusted value

= trend (T) = Y – S
• Forecast value (Y) = (forecast T) + S
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Time series 13
Example 1
• If T = $560,000 and S = $45,000, forecast = $515,000
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Time series 14
Example 2
• Suppose Y for weeks 1 to 4 is 120, 90, 110, 150 and S for weeks 1 to
4 is 20, 20, 10, 20 (with a four-week cycle)
• Calculate T (deseasonalised or seasonally-adjusted data) for weeks 1
to 4
• Wk 1: 120 – 20 = 100
• Wk 2: 90 – (20) = 110
• Wk 3: 110 – (10) = 120
• Wk 4: 150 – 20 = 130
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Time series 15
Example 2 (continued)
• Determine increase/decrease in T (increasing by 10 units per week)

• Forecast T for weeks 5 and 6 (130 + 10 = 140 units, 140 + 10 = 150
units)
• Adjust T by appropriate seasonal variations to get forecast Y (week 5,
Y = 140 + 20; week 6, Y = 150 – 20)
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Time series 16
Proportional/multiplicative model
• (Y = T × S)
• Deseasonalised or seasonally — adjusted value = trend (T) = Y/S
• Forecast value (Y) = (forecast T) × S
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Time series 17
Example 1
• If T = $560,000 and S = –15%, forecast = $560,000 × 85% = $476,000

• If T = $560,000 and S = 15%, forecast = $560,000 × 115% = $644,000
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Time series 18
Example 2
• If S is 15% of T, forecast Y = 115% of T, T = (100/115)% of Y

• If S is –15% of T, forecast Y = (100 – 15)% of T = 85% of T,
T = (100/85)% of Y
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Time series 19
Example 3
• Calculate T for weeks 1 to 4 (say 100 units, 110 units, 121 units, 133
units) using moving averages
• Determine increase/decrease in T (increasing by 10% per week eg
((121 – 110)/110) × 100%)
• Forecast T for week 5 (133 units × 110% = 146 units)
• Adjust T by appropriate seasonal variations (say – 20% of T) to get
forecast Y (146 × 80%)
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Time series 20
Example 4
• Calculate T for weeks 1 to 4 using moving averages

• Plot trend figures on a graph
• Extrapolate the trend line
• Read forecast trend for week 5, say, from the graph
• Adjust T by appropriate seasonal variations found from moving
averages calculations
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Time series 21
Time series analysis
Potential issues:
• Ignores factors other than time that could also cause change
• Is all data equally variable? Give recent data more importance than
older data?
• If using time series analysis for forecasting: Is past a reliable guide to
the future? Is data itself reliable?
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Index numbers 1
Forecasting and indices
• The effects of inflation need to be removed for costs and revenues to

be comparable over time.
• The only factor affecting costs and revenues will therefore be activity
level.
• We do this by adjusting figures to a common basis using index
numbers.
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Index numbers 2
• Step 1. Remove the effects of price movements by adjusting data to a

common basis, usually to the price level of the base period (cost 
(100/index for the year in question)).
• Step 2. Apply a forecasting technique to the data from Step 1.
• Step 3. Adjust the forecast produced in step 2 to take account of price
movements (unadjusted forecast  (index for year in question/100)).
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Index numbers 3
Index numbers provide a standardised way of comparing the values,

over time, of prices, wages, volume of output.
They are used extensively in business, government and commerce.
You will be aware of some index numbers – for example, the RPI.
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Index numbers 4
• An index may be a price index or a quantity index
Pn  100
• A price index measures the Price index =
P0
change in the money value of
a group of items over time.
The Retail Prices Index (RPI) in Where Pn is the price for the
the UK measures changes in period under consideration and
the costs of items of P0 is the price for the base
expenditure of the average period.
household.
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Index numbers 5
Qn  100
• A quantity index (or volume Quantity index =
Q0
index) measures the change
in the non-monetary values of
a group of items over time eg Where Qn is the quantity for the
productivity index, measuring period under consideration and
changes in the productivity of Q0 is the quantity for the base
various departments or groups period.
of workers.
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Suppose a cost of living index is to be calculated from the following three

items: cola, pizza and chocolate and that prices for 20X1 and 20X2 were
as follows.
X1 X2
Cola $2.00 $2.10
Pizza $3.50 $3.55
Chocolate $0.55 $0.60
What is the cost of living index for X2, assuming X1 as a base year?
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Answer
P
Price index = Pn  100
o
X1 X2
Cola $2.00 $2.10
Pizza $3.50 $3.55
Chocolate $0.55 $0.60
P6.05 Pn 6.25
6.25  100
Price index =
6.05
= 103.3
Prices have therefore inflated by 3.3% in a year.
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Past exam question
The following data relates to a company's overhead cost.
Time(units) Output Overhead cost $ Price index
2 years ago 1,000 3,700 121
Current year 3,000 13,000 155
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Using the high-low technique, what is the variable cost per unit (to the
nearest $0.01) expressed in current year prices?
A $3.22
B $4.13
C $4.65
D $5.06 (2 marks)
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The correct answer is B. This is calculated by firstly adjusting the

overhead cost from two years ago to current price levels by multiplying
by 155/121, to obtain a cost of $4,740. This figure is then used in a high-
low calculation (change in cost divided by change in activity) to obtain the
variable cost per unit (($13,000 – $4,740) / (3,000 units – 1,000 units) =
$4.13).
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Past exam question
The following question is taken from the June 2013 exam:
An additive time series has the following trend and seasonal variations:
• Trend
• Y = 4,000 + 6X
• Where
• Y = sales in units
• X is the number of quarters, with the first quarter of 2014 being 1, the
second quarter of 2014 being 2 etc.
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• Seasonal variation
• Quarter 1 2 3 4
• Quarterly variation (units) −4 −2 +1 +5
What is the forecast sales volume for the fourth quarter of 2015?
A 4,029
B 4,043
C 4,048
D 4,053 (2 marks)
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The correct answer is D. This is calculated by firstly computing the trend

for fourth quarter of 2015 (Y = 4,000 + 6 × 8 = 4,048) and then adding a
seasonal adjustment of 5, to give forecast sales of 4,053.
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Chapter summary 1
1. Correlation
▪ Two variables are correlated if a change in the value of one variable is
accompanied by a change in the value of another variable.
▪ Observations of the behaviour of two variables can be plotted on a
scattergraph.
2. Linear regression
▪ Linear regression is a mathematical technique that finds the line of
best fit that defines the relationship between two variables.
3. Reliability of regression line

▪ The degree of correlation is measured by the correlation coefficient
'r'.
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Chapter summary 2
4. Coefficient of determination
▪ The coefficient of determination, r2, measures the proportion of the
total variation in the value of one variable that appears to be explained
by variations in the value of the other variable.
5. Advantages and limitations of linear regression

▪ There are some important limitations of linear regression.
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Chapter summary 3
6. Time series
▪ There are four components of a time series: trend, seasonal
variations, cyclical variations and random variations.
▪ Additive model
TS = T + SV + RV + CV
▪ Multiplicative model
TS = T  SV  RV  CV
▪ Moving averages
One method of finding a trend is by the use of moving averages.
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Chapter summary 4
7. Index numbers
▪ An index is a measure, over time, of the average changes in value
(price or quantity) of a group of items relative to the situation at some
point in the past.
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Chapter 4b • Averages
• Dispersion
Summarising and • Probability and expected values
analysing data • Normal distribution
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• Calculate the mean, mode and median for ungrouped data and the
mean for grouped data.
• Calculate measures of dispersion including the variance, standard
deviation and coefficient of variation for both grouped and ungrouped
data.
• Calculate expected values for use in decision making.
• Explain the properties of a normal distribution.
• Interpret normal distribution graphs and tables.
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Overview
Summarising and
analysing data
Expected Normal
Averages Dispersion
values distribution
Mean Median Mode
Standard Coefficient
Variance
deviation of variation
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Grouped and ungrouped data
• Grouped data – frequency (how often something

occurs) is shown in terms of a range.
• Ungrouped data – where the frequency is shown in

terms of a specific measure or value.
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Averages 1
Averages
Mean Median Mode
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Averages 2
Arithmetic mean of ungrouped data = Sum of values of items / number of items
Written as:
The demand for a product on each of 10 days was as follows:
Units: 5, 3, 7, 10, 12, 9, 8, 3, 5, 6
What is the mean of the daily demand?
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Averages 3
Arithmetic mean of ungrouped data = Sum of values of items / number of items
Written as: (on formula sheet)
Units: 5, 3, 7, 10, 12, 9, 8, 3, 5, 6
𝑥ҧ = (5+3+7+10+12+9+8+3+5+6) / 10 = 6.8 units
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Averages 4
Arithmetic mean of grouped data =
(on formula sheet)
Daily demand Frequency (f)

>0≤5 4

> 6 ≤ 10 7
> 10 ≤ 15 6
> 15 ≤ 20 3
20
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Averages 5
Arithmetic mean of grouped data =
(on formula sheet)
Daily demand Mid point Frequency (f) fx

>0≤5 3

4 12
> 5 ≤ 10 8 7 56
> 10 ≤ 15 13 6 78
> 15 ≤ 20 18 3 54
Ʃ𝑓 =20 Ʃ𝑓𝑥 = 200
𝑥ҧ = 200/20 = 10 units
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Averages 6
Mode = the most frequently occurring value.
Median = the value of the middle member of an array.


Units: 5, 3, 7, 10, 12, 9, 8, 3, 5, 5
What are the mode and median of the daily demand?
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Averages 7
Mode = the most frequently occurring value.
Median = the value of the middle member of an array.
Units: 5, 3, 7, 10, 12, 9, 8, 3, 5, 5


What are the mode and median of the daily demand?
Mode = 5
Rearrange into order: 3,3,5,5,5,7,8,9,10,12

Median = (5 + 7) / 2 = 6
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Dispersion 1
Standard deviation (σ) measures the spread of data around the mean.
(on formula sheet)


Variance = the square of the standard deviation (𝜎 2 ).
Coefficient of variation = Standard deviation (on formula sheet)

Mean
• used for comparing spreads

• The bigger the coefficient of variation, the wider the spread
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Dispersion 2
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Dispersion 3
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Probability and expected values
P(x) = The probability of outcome x occurring
P(x) = The number of ways in which x can occur

The total number of possible outcomes
Expected value
• Long term, weighted average of outcomes
EV = x × p 
Where x = result of each outcome

p = probability of outcome occurring
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Normal distribution 1
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50% 50%

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Properties of the normal distribution
• Symmetrical and bell shaped

• Mean = μ
• Area under the curve = 1
• Area to the left of μ = area to the right of μ = 0.5
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Chapter summary 1
1. Averages
▪ Mean (sum of values/number of items)
▪ Mode (most)
▪ Median (middle)
2. Dispersion
▪ Standard deviation σ (on formula sheet)
▪ Variance σ2
▪ Coefficient of variation (on formula sheet)
3. Probability and expected values

▪ EV = Ʃxp
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Chapter summary 2
4. Normal distribution
• Symmetrical and bell shaped
• Mean = μ
• Area under the curve = 1
• Area to the left of μ = area to the right of μ = 0.5.
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• What is inventory control?
Chapter 5
• Ordering, receipt and issue of
materials
Accounting for • Storing inventory
materials • Monitoring inventory
• Reasons for holding inventory
• Managing inventory
• Inventory valuation
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• Describe the different procedures and documents necessary for

the ordering, receiving and issuing of materials from inventory.
• Describe the control procedures used to monitor physical and
'book' inventory and to minimise discrepancies and losses.
• Interpret the entries and balances in the material inventory
account.
• Identify, explain and calculate the costs of ordering and holding
inventory (including buffer inventory).
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• Calculate and interpret optimal reorder quantities.

• Calculate and interpret optimal reorder quantities when discounts
apply.
• Produce calculations to minimise inventory costs when stock is
gradually replenished.
• Describe and apply appropriate methods for establishing reorder
levels where demand in the lead time is constant.
• Calculate the value of closing inventory and material issues using
LIFO, FIFO and average methods.
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Overview
Material costs
Monitoring
Ordering, receipt Value inventory
of
and issue of raw using FIFO,
inventory
material LIFO and
levels
average
methods
Recording purchases Inventory
in accounts control
levels
Reorder level EBQ

Minimum level
Maximum level EOQ
Discounts
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Tackling the exam
Example
Question
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What is inventory control?
Inventory is a very important investment for most businesses. It is

vital that management establish an effective inventory control system.
Inventory control includes:
• Ordering
• Purchasing
• Receiving goods into store
• Storing
• Issuing inventory
• Controlling levels of inventory
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Ordering, receipt and issue of materials 1
Ordering materials has a number of steps:
• Step 1 – Inventory levels reach reorder level (the level set when
inventory must be ordered)
• Step 2 – Stores department issues purchase requisition (a
document stating that inventory is required)
• Step 3 – Purchase department draws up a purchase order
• Step 4 – Copies of purchase order sent to Accounts department
and Stores/Receiving department
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Proper records must be kept of the physical procedures for ordering

and receiving a consignment of materials to ensure the following:
• That enough inventory is held

• That there is no duplication of ordering
• That quality is maintained
• That there is adequate record keeping for accounts purposes
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Receiving inventory has a number of steps:
• Step 1 – Goods delivered and delivery note signed

• Step 2 – Delivery checked to purchase order
• Step 3 – Goods received note (GRN) prepared
• Step 4 – GRN sent to Accounts department and matched with
purchase order
• Step 5 – Invoice received by Accounts department and checked
to purchase order and GRN
• Step 6 – Supplier paid if all checks are in order
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Issuing inventory must be controlled as it is a valuable item.

A materials requisition must be raised before inventory is issued to
a department.
If inventory is transferred between departments a materials transfer
note must be raised.
If inventory is returned to stores then a materials returns note must
be filled out.
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Storing inventory
Objectives of storing inventory:
• Speedy issue and receipt of materials

• Full identification of all materials at all times
• Correct location of all materials at all times
• Protection of materials from damage and deterioration
• Provision of secure stores to avoid pilferage, theft and fire
• Efficient use of storage space
• Maintenance of correct inventory levels
• Keeping correct and up-to-date records of receipts, issues and
inventory levels
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Monitoring inventory 1
Free inventory – what is really available for future use
• Free inventory is calculated as materials in inventory + materials

on order – materials requisitioned but not yet issued.
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Perpetual inventory is an inventory recording system where the

records are updated for each receipt/issue of inventory.
Actual quantities of inventory may not agree to records therefore

inventory counts required.
Periodic inventory count – all items counted on specific date,

usually the end of the accounting period.
Continuous inventory count – each item counted at least once a

year, generally requires a specialised team.
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Advantages of continuous stocktaking compared to periodic

stocktaking
• Annual stocktaking is unnecessary and so disruption is avoided.

• Regular skilled stocktakers can be employed, reducing likely
errors.
• More time is available, reducing errors and allowing investigation.
• Deficiencies and losses are revealed sooner than they would be if
stocktaking were limited to an annual check.
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Advantages of continuous stocktaking compared to periodic

stocktaking
• Production hold-ups are eliminated because the stores staff are at

no time so busy as to be unable to deal with material issues to
production departments.
• Staff morale is improved and standards raised.
• Control over inventory levels is improved, and there is less
likelihood of overstocking or running out of inventory.
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Reasons for holding inventory
• To deal with unexpected demand

• To deal with unexpected delays in delivery
• To make use of bulk discounts
• To buy when prices are low
• Seasonal production (eg fruit picked when ripe)
• Technical reasons (eg whisky maturing for 12 years)
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Managing inventories – the order quantity 1
Inventory has associated costs:
• Cost of procurement
• Holding costs
• Purchase costs
• Shortage costs (such as stockouts)
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Procurement costs:
• Clerical and administrative costs associated with purchasing,

accounting for and receiving goods
• Transport costs
• Production run costs
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Holding costs:
• Costs of storage and stores operations. Larger inventories

require more storage space and possibly extra staff and equipment
to control and handle them.
• Interest charges. Holding inventories involves the tying up of
capital (cash) on which interest must be paid.
• Insurance costs. The larger the value of inventories held, the
greater insurance premiums are likely to be.
• Risk of obsolescence. The longer a inventory item is held, the
greater is the risk of obsolescence.
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Stockout costs:
• Costs of storage and stores operations. Lost contribution from lost

sales
• Loss of future sales due to disgruntled customers
• Loss of customer goodwill
• Cost of production stoppages
• Labour frustration over stoppages
• Extra costs of urgent, small quantity, replenishment orders
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Inventory control levels 1
Inventory control levels can be calculated in order to maintain

inventories at the optimum level.
The three critical control levels are:
• Reorder level
• Minimum level
• Maximum level
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Inventory control levels 2
There are various formulae for inventory levels:
Reorder level = maximum usage × maximum lead time

Minimum level = reorder level – (average usage × average
lead time)
Maximum level = reorder level + reorder quantity – (min.
usage × min. lead time)
Average inventory = safety inventory + 1/2 reorder quantity
Lead time is the time between ordering the inventory and its arrival.
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Question to consider: simple ROL
A company's supplier always delivers inventory 5 days after an order

is placed. The company always uses 300 units per day.
What is the reorder level?
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Answer: simple ROL
If a company's supplier always delivers inventory 5 days after an

order is placed and the company always uses 300 units per day:
ROL = 5 × 300 = 1,500
Place the order when inventory = 1,500 and just as the last item is
used, a delivery should be received.
Note. 1,500 tells you nothing about how much to order: that is
determined by the economic order quantity.
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Managing inventories – the reorder level (ROL) 1
Generally both lead time and usage per day vary. To avoid having
stock-outs (ie demand but no inventory), the reorder level is set
higher and a buffer or safety inventory is maintained:
Inventory
level x = order
placed
x x x x x
x
Safety inventory
Time
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Managing inventories – the reorder level (ROL) 2
Generally both lead time and usage per day vary. To avoid having
stock-outs (ie demand but no inventory).
ROL = maximum lead time × maximum daily usage
This will mean that inventory will rarely fall to zero and there will be
buffer or safety inventory:
Buffer inv = ROL – (average lead time × average usage)

Average inventory = buffer inv + reorder quantity/2
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Question to consider: buffer inventory cost
A company has set its reorder level at 5,000 units. Average lead time
= 4 days and average daily usage = 1,000.
The holding cost = $6 per unit per year
What is the cost of holding the buffer inventory?
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Answer: buffer inventory cost
A company has set its reorder level at 5,000 units. Average lead
time = 4 days and average daily usage = 1,000.
The holding cost = $6 per unit per year
Buffer inventory = ROL – (average lead time × average usage)
= 5,000 – 4 × 1,000 = 1,000
Annual buffer inventory holding cost = $6 × 1,000 = $6,000
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Economic order quantity 1
Managing inventory deals with two questions:
• The order quantity: how much inventory should be ordered?

• The reorder level: when should inventory be ordered?
These amounts are independent: how much you order tells you
nothing about when to place the order.
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Costs relevant to order quantities:
• Cost of procurement, called 'ordering costs'

• Holding costs
• Purchase costs (relevant if there are bulk discounts)
We start by assuming there are no bulk discounts. Purchase costs

are then irrelevant because the purchase expense over a year will be
constant (units bought per year × cost/unit).
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Assumption behind the analysis: inventory is used at a constant rate:
Inventory
Maximum inventory
Reorder Average
quantity, inventory
Q
Time
Delivery received
Maximum inventory = reorder quantity, Q

Average inventory = Q/2
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Annual demand = 5,000 units.

Cost of holding 1 unit for 1 year = $5
Ordering cost = $500/order
Prepare a table showing annual holding costs, ordering costs and

total costs at reorder quantities of:
200, 500, 1,000, 1,500 and 2,500 units
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Answer
Annual demand = 5,000 units. Cost of holding 1 unit for 1 year = $5.
Ordering cost = $500/order
Order Average Number of Annual Annual Total

quantity, Q inventory orders holding ordering cost $ cost ($)
Q/2 (5,000/Q) cost $ (Orders × $500)
(Q/2 × $5)
200 100 25 500 12,500 13,000
500 250 10 1,250 5,000 6,250
1,000 500 5 2,500 2,500 5,000
1,500 750 3.33 3,750 1,665 5,415
2,500 1,250 2 6,250 1,000 7,250
As order quantity increases, holding costs increase, but ordering

costs decrease.
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The table showed that, of the reorder quantities tried, 1,000 was the
most economical.
A precise result can be quickly obtained using a formula:
√
Economic order quantity = 2Co D
Ch
Where: Co = cost of placing an order

D = annual demand
Ch = cost of holding one unit for one year
(The formula is provided in the exam, but you are not told what the symbols
mean!)
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Managing inventories – the order quantity
√
Ch
Using the lecture example data (annual demand = 5,000 units, cost
of holding 1 unit for 1 year = $5, ordering cost = $500/order)
Economic order quantity =

√ 2 × 500 × 5,000
5
= 1,000 units
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A company sells 1,000 units/month and each item costs $400 to buy.
Placing an order costs $640. The company's cost of holding one unit
for one year is 6% of item cost. What is the economic order quantity?
√
Ch
Where: Co = cost of placing an order
D = annual demand
Ch = cost of holding one unit for one year
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Answer
√
Ch
Co = 640; D = 12 × 1,000 = 12,000 [annual demand]

Ch = 400 × 6% = 24 [cost of holding 1 unit for 1 year]
√
Economic order quantity = 2 × 640 × 12,000
24
= 800 units
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Placing an order costs $640. The holding cost is 6% pa. Economic
order quantity = 800 units.
What is the total annual cost of ordering, purchasing and holding

inventory?
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Answer (cont'd)
Placing an order costs $640. The holding cost is 6% pa. Economic
order quantity = 800 units.
Cost element $
Ordering: (1,000 × 12/800) × $640 9,600
Purchasing: 1,000 × 12 × $400 4,800,000
Holding: 6% × 800 × $400/2 9,600
Total cost 4,819,200
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The order quantity with bulk discounts
The purchase price of goods is relevant if a discount is given for

orders of a minimum quantity as it might be worth increasing the
order size to get the discount.
Technique:
1 Work out the EOQ as normal

2 Work out the total inventory-related price at the EOQ (ordering,
purchasing and holding inventory)
3 Work out the total inventory-related price where the discount is
first available (ordering, purchasing and holding inventory)
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Question: order quantity with discounts
Placing an order costs $640. The holding cost is 6% pa. The supplier
offers a 1% discount for purchases of at least 6,000 units.
Should the reorder quantity be moved from its current 800 units to
6,000 units?
Note. At EOQ of 800 units, total cost of ordering, purchasing and

holding = $4,819,200.
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Answer: order quantity with discounts
If the order quantity is moved to 6,000 units, the costs are:
Cost element $ Previously

Ordering: 1,000 × 12/6,000 × $640 1,280 9,600
Purchasing: 1,000 × 12 × $400 × 99% 4,752,000 4,800,000
Holding: 6% × 6,000 × 99% × $400/2 71,280 9,600
Total cost 4,824,560 4,819,200
If the reorder quantity were kept at 800 units, total annual costs =
$4,819,200, so the discount offer is not worthwhile
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Economic batch quantity
Economic batch quantity is used instead of the EOQ when

re-supply is gradual instead of instantaneous.
Formula for EBQ is provided in the exam
2C D
O
EBQ =
C (1−D / R )
H
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Turbot Co has capacity to manufacture 6,000 Whelks in a week. The

Whelks are in demand at a rate of 4,000 per week.
Set up costs for each production run are $750 and the holding cost of
each unit is 2 cents per week.
Required
(a) What is the EBQ (in units)?

(b) What are the total weekly holding and set up costs associated
with inventory if the firm aims to minimise costs?
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Answer
2  750  4,000
(a) EBQ =  4,000 
0.02 1 −
 
 6,000 
= 30,000 units
4,000 ×$750= $100

(b) Set up costs = 30,000
30,000 × 1 − 4,000  ×0.02= $100

Holding costs = 2  6,000 

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Accounting for materials
• Any increases in materials inventory will result in a debit entry in

the material control account.
• Any reductions in materials inventory will be shown as a credit
entry in the material control account.
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Inventory valuation 1
There are various methods of valuing inventories at the end of a

period.
The most common are:
• Last in First Out (LIFO)

• First in First Out (FIFO)
• Average cost (AVCO)
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FIFO assumes that materials are issued out of inventory in the order
in which they were delivered into inventory.
• Logical, represents what is physically happening
• Easy to understand and explain
• Inventory valuation based on replacement cost
• Cumbersome to operate
• Cost comparison and decision making difficult due to price
variations
• Issue prices can lag behind market value if inflation is high
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LIFO assumes that materials are issued out of inventory in the

reverse order to which they were delivered.
• Issues are at close to market value
• Current costs used in decisions
• Cumbersome to operate
• Opposite to what is physically happening normally
• Difficult to explain
• Decision making can be difficult due to price variations
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AVCO involves calculating a weighted average price by dividing total

cost by total number of units in inventory.
• A new average price is calculated when a new receipt of material
occurs
• Price fluctuations are smoothed out so decision making is easier
• Easier to administer than FIFO and LIFO
• Resulting price rarely an actual price
• Prices lag a little behind market values if there is gradual inflation
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We'll use the following information about receipts and issues of

materials to see the different methods in practice.
Receipts Issues Balance

Date Quantity Value Quantity Value Quantity Value
Units $ Units $ Units $
March 1 10 100
March 10 30 450
March 12 25
March 20 20 320
March 23 15
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FIFO
March 12 issue = (10 × $10) + (15 × $15)= $325

March 23 issue = 15 × $15 $225
Closing inventory = 20 × $16 $320
$870
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LIFO
March 12 issue = 25 × $15 $375

March 23 issue = 15 × $16 $240
Closing inventory = (5 × $16) + (5 × $15)
+ (10 × $10) $255
$870
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AVCO
March 12 issue at $(100 + 450)/40

= $13.75 × 25 $343.75
March 23 issue at $((13.75 × 15) + 320)/35
= $15.04 × 15 $225.60
Closing inventory = 20 × $15.04 $300.80
$870.15
(The 15c is a rounding difference.)
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1 March
(Opening inventory) : 100 units bought at $2 each
2 March : bought 300 units at $2.10 each
5 March : sold 50 units for $5 each
17 March : bought 100 units at $2.30 each
20 March : sold 150 units for $5 each
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Required
(a) Calculate the value of closing inventory at the end of March

using:
FIFO LIFO AVCO
(b) Calculate the gross profit for March using:
FIFO LIFO AVCO
(c) If prices are rising ______ method of inventory valuation will
give the highest closing inventory value and ______ will give
the highest gross profit.
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Answer
(a) FIFO
Units Cost Value
1 March 100 2 200
2 March 300 2.10 630
5 March (50) (2) (100)
17 March 100 2.30 230
20 March (50) (2) (100)
(100) (2.10) (210)
300 650
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Answer (cont'd)
LIFO
Units Cost Value
1 March 100 2 200
2 March 300 2.10 630
5 March (50) (2.10) (105)
17 March 100 2.30 230
20 March (100) (2.30) (230)
(50) (2.10) (105)
300 620
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Answer (cont'd)
AVCO
Units Cost Value
1 March 100 200
2 March 300 630
5 March 400 2.075 830
(50) (2.075) (103.75)
17 March 100 230
450 (2.125) 956.25
20 March 150 (2.125) (318.75)
300 637.50
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Answer (cont'd)
(b)
FIFO LIFO AVCO
Sales (50 × 5) 250 250 250
(150 × 5) 750 750 750
1,000 1,000 1,000
Less cost of sales (410) (440) (422.50)
FIFO: 100 + 100 + 210
LIFO: 105 + 230 + 105
AVCO: 103.75 + 318.75
590 560 577.50
(c) FIFO = Highest closing inventory

FIFO = Highest gross profit
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Tackling the exam
Make sure that you read the following article on inventory control
from the ACCA website:
www.accaglobal.com/uk/en/student/exam-support-
resources/fundamentals-exams-study-resources/f2/technical-
articles/stock-control.html
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Chapter summary 1
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. Ordering, receipt and issue of raw materials

▪ Every movement of material should be documented.
3. Monitoring inventory levels

▪ Inventory should be counted on a periodic or perpetual basis in
order to match physical and book quantities.
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Chapter summary 2
4. Inventory control levels

▪ Inventory control levels can be calculated in order to maintain
inventories at the optimum level.
▪ The three critical control levels are:
─ Recorder level
─ Minimum level
─ Maximum level
5. Costs involved with inventory

▪ Inventory costs include purchase costs, holding costs, ordering
costs and stockout costs.
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Chapter summary 3
6. The economic order quantity model

▪ The economic order quantity (EOQ) is the order quantity that
minimises inventory costs.
7. Discounts
▪ Discounts may be available if the order quantity is above a certain
size. This needs to be considered in determining the best order
quantity.
8. Economic batch quantity (EBQ)
▪ The economic batch quantity (EBQ) is a modification of the EOQ
and is used when re-supply is gradual instead of instantaneous.
9. Inventory valuation
▪ 3 methods: FIFO, LIFO and AVCO
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Chapter 6 • Measuring labour activity
• Remuneration methods
Accounting for • Recording labour costs
labour • Labour turnover
• Accounting for labour costs
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• Calculate direct and indirect labour costs.

• Explain the methods used to relate input labour costs to work done.
• Prepare the journal and ledger entries to record labour cost inputs and
outputs.
• Describe different remuneration methods: time-based systems,
piecework systems and individual and group incentive schemes.
• Calculate the level, and analyse the costs and causes of labour
turnover.
• Explain and calculate labour efficiency, capacity and production
volume ratios.
• Interpret the entries in the labour account.
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Overview
Labour costs
Methods of Labour
remuneration turnover
Measuring
labour activity
Accounting for
labour costs
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Tackling the exam
Example
Question
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Introduction
Just as management need to control inventories and operate an

appropriate valuation policy in an attempt to control material costs, so too
must they be aware of the most suitable remuneration policy for their
organisation.
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Measuring labour activity 1
• Production and productivity are common methods of measuring labour

activity.
• Production is the quantity or volume of output produced.
• Productivity is a measure of the efficiency with which output has been
produced.
• An increase in production without an increase in productivity will not
reduce unit costs.
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Management will wish to plan and control both production levels and
labour productivity.
Production levels can be raised as follows:
• Working overtime
• Hiring extra staff
• Sub-contracting some work to an outside firm
• Managing the work force so as to achieve more output
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Production levels can be reduced as follows:
• Cancelling overtime
• Laying off staff
Productivity, if improved, will enable a company to achieve its

production targets in fewer hours of work, and therefore at a lower cost.
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• A standard hour is the number of units produced by one worker

working in the standard way at the standard rate for one hour.
• We will look at standard costs in more detail in Chapter 13.
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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:
Product A 4 minutes
Product B 2 minutes
Product C 3 minutes
Required
What are the standard hours produced by the employee (in hours)?
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Answer
Standard hours produced:
Product A 200 × 4 = 800

Product B 350 × 2 = 700
Product C 300 × 3 = 900
2,400 mins ÷ 60 = 40 hours
BPP LEARNING MEDIA

There are three main productivity ratios:
• Production volume ratio =

Expected hours to make output
Hours budgeted
• Capacity ratio =
Actual hours worked
Hours budgeted
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• Efficiency ratio =
Expected hours to make output
Actual hours taken
Productivity ratio = Capacity ratio × Efficiency ratio
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Barnes Co budgeted to make 13,000 standard units of output during a

budgeted period of 26,000 hours (each unit should take two hours).
During the period, the company actually made 14,000 units which took
35,000 hours.
Required
(a) What is the efficiency ratio?
(b) What is the capacity ratio?
(c) What is the production volume ratio?
Give your answers to one decimal place
BPP LEARNING MEDIA

Answer
(a) Efficiency ratio = 14,000 × 2 ×100= 80%

35,000
(b) Idle capacity ratio = 35,000 ×100= 134.6%

26,000
14,000 × 2 ×100= 107.7%

(c) Production volume ratio =
26,000
BPP LEARNING MEDIA

Remuneration methods 1
There are three main methods of labour remuneration – time work,

piecework and bonus/incentive schemes.
Time work
• Wages = hours worked × rate per hour

• Overtime premium = extra rate per hour for hours over and above
basic hours
• Quality more important than quantity
• No incentive for employee performance improvement
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Piecework schemes
• Wages = units produced × rate per unit

• Guaranteed minimum wage
• Differential schemes pay higher rates for increased levels of
productivity
• Output inspected carefully
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Bonus/incentive scheme
Examples include the following:
• Employee paid more for higher productivity

• Increased profits shared between employer and employee
• Bonus schemes (group and individual)
• Profit-sharing schemes
• Incentive schemes involving shares
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High day-rate system is a system where employees are paid a high

hourly wage rate in the expectation that they will work more efficiently
than similar employees on a lower hourly rate in a different company.
Advantages
• It is simple to calculate and easy to understand.

• It guarantees the employee a consistently high wage.
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Disadvantages
• Employees cannot earn more than the fixed hourly rate for their extra
effort.
• There is no guarantee that the scheme will work consistently.
• Employees may prefer to work at a normal rate of output, even if this
entails accepting the lower wage paid by comparable employers.
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Normal working day 8 hours

Basic rate of pay $6 per hour
Standard time allowed to produce 1 unit 2 minutes
Premium bonuses 75% of time saved at basic rate
Required
What is the cost of producing 340 units in one day?
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Answer
Standard time 340 × 2 mins 680 mins
Actual time 8 hrs × 60 mins 480 mins
Time saved 200 mins
Bonus 75% × (200 mins/60) × $6/hr $15
Basic 8 hr × $6 $48
$63
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A company pays its employees using a piecework scheme. The rates are
as follows:
0–100 units per week $4 per unit
101–150 units per week $4.50 per unit
151–200 units per week $5 per unit
201+ units per week $5.50 per unit
Required
If an employee produces 163 units in week 48, what would their pay be
for that week?
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Answer
$
1st 100 units (100 × $4) 400
Next 50 units (50 × $4.50) 225
Remaining 13 units (13 × $5) 65
Week 48 pay 690
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Recording labour costs 1
• Attendance is recorded on an attendance record or clock card.

• Job time may be recorded on time sheets or job cards.
• Even though salaried staff are paid a flat rate monthly, they may be
required to prepare timesheets.
• Timesheets provide management with information (eg product costs).
• Timesheet information may provide a basis for billing for services
provided (eg service firms where clients are billed based on the
number of hours work done).
• Timesheets are used to record hours spent and so support claims for
overtime payments by salaried staff.
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Recording labour costs 2
Idle time occurs when employees cannot get on with their work, through
no fault of their own.
Examples are as follows:
• Machine breakdowns
• Shortage of work
• Idle time has a cost because employees will still be paid their basic
wage or salary for these unproductive hours and so there should be a
record of idle time.
• Idle time ratio = Idle hours  100%
Total hours
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Labour turnover 1
Labour turnover is measured by the labour turnover rate

Labour turnover rate = Replacements
Average no. of employees in period
Reasons for labour turnover include the following:
• Illness/accident
• Moving
• Marriage/pregnancy
• Better pay or career prospects elsewhere
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Labour turnover 2
• Costs of labour turnover can be classified as preventative or

replacement costs.
• Preventative costs include provision of medical services, welfare

services, pension schemes.
• Replacement costs include selection and replacement, training, more

wastage due to inexperienced new staff.
• Labour turnover may be reduced by offering satisfactory

wages/hours/conditions, creating job satisfaction.
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Labour turnover 3
Replacement costs
• Cost of selection and placement

• Inefficiency of new labour; productivity will be lower
• Costs of training
• Loss of output due to delay in new labour becoming available
• Increased wastage and spoilage due to lack of expertise among new
staff
• The possibility of more frequent accidents at work
• Cost of tool and machine breakages
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Labour turnover 4
Preventative costs
• Cost of personnel administration incurred in maintaining good

relationships
• Cost of medical services including check-ups, nursing staff
• Cost of welfare services, including sports facilities and canteen meals
• Pension schemes providing security to employees
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Labour turnover 5
How to reduce labour turnover
• Paying satisfactory wages

• Offering satisfactory hours and conditions of work
• Creating a good informal relationship between members of the
workforce
• Offering good training schemes and a well understood career or
promotion ladder
• Improving the content of jobs to create job satisfaction
• Proper planning so as to avoid redundancies
• Investigating the cause of an apparently high labour turnover
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A company has 1,000 staff at the start of 20X3 and at the end this had
reduced to 920 due to redundancies being made.
100 staff took voluntary redundancy which was 20 more than the
company had anticipated and these 20 employees were replaced.
Required
What is the labour turnover rate per year?
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Answer
Labour turnover = 20 ×100= 2.08%

(1,000+920)÷ 2
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Accounting for labour costs 1
Labour costs can be classified as direct labour or indirect labour.
Direct labour costs include the following:
• Basic pay of direct workers

• Overtime worked at specific request of customers
• Overtime worked regularly by production department
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Indirect labour costs include the following:
• Basic pay of indirect workers

• Overtime premium
• Bonuses
• Employer's NIC (social security)
• Idle time cost
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• Accounting for labour costs is in the Wages control account

• Debit account with net wages paid and income tax/social security
deductions
• Credit account with direct labour, indirect labour, overtime premium,
shift allowance, sick pay, idle time
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Company X employs two types of labour: skilled workers, considered to

be direct workers, and semi-skilled workers considered to be indirect
workers. Skilled workers are paid $10 per hour and semi-skilled $7.50
per hour. All employees work a standard 35 hour week. There are seven
skilled workers and four semi-skilled workers.
The skilled workers have worked 50 hours of overtime this week, 20
hours on a specific order and 30 hours on general production.
The semi-skilled workers have worked 20 hours of overtime, 10 hours on
a specific order at a customer's request and the remaining 10 hours to
meet general production requirements.
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All overtime is paid at time and a half.
Required
(a) What are the total direct labour costs for the week?
(b) What are the total indirect labour cost for the week?
(c) Complete the following account assuming the wages paid were cash
of $3,580 after deductions of $895.
Wages control account
$ $
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Answer
Direct cost Indirect cost

$ $
Skilled workers:
Basic pay for normal hours worked
(7 × 35 × $10) 2,450
Basic pay for general overtime
(30 × $10) 300
Specific overtime
(20 × $10 × 1.5) 300
Overtime premium for general overtime
(30 × $10 × 0.5) 150
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Answer (cont'd)
Direct Cost Indirect Cost

$ $
Semi-skilled workers:
Basic pay for normal hours
(4 × 35 × $7.50) 1,050
Specific overtime
(10 × $7.50 × 1.5) 112.50
General overtime
(10 × $7.50 × 1.5) 112.50
3,162.50 1,312.50
BPP LEARNING MEDIA

Answer (cont'd)
Wages control account

$ $
Bank – net pay 3,580.00 Work in process account
Deductions – PAYE/NIC 895.00 – direct labour 3,162.50
Production overheads
– indirect labour 1,312.50
4,475.00 4,475.00
BPP LEARNING MEDIA

Chapter summary 1
1. Introduction
▪ Methods of remuneration for production staff include
— Time based systems
— Piecework systems
— Bonus/incentive systems
2. Measuring labour activity

▪ Labour productivity is a measure of the efficiency with 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.
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Chapter summary 2
3. Accounting for labour costs

▪ Labour costs will be split between direct and indirect costs and double
entry will be used to record these costs.
4. Labour turnover
▪ High labour turnover will cause increased cost to a business.
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Chapter 7a • Overheads
• Absorption costing: an introduction
Accounting for • Overhead allocation
overheads • Overhead apportionment
• Blanket and departmental
absorption rates
• Over and under absorption of
overheads
• Ledger entries relating to overheads
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• 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.
• Reapportion 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.
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Overview
Accounting for
Overheads
Types of Predetermined
overhead OAR
Allocating overheads Calculating a profit

to units to find the full or loss under
production cost absorption costing
Allocating non
production
3-step approach to overheads to a
absorption costing product
(1) Allocate &

apportion (2) Reapportion (3) Absorb
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Tackling the exam
Example
Question
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Introduction 1
Businesses need to ascertain the cost of making a product or service for:
• Profitability analysis
• Selling price determination
• Inventory valuation
But how easy is it to work out the cost of making a product?
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Introduction 2
For example, look at this list of costs (called a cost card) for the
manufacture of a door.
Cost card – Door

$
Material 20 kg @ $4/kg 80
Labour 4 hours @ $6/hour 24
Machine 4 hours @ $2/hour 8
112
Here we have calculated the marginal cost of a door as $112.

The marginal cost is defined as the sum of the variable costs.
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Overheads
However, these are not all of the costs that you would incur if you were
making doors on a commercial basis.
There are the following costs:
• Renting the factory
• Heating and cooling the factory
• Cleaning and maintenance
• Production administration
These costs are known as production overheads and unless some
account is taken of them, the cost of items produced will be
underestimated.
To do this, we use absorption costing.
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Absorption costing: an introduction 1
Absorption costing is a method of accounting for overheads. It is

basically a method of sharing out overheads incurred amongst units
produced.
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Calculation of overhead absorption rates:
• Step 1. Estimate the overhead likely to be incurred during the coming

period.
• Step 2. Estimate the activity level for the period. This could be total
hours, units, or direct costs or whatever it is upon which the overhead
absorption rates are to be based.
• Step 3. Divide the estimated overhead by the budgeted activity level.
This produces the overhead absorption rate.
• Step 4. Absorb the overhead into the cost unit by applying the
calculated absorption rate.
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• Going back to our example of the doors, say that the overhead
production costs are expected to be $500 for the period. Ten doors are
expected to be produced.
• The overhead absorption rate (OAR) per unit =
Estimated overhead costs for period

Estimated level of activity
• So the OAR = $500 / 10 = $50 per unit
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We can now re-do the cost card:
Cost card – Door

$
Marginal cost 112
Overheads 50
Total absorption cost 162
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The main reasons for using absorption costing are for:
• Inventory valuations. Inventory in hand must be valued for two

reasons.
(i) For the closing inventory figure in the statement of financial
position
(ii) For the cost of sales figure in the statement of profit or loss
• Pricing decisions
• Establishing the profitability of different products
• It is recommended in financial accounting by IAS 2
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IAS 2 Inventories deals with financial accounting systems.

The cost accountant is free to value inventories by whatever method
seems best, but where companies integrate their financial accounting
and cost accounting systems into a single system of accounting records,
the valuation of closing inventories will be determined by IAS 2.
IAS 2 states that costs of all inventories should comprise those costs
which have been incurred in the normal course of business in bringing
the inventories to their 'present location and condition'.
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In the example with the doors we calculated an OAR per unit. However,
this is not always appropriate.
Imagine that a business makes both doors and windows.
Obviously doors and windows will take different amounts of material and
labour.
They probably also benefit from overheads to different extents.
Therefore it would be inappropriate to work out an OAR per unit.
The most common solution is to work out an OAR per labour hour and
then 'charge' each unit according to the amount of labour needed for
each unit.
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Say that each door took 1.5 hours to make and each window took 2
hours.
(a) How many hours' work in total would four doors and two windows
take?
(b) What is the overhead absorption rate per hour? (Remember that
overheads were estimated to be $500 for the period.)
(c) How much overhead will be included in the total absorption cost of
each door?
(d) How much overhead will be included in the total absorption cost of
each window?
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Answer
(a) 4 doors × 1.5 hours = 6 hours

2 windows × 2 hours = 4 hours
Total = 10 hours
(b) $500 / 10 hours = $50 per hour
(c) $50 × 1.5 hours = $75 per door
(d) $50 × 2 hours = $100 per window
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Many factories use a direct labour hour rate or machine hour rate.
• A direct labour hour basis is most appropriate in a labour intensive

environment.
• A machine hour rate would be used in departments where production
is controlled or dictated by machines.
• A rate per unit would be effective only if all units were identical.
• Other bases include calculating a percentage of direct material or
labour or prime cost.
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The three stages of absorption costing are:
1. Allocation
2. Apportionment
3. Absorption
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Overhead allocation 1
• Overheads need to be shared out amongst the units produced in an

absorption costing system.
• Allocation is the process by which cost items are charged directly to a
cost unit or cost centre.
• Direct costs are allocated directly to cost units.
• If indirect costs are clearly identifiable with cost centres, they are
allocated to those cost centres.
• If indirect costs are not clearly identifiable with particular cost
centres, they are allocated to general overhead cost centres.
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The types of cost centres that indirect costs may be allocated to are:
• Production cost centres – such as factories

• Service cost centres – such as stores or the canteen
• Administration and selling and distribution cost centres
• General overhead cost centres
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• Here is a plan of a factory building:

Some areas are
obviously to do with
Finished goods production:
warehouse Offices • Assembly dept
• Machinery dept
Canteen Some areas will

help production
Assembly
effort:
department
• Offices
Machining • Canteen
department
Finished goods
warehouse does not
aid production of
goods.
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Each part of the factory will have costs that relate solely to their
respective activities.
For example, they will have dedicated employees, equipments and
supplies.
The first step in collecting overheads is to allocate such costs to the
appropriate area.
See example below.
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Invoiced cost for each Finished Offices Canteen Machining Assembly

department Goods dept dept
warehouse
Supervisor salary 10,000 8,000 12,000 11,000 9,000
Depreciation of equip 8,000 3,000 2,000 25,000 30,000
used in each area
Canteen expenses 5,000
Total allocated 18,000 11,000 19,000 36,000 39,000
overheads
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Overhead apportionment 1
Some of the invoices received by the business, for example for rent,
cannot be allocated to just one area.
Some of this will relate to production areas, some will relate to non-
production areas.
The invoice will have to be apportioned, or split, over the different
departments to estimate how much relates to each.
Apportionment will have to be carried out for many overhead costs.
After estimating how much of each cost relates to the production areas,
the overhead absorption rate can be calculated.
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If costs are going to be apportioned, or shared, over different

departments, then you must decide how the costs should be divided up.
For rent, a fair way would be to apportion on the basis of floor area.
Heating costs could be split on the basis of:
• Floor area
• Volume to be heated
• Number and size of radiators
Note. Different methods of apportioning costs can lead to different

profits.
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Let's work through some apportionments:
Total Finished Offices Canteen Machining Assembly

cost $ goods dept dept
warehouse
Rent 36,000
Heating 12,000
Insurance 2,000
Cleaning 6,000
Factory manager 8,000
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First, we must decide on what basis the costs should be apportioned.

Choose a basis for each cost.
Total cost Basis of apportionment

$
Rent 36,000
Heating 12,000
Insurance 2,000
Cleaning 6,000
Factory manager 8,000
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Answer
Here are our suggestions, although other bases could

be justified:
Total cost Basis of apportionment

$
Rent 36,000 Floor area
Heating 12,000 Floor area
Insurance 2,000 Machinery value
Cleaning 6,000 Floor area
Factory manager 8,000 Number of workforce
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We need some more information before we can apportion the costs.
Floor Machine Staff

area m2 value $ numbers
Warehouse 10,000 20,000 12
Offices 2,000 8,000 12
Canteen 3,000 5,000 6
Machining 12,000 40,000 25
Assembly 9,000 27,000 25
TOTAL 36,000 100,000 80
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Use the information on the previous slide to apportion the costs.

(Use the basis that we suggested for each cost.)
Finished
Total goods Machining Assembly
cost warehouse Offices Canteen dept dept
$
Rent 36,000
Heating 12,000
Insurance 2,000
Cleaning 6,000
Factory 8,000
manager
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Answer
Workings are on the following slides:
Finished
$
Rent 36,000 10,000 2,000 3,000 12,000 9,000
Heating 12,000 3,333 667 1,000 4,000 3,000
Insurance 2,000 400 160 100 800 540
Cleaning 6,000 1,667 333 500 2,000 1,500
Factory 8,000 1,200 1,200 600 2,500 2,500
manager
Total 16,600 4,360 5,200 21,300 16,540
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Answer (cont'd)
Workings – Rent
$
Warehouse 36,000 × (10,000 / 36,000) = 10,000
Offices 36,000 × (2,000 / 36,000) = 2,000
Canteen 36,000 × (3,000 / 36,000) = 3,000
Machining 36,000 × (12,000 / 36,000) = 12,000
Assembly 36,000 × (9,000 / 36,000) = 9,000
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Answer (cont'd)
Workings – Heating
$
Warehouse 12,000 × (10,000 / 36,000) = 3,333
Offices 12,000 × (2,000 / 36,000) = 667
Canteen 12,000 × (3,000 / 36,000) = 1,000
Machining 12,000 × (12,000 / 36,000) = 4,000
Assembly 12,000 × (9,000 / 36,000) = 3,000
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Answer (cont'd)
Workings – Insurance
$
Warehouse 2,000 × (20,000 / 100,000) = 400
Offices 2,000 × (8,000 / 100,000) = 160
Canteen 2,000 × (5,000 / 100,000) = 100
Machining 2,000 × (40,000 / 100,000) = 800
Assembly 2,000 × (27,000 / 100,000) = 540
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Answer (cont'd)
Workings – Cleaning
$
Warehouse 6,000 × (10,000 / 36,000) = 1,667
Offices 6,000 × (2,000 / 36,000) = 333
Canteen 6,000 × (3,000 / 36,000) = 500
Machining 6,000 × (12,000 / 36,000) = 2,000
Assembly 6,000 × (9,000 / 36,000) = 1,500
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Answer (cont'd)
Workings – Factory manager
$
Warehouse 8,000 × (12 / 80) = 1,200
Offices 8,000 × (12 / 80) = 1,200
Canteen 8,000 × (6 / 80) = 600
Machining 8,000 × (25 / 80) = 2,500
Assembly 8,000 × (25 / 80) = 2,500
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Now look at the canteen costs which amount to $5,200.

The next step is to apportion costs of service cost centres to
production cost centres – known as reapportionment.
The canteen is a service department which provides refreshments for the
staff of other departments.
At this stage, for simplicity, we will assume that the canteen only serves
the production departments.
The costs of running the canteen should be re-apportioned to the
production departments if we are to find the full cost of running those.
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The easiest way of reapportioning these costs is to look at the staff

numbers excluding the canteen.
Staff numbers
Warehouse 12 12
So, the canteen costs will be
Offices 12 12
reapportioned using fractions
Canteen 6 X 12/74, 12/74, 25/74, 25/74.
Machining 25 25
Assembly 25 25
Total 80 74
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Finished
$
Rent 36,000 10,000 2,000 3,000 12,000 9,000
Heating 12,000 3,333 667 1,000 4,000 3,000
Insurance 2,000 400 160 100 800 540
Cleaning 6,000 1,667 333 500 2,000 1,500
Factory 8,000 1,200 1,200 600 2,500 2,500
manager
Total 16,600 4,360 5,200 21,300 16,540
Reapportion 843 843 (5,200) 1,757 1,757
17,443 5,203 - 23,057 18,297
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The machining department uses 40,000 labour hours for the period.
The assembly department uses 42,000 labour hours for the period.
(a) What is the overhead absorption rate (in $) in the machine
department?
(b) What is the overhead absorption rate (in $) in the assembly
department?
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Answer
(a) Overhead absorption rate = $23,057 / 40,000

= $0.58 / hour
(b) Overhead absorption rate = $18,297 / 42,000
= $0.44 / hour
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Now we'll look at a factory with two service departments, canteen and
maintenance.
• Say the overheads have already been apportioned.
Now we want to reapportion the canteen costs on the basis of employee
numbers.
• Say 50% to machining, 40% to assembly and 10% to maintenance.
Similarly we want to reapportion maintenance on the basis of time spent
in each department.
• Say 45% to machining, 50% to assembly and 5% to canteen.
Here we have reciprocal apportionment.
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Total Machining Assembly Canteen Maintenance

cost $ dept dept dept
Apportioned 40,000 20,000 4,000 6,000
costs
Reapportion 2,700 3,000 300 (6,000)
maintenance (45%) (50%) (5%)
42,700 23,000 4,300 –
Reapportion 2,150 1,720 (4,300) 430
canteen (50%) (40%) (10%)
44,850 24,720 430
Notice that costs have reappeared in the maintenance department,

so we have to repeat the reapportionment of maintenance costs.
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Apportioned 40,000 20,000 4,000 6,000
costs
Reapportion 2,700 3,000 300 (6,000)
maintenance (45%) (50%) (5%)
42,700 23,000 4,300 –
Reapportion 2,150 1,720 (4,300) 430
canteen (50%) (40%) (10%)
44,850 24,720 430
Reapportion 194 215 21 (430)
maintenance
….then canteen costs again
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Apportioned costs 40,000 20,000 4,000 6,000
Reapportion 2,700 3,000 300 (6,000)
maintenance (45%) (50%) (5%)
42,700 23,000 4,300 –
Reapportion 2,150 1,720 (4,300) 430
canteen (50%) (40%) (10%)
44,850 24,720 430
Reapportion 194 215 21 (430)
maintenance
45,044 24,935 21
Reapportion canteen 10 9 (21) 2
45,054 24,944 – 2
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When the service departments are reduced to immaterial amounts (such

as $2), simply reapportion to the two production departments.
Here each will receive $1.

45,054 24,944 – 2
Reapportion 1 1 (2)
maintenance
45,055 24,945 – –
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• The reciprocal method of reapportionment that we just saw assumes

that the service departments do work for each other.
There are two other methods that you need to know:
• The direct method, where the service centre costs are apportioned to
production departments only.
• The step-down method, where each service centre's costs are not
only apportioned to production departments but to some (but not all) of
the other service centres that make use of the services provided.
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Direct method
• Say the canteen gives benefit to the other departments in the ratio
10:40:50, but we will ignore the 10% as it goes to maintenance.
• Instead we will apportion the canteen costs in the ratio 40:50 or 40/90
to 50/90.
• Similarly, where the maintenance department benefits the other
departments in the ratio 50:45:5 we will apportion costs in the ratio
50:45 or 50/95 to 45/95.
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Reapportion 2,842 3,158 (6,000)
maintenance (45/95) (50/95)
42,842 23,158 4,000 –
Reapportion 2,222 1,778 (4,000)
canteen (50/90) (40/90)
45,064 24,936
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Step down method
• Step 1. Reapportion one of the service cost centre's overheads to all

of the other centres which make use of its services (production and
service).
• Step 2. Reapportion the overheads of the remaining service cost
centre to the production departments only. The other service cost
centre is ignored.
• See example on the next slide.
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Reapportion 2,700 3,000 300 (6,000)
maintenance (45%) (50%) (5%)
42,700 23,000 4,300 –
Reapportion 2,389 1,911 (4,300)
canteen (50/90) (40/90)
45,089 24,911 –
If one service cost centre, compared with the other(s), has higher
overhead costs and carries out a bigger proportion of work for the
other service cost centre(s), then the overheads of this service centre
should be reapportioned first.
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Blanket and departmental absorption rates
A blanket overhead absorption rate is an absorption rate used

throughout a factory and for all jobs and units of output irrespective of the
department in which they were produced.
Blanket overhead rates are not appropriate in the following
circumstances:
• There is more than one department.

• Jobs do not spend an equal amount of time in each department.
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The following data relate to one year in department A:

• Budgeted machine hours 22,222
• Actual machine hours 21,875
• Budgeted overheads $399,996
• Actual overheads $350,000
Based on the data above, what is the machine hour absorption rate as
conventionally calculated?
• A $12 B $14 C $16 D $18
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Answer
D
Budgeted overheads
Overhead absorption rate =
Budgeted machine hours
Overhead absorption rate = $399,996 / 22,222

= $18 / machine hr
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Over and under absorption of overheads 1
The rate of overhead absorption is based on estimates (of both

numerator and denominator) and it is quite likely that either one or both
of the estimates will not agree with what actually occurs.
Over absorption means that the overheads charged to the cost of sales
are greater then the overheads actually incurred.
Under absorption means that insufficient overheads have been
included in the cost of sales.
It is almost inevitable that at the end of the accounting year there will
have been an over absorption or under absorption of the overhead
actually incurred
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• Here is a cost card:
Cost card – Product A $

Sales price 50
Material 15
Labour 10
Variable overhead 5
Marginal cost 30
Overhead cost 5
Total absorption cost 35
OAR = Budgeted overheads / budgeted production

= $75,000 / 15,000
= $5 per unit
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Remember that overhead rates are set in advance using estimated costs
and output.
Once set, the OAR is not varied in the light of actual production or costs.
From our cost card we can see that Product A makes a profit of
$50 – $35 = $15.
Assuming 15,000 units have been made and sold (as per budget):
$
Sales (15,000 × $50) 750,000
Absorption cost of sales (525,000)
(15,000 × $35)
Profit 225,000
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Under marginal costing the profit would be:

$
Sales (15,000 × $50) 750,000
Cost of sales (450,000)
(15,000 × $30)
Contribution 300,000
Less fixed costs (75,000)
Profit 225,000
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But what would happen if budget and actual production volumes were
different? Say, 20,000 units were made and sold.
Marginal $ Absorption $
costing costing
Sales (20,000 × $50) 1,000,000 Sales 1,000,000
Cost of sales (600,000) Cost of sales (700,000)
(20,000 × $30) (20,000 × $35)
Contribution 400,000 –
Less fixed costs (75,000) –
Profit 325,000 300,000
As you can see the profits do not agree.
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When the cost of production is worked out as 20,000 × $35, the

calculation is equivalent to:
$
20,000 × $30 (marginal cost) 600,000
20,000 × $5 (prod o/h per unit) 100,000
Total absorption cost 700,000
Too much fixed cost has been accounted for – this should
only amount to $75,000. Actual output applied to the absorption rate
accounts for 5,000 units too much of fixed costs – ie $25,000.
This is over-absorption as more fixed costs have been accounted for

than should have been.
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This can be worked out as:

Absorbed overhead costs – Actual overhead costs
(20,000 × 5) – $75,000 = $25,000
The $25,000 has to be added back to the $300,000 profit:
costing costing
Sales (20,000 × $50) 1,000,000 Sales 1,000,000
(20,000 × $30) (20,000 × $35)
Contribution 400,000 -
Less fixed costs (75,000) Over-absorption 25,000
Profit 325,000 325,000
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What would happen if budget and actual production volumes were the
same but actual overheads were $80,000?
costing costing
Sales (15,000 × $50) 750,000 Sales 750,000
(15,000 × $30) (15,000 × $35)
Less fixed costs (80,000) –
Profit 220,000 225,000
As you can see the profits do not agree.
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When the cost of production is worked out as 15,000 × $35, the

calculation is equivalent to:
$
15,000 × $30 (marginal cost) 450,000
15,000 × $5 (prod o/h per unit) 75,000
Total absorption cost 525,000
Not enough fixed cost has been accounted for – this should
amount to $80,000.
This is under-absorption as fewer fixed costs have been

accounted for than should have been.
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This can be worked out as:

Absorbed overhead costs – Actual overhead costs
(15,000 × 5) – $80,000 = $5,000
The $5,000 has to be deducted from the $225,000 profit:
costing costing
Sales (15,000  $50) 750,000 Sales 750,000
Cost of sales 450,000) Cost of sales (525,000)
(15,000 × $30) (15,000 × $35)
Less fixed costs (80,000) Under-absorption (5,000)
Profit 220,000 220,000
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We looked at over-absorption which occurred because more units

were produced than budgeted.
We looked at under-absorption which occurred because the actual
overheads were more than budgeted.
• Note also, over-absorption can occur when actual overheads are
less than budgeted.
• Note also, under-absorption can occur when fewer units are
produced than budgeted.
And remember, volume of units produced and actual overheads incurred

may both be different from budget!
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The following data relate to last month.

Budgeted overhead cost $450,000
Actual labour hours 32,000 hrs
Under recovery $30,000
If actual overheads were $510,000, what was the budgeted overhead

absorption rate per hour?
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Answer
$
Actual overheads 510,000
Under-recovery 30,000
Overheads recovered for 480,000
32,000 hours at budgeted OAR
32,000 x = 480,000
x = 480,000 / 32,000 = $15
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Ledger entries relating to overheads
Over-absorption is a credit in the statement of profit or loss.
Under-absorption is a debit in the statement of profit or loss.
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Tackling the exam
Make sure that you read the following article on fixed overhead
absorption from the ACCA website:
articles/overhead-absorption.html
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Chapter summary
▪ Absorption costing is a method of accounting for overheads. It is

basically a method of sharing out overheads incurred amongst units
produced.
▪ The three stages of absorption costing are:
1. Allocation
2. Apportionment
3. Absorption
▪ The rate of overhead absorption is based on estimates.
▪ Over absorption means that the overheads charged to the cost of
sales are greater then the overheads actually incurred.
▪ Under absorption means that insufficient overheads have been
included in the cost of sales.
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Chapter 7b • Marginal cost and marginal costing
• The principles of marginal costing
Absorption and • Calculating profit
marginal costing • Reconciling profits
• Marginal costing versus absorption
costing
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• 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.
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Overview
Marginal and
absorption costing
Cost card under Cost card under

AC MC
Profit/loss under CONTRIBUTION

AC
Profit/loss under
MC
Reconciliations
Advantages/disadvantages
of AC and MC
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Tackling the exam
Example
Question
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Marginal cost and marginal costing 1
• Marginal cost is the cost of one unit of product which would be

avoided if that unit were not produced = variable cost
• Contribution = sales revenue – variable (marginal) cost of sales
• It is short for contribution towards covering fixed overheads and
making a profit
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Marginal cost and marginal costing 2
Remember the cost card from Chapter 7a for the manufacture of a door.
Cost card – Door

$
Marginal cost 112
Here we calculated the marginal cost of a door as $112.

If the selling price of the door was $150 then the contribution would be
$150 – $112 = $38
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The principles of marginal costing
Marginal costing has the following attributes:
• Only variable costs charged as cost of sales.

• Closing inventories are valued at marginal cost.
• Fixed costs are treated as period costs.
• Period costs are charged in full to statement of profit or loss.
• If sales increase by one item, profit will increase by contribution for
one item.
• Contribution per unit is constant at all levels of output and sales.
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Calculating profit
Statement of profit or loss
$
Sales X
Less variable cost of sales (X)
Less variable selling, distribution and admin costs (X)
CONTRIBUTION X
Less fixed costs (X)
Net profit X
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Selling price $25.

Cost card per unit: $
Direct materials 7
Direct wages 8
Variable production overheads 5
20
There is a variable selling cost per unit of $0.50.
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Year 1 Year 2
Units Units
Normal/budgeted production 12,000 12,000
Actual production 14,000 11,500
Actual sales 13,000 12,500
Actual fixed prodn overheads $11,000 $11,000
Actual fixed selling costs $5,000 $5,000
There is no opening inventory. All variable costs were as per budget
for the two years.
Set out a statement of profit or loss under marginal costing for both
years 1 and 2.
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Answer
Year 1 Year 1 Year 2 Year 2
$ $ $ $
Sales @ $25 325,000 312,500
Less: CoS
Opening inventory
(1,000  $20) – 20,000
Production costs
– variable
(14,000  $20) 280,000
(11,500  $20) 230,000
280,000 250,000
Less closing inventory
(1,000  $20) (20,000) –
(260,000) (250,000)
65,000 62,500
Less variable selling costs
(13,000  $0.50) (6,500)
(12,500  $0.50) (6,250)
Contribution 58,500 56,250
Less fixed costs
– Production 11,000 11,000
– Selling 5,000 5,000
(16,000) (16,000)
Net profit 42,500 40,250
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Year 1 Year 2
Units Units
Normal/budgeted production 12,000 12,000
Actual production 14,000 11,500
Actual sales 13,000 12,500
Actual fixed prodn overheads $11,000 $11,000
Actual fixed selling costs $5,000 $5,000
There is no opening inventory. All variable costs were as per budget
for the two years.
(a) What are the total budgeted fixed production overhead?
(b) Set out a statement of profit or loss under absorption costing for
years 1 and 2 using the proforma given.
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Answer
(a) FOAR = $0.90
Budgeted fixed production overheads

FOAR =
Normal activity
Budgeted fixed production overheads

$0.90 =
12, 000
Budgeted fixed production overhead = 12,000 × $0.90

= $10,800
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Answer (cont'd)
(b) Absorption profit and loss
Year 1 Year 1 Year 2 Year 2
$ $ $ $
Sales @ $25 325,000 312,500
Less: CoS
Opening inventory
(1,000  $20.90) – 20,900
Production costs
– variable
(14,000  $20) 280,000
(11,500  $20) 230,000
– fixed (absorbed)
(14,000  $0.90) 12,600
(11,500  $0.90) 10,350
292,600 261,250
Less closing inventory

(1,000  $20.90) (20,900) –
271,700 261,250
(Over)/under absorption (1,600) 650
(270,100) (261,900)
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Answer (cont'd)
Year 1 Year 2
$ $
Gross profit 54,900 50,600
Less selling costs

– variable
(13,000 × $0.50) (6,500)
(13,000 × $0.50) (6,250)
– fixed (5,000) (5,000)
43,400 39,350
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Calculating profit
Marginal costing and absorption costing give rise to different profit

figures which can be reconciled.
Under marginal costing closing inventories are valued at marginal
production cost.
Under absorption costing closing inventories are valued at full
production cost (including production overheads).
The difference in profits is the difference between fixed production
overhead included in the opening and closing inventory valuations using
absorption costing.
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Reconciling profits 1
RECONCILIATION
Marginal costing profit X

Adjust for fixed overheads in inventory:
+ increase / – decrease X/(X)
Absorption costing profit X
If inventory levels are increasing then absorption profit will be

higher therefore add adjustment.
If inventory levels are falling then absorption profit will be lower

therefore deduct adjustment.
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To summarise these are the reasons for the difference in profits and the
reconciliation:
Increase in inventory in a period

• Absorption costing reports higher profit
• Fixed overheads included in opening inventory are lower than fixed
overheads included in closing inventory
• Therefore cost of sales lower
• Hence, profit higher
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Decrease in inventory in a period
• Absorption costing reports lower profit

• Fixed overheads included in opening inventory are higher than fixed
overheads included in closing inventory
• Therefore cost of sales higher
• Hence, profit lower
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Year 1 Year 2 Total

$ $ $
Absorption costing 43,400 39,350 82,750
Marginal costing 42,500 40,250 82,750
900 (900) -
Reconcile the profit figures for each year.

Year 1 Year 2
$ $
Absorption costing profit
Add fixed overheads b/f in opening inventory
Less fixed overheads b/f in closing inventory
Marginal costing profit
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Answer
Reconciliation of absorption and marginal costing profits

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
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Profits generated using AC and MC can also be reconciled as follows:
Difference in the profit = Change in inventory in units  OAR per

unit
Going back to the example above the opening and closing inventories
were as follows.
Year 1 Year 2
Opening inventory Zero 1,000
Closing inventory 1,000 Zero
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Difference in the profit = Change in inventory in units

 OAR per unit
Year 1 Year 2
Change in inventory +1,000 –1,000
OAR = $0.90
Year 1 Year 2
Marginal profit 42,500 40,250
Difference in profit (1,000  $0.90) 900 (900)
(Increase in (Decrease in
inventory so add inventory so
difference) deduct difference)
Absorption profit 43,400 39,350
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Marginal versus absorption costing 1
There are certain advantages to using absorption costing which

include the following:
• Fixed production costs are incurred making the output and so it is only
'fair' to charge all output with a share of these costs.
• Closing inventory will be valued in accordance with IAS 2.
• Appraising products in terms of contribution gives no indication of
whether fixed costs are being covered.
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There are also certain advantages to using marginal costing which

include the following:
• Absorption costing information is irrelevant when making short-run

decisions – contribution is most important.
• It is simple to operate.
• There are no arbitrary fixed cost apportionments.
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• Fixed costs in a period will be the same regardless of the level of

output and so they should be charged as a period cost.
• It is realistic to value closing inventory items at the (directly
attributable) cost to produce an extra unit – marginal cost.
• Under/over absorption is avoided.
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Absorption costing may give managers the wrong signals.

Goods may be produced, not to meet demand, but to absorb allocated
overheads.
Absorption costing profit can be increased merely by producing in excess
of sales and therefore increasing closing inventory.
Production in excess of demand however increases the overheads (for
example warehousing).
BPP LEARNING MEDIA

Past exam question
A company uses standard absorption costing to value inventory. Its fixed

overhead absorption rate is $12 per labour hour and each unit of
production should take four hours. In a recent period where there was no
opening inventory of finished goods, 20,000 units were produced using
100,000 labour hours. 18,000 units were sold. The actual profit was
$464,000.
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What profit would have been earned under a standard marginal costing
system?
A $368,000
B $440,000
C $344,000
D $560,000
(2 marks)
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The correct answer is A.

Standard absorption costing will include $96,000 of the period's overhead
(2,000 units × 4 labour hours × $12 per hour) in the valuation of closing
inventory. Under standard marginal costing the $96,000 would be
charged against the period's profit resulting in a profit $96,000 lower than
$464,000.
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Past exam question
A company has the following budgeted costs and revenues:

$ per unit
Sales price 50
Variable production cost 18
Fixed production cost 10
In the most recent period, 2,000 units were produced and 1,000 units
were sold. Actual sales price, variable production cost per unit and total
fixed production costs were all as budgeted. Fixed production costs were
over-absorbed by $4,000. There was no opening inventory for the period.
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What would be the reduction in profit for the period if the company has
used marginal costing rather than absorption costing?
A 4,000
B 6,000
C 10,000
D 14,000
(2 marks)
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The correct answer is C. This can be calculated by multiplying the

increase in finished goods inventory of 1,000 units (2,000 units produced
less 1,000 units sold) by the fixed production cost per unit that will be
included in absorption costing closing inventory valuation.
Under- or over-absorption adjustments to profit do not cause a difference
between marginal and absorption costing profits. They simply ensure that
absorption costing charges the same amount of fixed overhead as
marginal costing.
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Chapter summary 1
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. Calculating a profit or loss under marginal costing

▪ In marginal costing fixed costs are treated as period costs.
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Chapter summary 2
4. Calculating a profit or loss under absorption costing

▪ In absorption costing fixed costs are absorbed into the units and
carried forward with closing inventory.
5. Reconciliation of absorption and marginal costing profits

▪ 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.
6. Absorption costing vs marginal costing

▪ Each costing method has its own advantages and disadvantages.
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Chapter 8a
• The basics of process costing
• Losses in process costing
Process costing
• Valuing closing work in progress
• Valuing opening work in progress
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• 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.
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• Calculate and explain the concept of equivalent units.

• Apportion process costs between work remaining in process and
transfers out of a process using the weighted average and FIFO
methods.
• Prepare process accounts in situations where work remains
incomplete.
• Prepare process accounts where losses and gains are identified at
different stages of the process.
Note. Situations involving WIP and losses in the same process are
excluded.
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Overview
Process costing
Work in progress
General principles of Abnormal loss or
(WIP)
process costing with no gain
losses
Normal losses
Closing WIP Opening WIP
Without With scrap

scrap value value
Subsequent/previous
processes
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Tackling the exam
Example
Question
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The basics of process costing
Process costing is used in businesses where identical items are

produced continuously and therefore costs cannot be traced to individual
units of production or batches.
There may be a single process or a series of processes.
There are two main problem areas:
1 Accounting for waste and sub-standard production

2 Deciding how to value finished units and work in progress at the end
of a period
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Losses in process costing 1
We will first deal with losses.
Consider the process of making fruit jam.

We may start with 20 kg of fruit and 10 kg of sugar (total input weight
30 kg) but the weight of jam obtained may be only 25 kg.
The loss is caused by:
• Removal of stalks on the fruit

• Removal of impurities by cleaning
• Loss of water through evaporation
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The relationship between input and output quantities is known as the

normal loss rate.
Looking at regular statistics, operating managers will be aware of any
abnormal results and can take corrective action.
Losses can be:
• Spoilage – defective production identified at any stage

• Scrap – material which emerges from a process with little or no scrap
value
• Weight loss – a loss in weight of input materials due to evaporation or
perhaps spillage
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Losses can be accounted for in two ways, depending on whether the loss
was expected or not.
Normal loss
• Where the level of spoilage, scrap or weight loss is as expected
• As suffering these losses is an unavoidable part of production, the
cost of normal losses is added to the cost of good production
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Abnormal loss
• Where the level of spoilage, scrap or weight loss is over and above the
normal loss
• The cost of abnormal losses appears as a separate expense in
the statement of profit or loss
Abnormal gain
• Where the level of spoilage, scrap or weight loss is below the normal
loss
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Example
2,000 tons of material were put into a process in January at a cost of

$15,000. The output of finished product was 1,700 tons. The normal level
of waste in this process is 10% of input weight and the waste, which is
identified at the end of the process, can be sold at $3 per ton.
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(a) What is the normal loss (in tons)?

(b) What is the actual loss (in tons)?
(c) What is the abnormal loss (in tons)?
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Answer
(a) Input in tons  normal loss percentage

= 2,000 tons  10%
= 200 tons
(b) Input – output = 2,000 – 1,700 = 300 tons
(c) Normal loss – actual loss = 200 – 300 = 100 tons
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The vital point to remember when dealing with a process that has losses
is that the cost per unit is worked out on the basis of expected output.
In our example, the expected output = input – normal loss = 2,000 – 200
= 1,800 tons.
The initial costs are $15,000 but we expect to be able to sell 200 tons for
$3 per ton.
The net cost of the expected output is therefore:
• $15,000 – ($3  200) = $14,400
So cost per unit = $14,400 / 1,800 = $8 per ton.
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Process account
Tons $ Tons $
Materials 2,000 15,000 Normal loss 200 600
Actual output 1,700 13,600
Abnormal loss 100 800
2,000 15,000 2,000 15,000
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Loss account
Tons $ Tons $
Process – normal 200 600 Cash (waste 300 900
sold at $3)
Process – 100 800 St of profit or 500
abnormal loss
300 1,400 300 1,400
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Example
2,000 tons of material were put into a process in January at a cost of

$16,800. The output of finished product was 1,900 tons. The normal level
of waste in this process is 10% of input weight and the waste, which is
identified at the end of the process, can be sold at $3 per ton.
BPP LEARNING MEDIA

(a) What is the normal loss (in tons)?

(b) What is the actual loss (in tons)?
(c) What is the abnormal gain/loss (in tons)?
(d) What is the cost per unit?
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Answer
(a) Input in tons  normal loss percentage

= 2,000 tons  10%
= 200 tons
(b) Input – output = 2,000 – 1,900 = 100 tons
(c) Normal loss – actual loss = 200 – 100 = 100 tons
(d) Expected output = 2,000 – 200 = 1,800 tons

Initial costs are $16,800 but we expect to sell waste for
$3. Net cost is therefore $16,800 – ($3  200) =
$16,200.
Cost per unit = $16,200 / 1,800 = $9 per ton
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(a) Draw up the process account.

(b) Draw up the loss account.
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Answer
(a) Process account

Tons $ Tons $
Materials 2,000 16,800 Normal loss 200 600
Abnormal gain 100 900 Actual output 1,900 17,100
2,100 17,700 2,100 17,700
BPP LEARNING MEDIA

Answer (cont'd)
(b) Loss account
Tons $ Tons $
Process – normal 200 600 Abnormal gain 100 900
St of profit or loss 600 Cash (waste 100 300
sold at $3)
200 1,200 200 1,200
Note that the $600 credit to the statement of profit or loss is

explained by
100 tons abnormally gained valued at $9 per ton $900
Less 100 tons less actual scrap that would
Otherwise have been sold for $3/ton ($300)
$600
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Valuing closing work in progress 1
In process costing, production is continuous so that at any time there will

be partly finished items within the process.
This means that some of the costs incurred in the period will relate to
completed production, and some to the uncompleted work in progress.
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Example
Say that four motorcycles were produced at a total cost of $4,000.
What would you expect the cost per bike to be?

• $4,000 / 4 = $1,000
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Say that in the second period, 2 complete bikes and 2 part-complete

bikes were produced at a cost of $3,500.
We now have a problem working out the cost per unit as it would be
unfair to divide the cost by 4 items.
The approach used to get round this problem is to consider the
equivalent units of production.
For example, let's assume that the 2 part-finished bikes are 75%
complete.
We can argue that this amounts to 1.5 bikes (2  75%)
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The total production for the period is therefore equivalent to:

2 whole bikes plus the equivalent of 1.5 bikes = 3.5 bikes.
For a cost of $3,500, we have produced the equivalent of 3.5 bikes, so

the cost per unit is:
$3,500 / 3.5 = $1,000 per whole bike
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The production and work in progress can now be valued as follows:
• 2 finished units at $1,000 each $2,000

• 2 units, 75% complete ($1,000  75%  2) $1,500
$3,500
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A furniture manufacturing company produces a standard coffee table. In

a period they produced 160 complete tables. At the end of the period
they had a further 80 tables part finished, half of which were considered
to be 25% complete, the rest 75% complete. There were no incomplete
tables at the start of the period. Costs during the period were $2,000.
(a) What were the equivalent number of units produced in the period?
(b) What is the cost per equivalent unit?
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Answer
(a) Number of complete tables 160

40 tables  25% complete 10
40 tables  75% complete 30
Total 200
(b) $2,000 / 200 = $10 per equivalent unit and costs are
allocated as
160 completed units @ $10 $1,600

10 equivalent units @ $10 $100
30 equivalent units @ $10 $300
$2,000
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Let's return to the motorcycle manufacturer and look at Period 3:
• Costs were $3,630.

• Opening WIP was 75% complete and cost $1,500. It was completed in
Period 3.
• 2 further bikes were completed.
• 1 more bike is partly completed (50%).
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The opening WIP costs plus the additional cost introduced in this period
are enough to make whole units (the units completed in the period) plus
the first 50% of another bike.
Equivalent units
4 bikes have been completed 4
1 bike has been 50% completed 0.5
4.5
Cost per equivalent unit = ($3,630 + $1,500) / 4.5 = $1,140
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Once the equivalent units have been worked out, you can begin to value
the output.
$
4 bikes completed (4  $1,140) 4,560
1 bike 50% completed (50%  $1,140) 570
5,130
Note that we can reconcile the costs:

• $1,500 b/f in opening WIP + $3,630 additional costs = $5,130.
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A widget manufacturer starts a period with 100 widgets which are

considered to be 45% complete and which cost $225. During the period,
1,000 completed widgets (including 100 which were partly completed at
the start of the period) left the factory. At the end of the period, there were
200 partly completed widgets which were 60% complete. The total costs
incurred in the manufacture of widgets for the period was $5,375.
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(a) How many units are completed in the period?

(b) How many equivalent units of production were needed to make the
closing work in progress?
(c) What is the cost per equivalent unit?
(d) What is the cost of the closing work in progress?
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Answer
(a) 1,000 units were completed and left the factory.

(b) 200  60% = 120
(c) 1,000 + 120 = 1,120 equivalent units in period
($5,375 + $225) / 1,120 = $5
(d) 120  $5 = $600
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Now let's look at a manufacturing process in which different types of cost

are incurred at different times during the process.
A manufacturer makes models of teddy bears in two stages:
1 Fabric is cut out. 60% of material cost and 25% of labour cost are
incurred
2 Bears are stitched and stuffed incurring the rest of the costs
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The total cost of the finished product is:
$
Materials 10
Labour 8
18
At stage 1 materials are 60% complete and labour 25%.

Material 60%  $10 = $6
Labour 25%  $8 = $2
Value of WIP = $8
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Valuing opening work in progress 1
There are two methods of dealing with opening work in progress – the
FIFO method and the weighted average method.
Under the FIFO method the assumption is that the first units completed
in any period are the units of opening inventory.
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• Step 1. Determine output and losses

• Step 2. Calculate cost per unit of output and losses
• Step 3. Calculate total costs of output, losses and WIP
• Step 4. Complete accounts
Note. Exam questions will not contain both WIP and losses.
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Statement of equivalent units under FIFO
Actual Equivalent Units

Units Materials Labour Overheads
Opening WIP
Goods started and
finished
Good output
Closing WIP
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Statement of equivalent units under weighted average
Actual Equivalent Units

Units Materials Labour Overheads
Good output
Closing WIP
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Raw materials 2,050 units $22,550

Labour $16,304
Overheads $8,212
Opening WIP 50 units $610 (labour 60% complete,
overheads 30% complete)
Output from Process I 2,020 units
Closing WIP 80 units complete as below
Raw materials 100% complete
Labour 60% complete
Overheads 60% complete
There were no losses.
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Required
Prepare a Process I ledger account using:

(a) FIFO
(b) Weighted average methods
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Answer
(a) FIFO
Op WIP + Input units = Good output + Normal loss +/– Ab loss/gain + CI WIP
50 + 2,050 = 2,020 + 0 + 0 + 80
Process I
Units $ Units $
Opening WIP 50 610 To Process II 2,020 46,220
Raw materials 2,050 22,550
Labour 16,304
Overheads 8,212 Closing WIP 80 1,456
2,100 47,676 2,100 47,676
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Answer (cont'd)
Statement of equivalent units

Total Materials Labour Overheads
Opening WIP 50 – 20 35
(completed)
Started & finished 1,970 1,970 1,970 1,970
Output 2,020 1,970 1,990 2,005
Closing WIP (started) 80 80 48 48
2,100 2,050 2,038 2,053

Costs per equivalent unit
Materials Labour Overheads

$ $ $
Costs 22,550 16,304 8,212
Cost/EU $11.00 $8.00 $4.00
Total cost/EU $23.00
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Answer (cont'd)
Valuations $
Good output
Costs b/f in opening WIP 610
Materials (1,970  $11.00) 21,670
Labour (1,990  $8.00) 15,920
Overheads (2,005  $4.00) 8,020
46,220
$
Closing WIP
Materials (80  $11.00) 880
Labour (48  $8.00) 384
Overheads (48  $4.00) 192
1,456
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Answer (cont'd)
(b) Weighted average

Process I
Units $ Units $
Opening WIP 50 610 To Process II 2,020 46,238
Raw materials 2,050 22,550 Closing WIP 80 1,448
Labour 16,304
Overheads 8,212 Rounding (10)
2,100 47,676 2,100 47,676
Statement of equivalent units

Total Materials Labour Overhead
Good output 2,020 2,020 2,020 2,020
Closing WIP 80 80 48 48
2,100 2,100 2,068 2,068
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Answer (cont'd)
Cost per equivalent unit
Materials Labour Overhead
$ $ $
Costs – b/f 400 180 30
– incurred 22,550 16,304 8,212
22,950 16,484 8,242

Cost/EU $10.93 $7.97 $3.99
Total Cost/EU $22.89
Valuations $
Good output
(2,020  $22.89) 46,238
Closing WIP $
– materials (80  $10.93) 874.40
– labour (48  $7.97) 382.56
– overheads (48  $3.99) 191.52
1,448.48
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Tackling the exam
Make sure that you read the following article on process costing from the
ACCA website:
articles/process-costing.html
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Chapter summary
1. Process costing
▪ Process costing is used in businesses where identical items are
produced continuously and therefore costs cannot be traced to
individual units of production or batches.
▪ Normal losses are an unavoidable part of production, the cost of
normal losses is added to the cost of good production.
▪ Abnormal losses are where the level of spoilage, scrap or weight loss
is over and above the normal loss.
▪ Abnormal gain is where the level of spoilage, scrap or weight loss is
below the normal loss.
▪ There are two methods of dealing with opening work in progress – the
FIFO method and the weighted average method.
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Chapter 8b
Process costing, • Joint products and by-products
joint products and • Dealing with common costs
by-products
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• 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.
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Overview
Processing costing,
joint and by-products
Joint products By-products
Method of allocating costs

Accounting treatments
Physical Relative
units sales value
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Joint products and by-products 1
Joint products are two or more products which are output from the
same processing operation.
They will be indistinguishable from each other up to their point of
separation (split-off point).
Costs incurred up to this point are called common costs or joint costs.
They possess substantial sales value before or after further processing.
Joint costs must be apportioned between the joint products.
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A by-product is a supplementary or secondary product (arising as the

result of a process) whose value is small relative to that of the principal
product.
What exactly separates a joint product from a by-product?
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A joint product is regarded as an important saleable item, and so it

should be separately costed.
The profitability of each joint product should be assessed in the cost
accounts.
A by-product is not important as a saleable item, and whatever revenue

it earns is a 'bonus' for the organisation.
Because of their relative insignificance, by-products are not separately
costed.
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State three examples of joint products and by-products.
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Answer
Joint products
Oil refinery (diesel, petrol, paraffin)
Chicken farm (legs, wings)
Saw mill (timber, shavings)
By-product
Saw mill (sawdust)
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Dealing with common costs 1
The point at which joint products and by-products become separately

identifiable is known as the split-off point or separation point. Costs
incurred up to this point are called common costs or joint costs.
Costs incurred prior to this point of separation are common or joint
costs, and these need to be allocated (apportioned) in some manner to
each of the joint products.
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Split off point
Input
materials Joint product A
Process Joint product B
By-product X
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There are two main methods of apportioning joint costs – physical

measurement or sales value at split-off point.
• Physical measurement method – costs apportioned on basis of

proportion of output to the total output
• Sales value method – costs apportioned in proportion of sales value
of joint product to total sales value of output
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Physical measurement method – costs apportioned on basis of

proportion of output to the total output
• This proportion can be based upon weight or volume.

• This method is unsuitable where products separate into different states
during processing.
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Physical measurement method
• Suppose that the joint costs of a process at split off point are $3,000
with 2 joint products:
Joint product 1 500 tonnes
Joint product 2 1,000 tonnes
1,500 tonnes
• Apportioned costs
JP1 500 / 1,500  $3,000 = $1,000
JP2 1,000 / 1,500  $3,000 = $2,000
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A process involves incorporating 2,000 units input of material costing

$2,000 with labour costs of $2,000 and overheads of $1,000.
The output of the process is two joint products: 600 units P1, 1,200 units
P2; and 200 units of by-product. The by-product will be able to be sold for
$50 in total.
Required
Allocate the joint costs on a physical units basis.
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Answer
P1: 600  (5,000 − 50) = $1,650

1,800
1,200  (5,000 − 50) = $3,300

P2:
1,800
Process Account
Units $ Units $
Material 2,000 2,000 Output P1 600 1,650
Labour 2,000 P2 1,200 3,300
Overheads 1,000 By-product 200 50
2,000 5,000 2,000 5,000
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The relative sales value method is the most widely used method of
apportioning joint costs.
• This is because (ignoring the effect of further processing costs) it

assumes that all products achieve the same profit margin.
• The cost is allocated according to the product's ability to produce
income.
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Tackling the exam
Make sure you split the joint costs according to sales value of
production rather than individual selling prices or sales value of sales.
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Two products (P and Q) are created from a joint process. Both products
can be sold immediately after split-off. There are no opening inventories
or work in progress. The following information is available for last period.
Total joint production costs $850,000
Product Production
per unit units Sales units Selling price
P 15,000 10,000 $15
Q 11,000 8,000 $25
Allocate the joint costs on a sales value basis.
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Answer
Sales value of production:
Product P (15,000  $15) $225,000

Product Q (11,000  $25) $275,000
Therefore joint costs are apportioned 45%:55%.
Amount apportioned
Product P ($850,000  45%) $382,500

Product Q ($850,000  55%) $467,500
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D Co operates a process costing system, the final output from which is

three different products: X, Y and Z. Details of the three products for June
are as follows.
X Y Z
Selling price per unit $25 $18 $32
Output for March 12,000 units 20,000 units 8,000 units
50,000 units of material were input to the process, costing $430,000.

Conversion costs were $320,000. No losses were expected and there
were no opening or closing inventories.
Using the units basis of apportioning joint costs, what was the profit or
loss on sales of X for June?
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Answer
Total output 40,000 units (12,000 + 20,000 + 8,000)
Total input 50,000 units
Abn loss 10,000 units
Total cost = $750,000
Cost per unit = $750,000 / 50,000 = $15

Cost of 'good' output = 40,000 units  $15 = $600,000
Amount apportioned to X:
(12,000/40,000)  $750,000 = $225,000
Profit for X = Sales revenue – apportioned costs

= (12,000  $25) – $225,000
= $75,000
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Chapter summary 1
1. Introduction
▪ 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.
2. 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.
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Chapter summary 2
3. Apportioning joint costs

▪ The main methods of apportioning joint costs are by physical
measurement and by relative sales value.
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Chapter 9a
• Costing methods
Job, batch and • Job costing
service costing • Batch costing

• Service costing
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• Describe the characteristics of job and batch costing.

• Describe the situations where the use of job or batch costing would be
appropriate.
• Prepare cost records and accounts in job and batch costing situations.
• Establish job and batch 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.
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Overview
Job and service

costing
Job and batch Service industry

costing
Cost card
Composite cost
units
Service
department
costing
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Costing methods
A costing method is designed to suit the way goods are processed or

manufactured or the way services are provided.
This chapter looks at:
• Job costing
• Batch costing
• Service costing
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Job costing 1
A job is a cost unit which consists of a single order or contract
Job costing has the following features:
• Work is undertaken to customers' special requirements.

• Each order is of short duration.
• Jobs move through operations as a continuously identifiable unit.
• Jobs are usually individual and separate records should be maintained
on an individual job costing sheet.
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Suggest three examples of businesses that use job costing.
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Answer
Job costing may be used by:
• Plumbers
• Builders
• Engineering company
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Job costing 2
Procedure:
• Customer approaches supplier with job requirements.

• Details agreed between customer and supplier.
• Estimating department prepares estimate for the job based on cost of
materials, labour expense, overheads and profit margin.
• Estimate is accepted and job is scheduled.
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Job costing 3
Pricing:
• Cost plus pricing means that a desired profit margin is added to total
costs to arrive at the selling price.
• Selling price based on a 20% margin means that profit is 20% of
selling price.
%
Cost of job 80
+ profit 20
= selling price 100
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Job costing 4
Selling price based on a 20% mark-up means that profit is 20% of cost.
%
Cost of job 100
+ profit 20
= selling price 120
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A company sells Product A at unit cost plus a margin of 20%.

If the unit cost is $240, what is the selling price?
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Answer
$ %
Cost 240 80
Profit ? 20
Selling price ? 100
 selling price = $240 / 80% = $300
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A company sells Product B at unit cost plus a mark up of 30%.

If the unit cost is $425, what is the selling price?
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Answer
$ %
Cost 425 100
Profit ? 30
Selling price ? 130
 selling price = $425  130% = $552.50
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Job costing 5
It is possible to use a job costing system to control the costs of an

internal service department, such as the maintenance department or
the printing department.
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Job costing 6
Advantages of internal job costing
Advantages Comment
Realistic The identification of expenses with jobs and the subsequent
apportionment charging of these to the department(s) responsible means
that costs are borne by those who incurred them.
Increased User departments will be aware that they are charged for the
responsibility specific services used and may be more careful to use the
and facility more efficiently. They will also appreciate the true cost
awareness of the facilities that they are using and can take decisions
accordingly.
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Job costing 7
Advantages of internal job costing
Advantages Comment
Control of The service department may be restricted to charging a
service standard cost to user departments for specific jobs carried out
department or time spent. It will then be possible to measure the efficiency
costs or inefficiency of the service department by recording the
difference between the standard charges and the actual
expenditure.
Planning This information will ease the planning process, as the
information purpose and cost of service department expenditure can be
separately identified.
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A company is preparing for job X112. The job requires materials worth
$1,350 and 150 hours of labour.
Labour is paid at $6 per hour, variable overheads are absorbed at a rate
of $2 per labour hour and fixed overheads at a rate of $3 per labour hour.
Required
What is the total cost of job X112?
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Answer
(a)
Job X112
$
Direct materials 1,350
Direct labour (150 × $6) 900
Variable overheads (150 × $2) 300
Prime cost 2,550
Fixed overheads (150 × $3) 450
Total cost 3,000
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Batch costing
A batch can be defined as a cost unit which consists of a separate,

readily identifiable group of product units which maintain their separate
identity throughout the production process.
For costing purposes, each batch can be looked at as a separate job.
After the batch is completed, the cost per unit can be calculated as
Total batch cost

Number of units made in the batch
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Service costing 1
Service costing is a costing method concerned with establishing the

costs of services rendered.
There are two main types of service:
• Services provided by a company operating in a service industry

• Services provided internally by a service department to other
departments
Service costing is a costing method concerned with establishing the

costs, not of items of production, but of services rendered.
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Service costing 2
Specific characteristics of services (SHIP):
• Simultaneity – production and consumption occur at the same time so

quality cannot be inspected in advance
• Heterogeneous – exact service received will vary each time
• Intangible – services cannot be touched
• Perishable – they cannot be stored
Cost per Total costs for period

=
service unit Number of service units in the period
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Service costing 3
Can be difficult to define realistic cost unit.

Typical cost units:
Service Cost unit

Road, rail, air transport Passenger/mile, tonne/kilometre
Hotels Occupied bed-night
Education Full-time student
Hospitals Patient
Catering establishment Meal served
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Past exam question
A truck delivered sand to two customers in a week. The following details

are available.
Customer Weight of goods Distance
covered
Delivered (kilograms) (kilometres)
X 500 200
Y 180 1,200
680 1,400
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The truck cost $3,060 to operate in the week. Each customer delivery
was carried out separately, and the truck made no other deliveries in the
week.
What is the cost per kilogram/kilometre of sand delivered in the week (to
the nearest $0.001)?
A $0.003
B $0.010
C $2.186
D $4.500
(2 marks)
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The correct answer is B. The cost per kilogram/kilometre of sand

delivered is the cost of carrying one kilogram of sand for one kilometre.
Kilogram kilometres can be calculated by multiplying the weight of goods
delivered to each customer by the distance covered. (500 kg × 200 km +
180 kg × 1200 km = 316,000 kilogram kilometres.) If truck costs are
divided by this figure a cost of $0.010 is obtained.
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Tackling the exam
Make sure that you read the following article on re-apportionment of

service cost centre costs from the ACCA website:
resources/fundamentals-exams-study-resources/f2/technical-articles/re-
apportionment-of-service-cost-centre-costs.html
BPP LEARNING MEDIA

Chapter summary 1
1. Job and batch costing

▪ Job costing is a costing method applied where work is undertaken to
customers' special requirements and each order is of comparatively
short duration.
▪ 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).
2. Service industry costing

▪ Service costing is used by companies operating in a service industry.
The main difficulty is defining an appropriate cost unit.
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Chapter summary 2
3. Charging customers for services

▪ Service companies often use composite cost units to work out cost per
unit on which to base their prices.
4. Service department costing

▪ This is used to determine costs for 'internal services' such as canteens
or IT support.
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Chapter 9b
• Activity-based costing (ABC)
Alternative costing • Total quality management (TQM)
principles • Life cycle costing

• Target costing
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• Explain activity based costing (ABC), target costing, lifecycle costing

and total quality management (TQM) as alternative cost management
techniques.
• Differentiate ABC, target costing and lifecycle costing from the
traditional costing techniques (calculations are not required).
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Overview
Activity based costing Total quality

(ABC) management (TQM)
Alternative costing principles
Life cycle costing Target costing
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Tackling the exam
Example
Question
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Activity based costing (ABC) 1
• Alternative to absorption costing

• Volume-related production overhead rates do not adequately reflect
complexity of producing certain products
• Consider what causes costs – cost drivers
• Each type of overhead is absorbed using a different basis depending
on cost driver
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Major ideas behind ABC are:
• Activities cause costs. Activities include ordering, materials handling,

machining, assembly, production scheduling and despatching.
• Producing products creates demand for the activities.
• Costs are assigned to a product on the basis of the product's
consumption of the activities.
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Calculating product costs using ABC:
• Step 1. Identify an organisation's major activities.

• Step 2. Identify the factors which determine the size of the costs of an
activity/cause the costs of an activity. These are known as cost drivers.
• Step 3. Collect the costs of each activity into what are known as cost
pools.
• Step 4. Charge support overheads to products on the basis of their
usage of the activity.
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Cost drivers
• Any factor which causes a change in the cost of an activity.

• Cost driver for cost that varies with production volume in the short term
should be volume related.
• Eg power costs should be labour or machine hours.
• Cost driver for a cost that is related to transactions by support
department should be the transaction in the support department.
• Eg setting up production runs should be number of runs.
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Merits of ABC
• Simple (once info obtained)

• Recognises complexity of modern manufacturing
• Gives better understanding of what drives costs
• Concerned with all overhead costs (not just production)
• Helps with cost control (by controlling incidence of cost drivers)
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Criticisms of ABC
• Can be more complex than absorption costing so benefits must

outweigh cost of implementation.
• Cost drivers may be difficult to identify.
• Can one cost driver explain the behaviour of all items in a cost pool?
• There is still an element of arbitrariness (eg rent).
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Quality 1
Cost of quality is
• The difference between the actual cost of producing, selling and

supporting, products or services and the equivalent costs if there were
no failures during production or usage
Note.
• Concern for quality saves money
• Poor quality costs money
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Quality 2
Cost of quality can be analysed into:
• Cost of conformance
─ Cost of prevention
─ Cost of appraisal
• Cost of non-conformance
─ Cost of internal failure
─ Cost of external failure
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Quality 3
Cost of conformance
• Cost of prevention – 'Costs incurred prior to or during production in

order to prevent substandard or defective products or services from
being produced'
• Cost of appraisal – 'Costs incurred in order to ensure that outputs

produced meet required quality standards'
(CIMA Official Terminology)
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Quality 4
Cost of non-conformance
• Cost of internal failure – 'Costs arising from inadequate quality which

are identified before the transfer of ownership from supplier to
purchaser'
• Cost of external failure – 'Costs arising from inadequate quality

discovered after the transfer of ownership from supplier to purchaser'
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Quality 5
Quality related costs
• Prevention costs
• Appraisal costs
• Internal failure costs
• External failure costs
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Quality 6
Prevention cost examples
• Quality engineering
• Design/development of quality control/inspection equipment
• Maintenance of quality control/inspection equipment
• Administration of quality control
• Training in quality control
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Quality 7
Appraisal cost examples
• Acceptance testing
• Inspection of goods inwards
• Inspection costs of in-house processing
• Performance testing
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Quality 8
Internal failure costs
• Failure analysis
• Re-inspection costs
• Losses from failure of purchased items
• Losses due to lower selling prices for sub-quality goods
• Costs of reviewing product specifications after failures
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Quality 9
External failure costs
• Administration of customer complaints section

• Costs of customer service section
• Product liability costs
• Cost of repairing products returned from customers
• Cost of replacing items due to sub-standard products/marketing errors
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Total quality management (TQM) 1
Two key philosophies:
• Get it right, first time

The cost of preventing mistakes is less than the cost of correcting
them if they occur.
• Continuous improvement
Never be satisfied with current achievement. It is always possible to
improve performance.
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Also:
Measuring and controlling quality

• Quality assurance (supplier guarantees quality)
• Inspection of output at key stages
• Monitoring customer reaction
Employees
• Encouraged to become multi-skilled
• Encouraged to take responsibility for their work
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Performance measures should not be confined to the production

process.
Type of measure Example

Measuring incoming Percentage of defective items per
supplies delivery
Number of returns per supplier
Monitoring work done Number of rejects per production run
as it proceeds Ratio of waste material to used material
Measuring customer Complaints per 10,000 units sold
satisfaction Number of claims under warranty
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Life cycle costing 1
An organisation's ability to generate revenues and profits depends on it

having products or services to sell.
Revenues and profits vary over a products' life cycle.
So firms should try to develop a portfolio of products which are at
different stages of their life cycles.
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The benefits of life cycle costing are:
• Full understanding of individual product profitability

• More accurate feedback information
• Cost reduction/minimisation and revenue expansion opportunities
more apparent
• Increased visibility of non-production costs
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Case study: Apple Inc
Discussion activity:
Discuss the importance of product development, product life cycle and
product portfolio in Apple's competitive position.
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Product life cycle
Sales
+
Time
– Introduction Growth Maturity Decline Senility
Profit
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Characteristics of different stages of the product life cycle:
Introduction
• Slow growth in sales as not yet accepted by would-be purchasers. Unit
cost highs because of low output (eg few economies of scale)
• High marketing costs to try to get product recognised by customers
• Few competitors yet
• Product is a loss maker
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Growth
• Sales rise more sharply as product gains market acceptance; product
will start to make profits.
• Capital investment needed to fulfil the level of demand, meaning cash
flow remains lower than profit. Cash flow likely to remain negative.
• As sales and production rise, unit costs fall.
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Growth (continued)
• Competitors are attracted to market. Need to add additional features to
differentiate from competitors, so product complexity likely to rise.
• Continued marketing expenditure required to differentiate products
from competitors' offerings.
• Growth is sustained by attracting new types of customers.
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Maturity
• Probably the longest period of a successful product's life. Most
products on the market will be at a mature stage.
• The market is no longer growing. Purchases based on repeat business
rather than new customers.
• Rate of sales growth slows down.
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Maturity (continued)
• Profits remain good, and levels of investment are low meaning cash
flow is also positive.
• Prices start to decline, as firms compete to try to increase their share
of the market.
• Firms try to capitalise on a brand name by launching spin off products
under the same name.
• The number of firms in industry reduces, due to consolidation in the
industry.
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Decline
• Sales decline, and there is over-capacity of production in the industry
• Severe competition and falling profits
• Some producers leave the market (as a result of falling profits)
• Remaining producers seeks ways to modify product or to find new
market segments to prolong product life
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Discussion question
Discuss the stage of their life cycles the following products have reached:
• Cameras
• Cars
• Newspapers
• Smartphones
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Discussion question
Suggested solutions:
• Cameras: Decline; now being substituted by i-phones and tablet PCs

as means of taking photos.
• Cars: Mature. Particular models may grow or decline, but cars as a
generic product are now mature. (This could be very different in
developing countries though where markets are likely still to be
growing).
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Discussion question (cont'd)
Suggested solutions (continued):
• Newspapers: Decline; paper-copy newspapers are now being

superseded by online news services.
• Smartphones: Worldwide sales of smartphones are increasing rapidly
(and now now account for the majority of all mobile phone sales). The
price of entry-level smartphones has fallen recently, and
manufacturers developing more affordable models has resulted in a
major sales boost.
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Difficulties with applying the life cycle concept:
• Recognition: how can you tell where a product stands in its life cycle?
(eg what will its future sales be?)
• Not all products follow a consistent patterns of stages as suggested by
the model (eg some go straight from 'growth' to 'decline')
• Nature of competition varies in different industries
• Length of stages can vary; strategic decisions can change or extend a
product's life cycle
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Target costing 1
Traditional approach to product costing
• Develop a product
• Determine the expected standard production cost
• Set a selling price (probably based on cost)
• Resulting profit
• Costs are controlled through variance analysis at monthly intervals
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Target costing 2
Target costing approach
Competitive market price

• Set according to what the competition is charging
Or
• If the product is new, set using market research or functional
analysis/pricing by function
Desired profit margin

• As determined by the organisation's strategic profit plans
• Target cost = Competitive market price less desired profit margin
• This is the resulting cost that must be achieved
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Target costing 3
Target cost – steps
• Step 1 – Determine product specification

• Step 2 – Set selling price
• Step 3 – Estimate required profit
• Step 4 – Calculate target cost
• Step 5 – Compile estimated cost
• Step 6 – Calculate cost gap
• Step 7 – Attempt to close the cost gap, eg 'design out' costs
• Step 8 – Negotiate with customer
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Target costing 4
Target cost
• When a product is first manufactured, the target cost may be well

below currently achievable cost.
• But management will set benchmarks for improvement towards the
target cost by specified dates.
• These will be incorporated into the budgeting process.
• Value analysis can be used to reduce costs if and when targets are
missed (see Chapter 16).
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Tackling the exam
Note that calculations will not be required in the exam for
• Activity based costing

• Target costing
• Life cycle costing
This means that questions will be on understanding the principles of

these costing methods.
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Chapter summary 1
1. Activity based costing
▪ ABC groups overheads into activities. These are referred to as cost
pools. The item that causes the costs to be incurred is known as the
cost driver and the overheads are absorbed into products using the
cost driver.
▪ Overheads absorbed using ABC should be more reliable than those
using traditional absorption costing giving a more meaningful product
cost.
2. Total quality management

▪ TQM is a business philosophy aimed at improving quality with two
main ideas:
— Get it right, first time
— Continuous improvement
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Chapter summary 2
3. Life cycle costing

▪ Life cycle costing considers all costs and revenues of a product
throughout its life rather than on a periodic basis.
4. Target costing
▪ A target cost is derived by setting a selling price for a product and
deducting a desired profit margin to arrive at the target cost.
▪ Costs are then designed out of the product to ensure the target cost is
achieved.
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Chapter 10a • The planning and control cycle
• The functions of budgets
Budgeting • Responsibility centres

• Controllable costs
• Fixed and flexible budgets
• Spreadsheets
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• Explain why organisations use budgeting.

• Describe the planning and control cycle in an organisation.
• Explain the role and features of a computer spreadsheet system.
• Identify applications for computer spreadsheets and their use in cost
and management accounting.
• Explain and illustrate 'what if' analysis and scenario planning.
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• Explain the importance of flexible budgets in control.

• Explain the disadvantages of fixed budgets in control.
• Identify situations where fixed or flexible budgetary control would be
appropriate.
• Flex a budget to a given level of volume.
• Define the concept of responsibility accounting and its significance in
control.
• Explain the concept of controllable and uncontrollable costs.
• Prepare control reports suitable for presentation to management.
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Overview
Planning and
Spreadsheet
control systems
Seven steps in Responsibility

planning and control Budget Forecast
accounting
cycle
Cost/ Controllable
Types profit/ vs
investment uncontrollable
Fixed Flexible Flexed
Variances
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Tackling the exam
Example
Question
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The planning and control cycle
This chapter is about budgeting. But budgeting is part of the planning

and control cycle.
The planning and control cycle:
• Identify objectives
• Identify courses of action (strategies) to achieve objectives
• Evaluate each strategy
• Choose course of action
• Implement long-term plan in annual budget
• Measure actual results and compare with plan
• Respond to divergences from plan
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The functions of budgets 1
Most people, in their private lives, have prepared budgets for themselves.
Typically you estimate your income and your outgoings (food, rent, fuel
etc).
You can then see if income will cover expenditure.
And you can work out whether you can afford a holiday and how much
you need to save for it!
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Budgets can be used in business for:
• The quantification, ultimately in financial terms, of an organisation's

plans
• Ensuring that the plans can be financed
• Controlling resources and performance
These functions can be further broken down to give us the objectives of a

budgetary planning and control system.
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The objectives of a budgetary planning and control system are as

follows:
• To ensure the achievement of the organisation's objectives

• To compel planning
• To communicate ideas and plans
• To coordinate activities
• To provide a framework for responsibility accounting
• To establish a system of control
• To motivate employees to improve their performance
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Ensure the achievement of the organisation's objectives
• Objectives are set for the organisation as a whole, and for individual
departments and operations within the organisation. Quantified
expressions of these objectives are then drawn up as targets to be
achieved within the timescale of the budget plan.
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Compel planning
• This is probably the most important feature of a budgetary planning

and control system. Planning forces management to look ahead, to set
out detailed plans for achieving the targets for each department,
operation and (ideally) each manager and to anticipate problems. It
thus prevents management from relying on ad hoc or uncoordinated
planning which may be detrimental to the performance of the
organisation. It also helps managers to foresee potential threats or
opportunities, so that they may take action now to avoid or minimise
the effect of the threats and to take full advantage of the opportunities.
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Communicate ideas and plans
• A formal system is necessary to ensure that each person affected by

the plans is aware of what he or she is supposed to be doing.
Communication might be one-way, with managers giving orders to
subordinates, or there might be a two-way dialogue and exchange of
ideas.
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Co-ordinate activities
• The activities of different departments or sub-units of the organisation

need to be co-ordinated to ensure maximum integration of effort
towards common goals. This concept of co-ordination implies, for
example, that the purchasing department should base its budget on
production requirements and that the production budget should in turn
be based on sales expectations. Although straightforward in concept,
coordination is remarkably difficult to achieve, and there is often
'sub-optimality' and conflict between departmental plans in the
budget so that the efforts of each department are not fully integrated
into a combined plan to achieve the company's best targets.
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Provide a framework for responsibility accounting
• Budgetary planning and control systems require that managers of

budget centres are made responsible for the achievement of budget
targets for the operations under their personal control.
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Establish a system of control
• A budget is a yardstick against which actual performance is

monitored and assessed. Control over actual performance is provided
by the comparisons of actual results against the budget plan.
Departures from budget can then be investigated and the reasons for
the departures can be divided into controllable and uncontrollable
factors.
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Motivate employees to improve their performance
• The interest and commitment of employees can be retained via a

system of feedback of actual results, which lets them know how well or
badly they are performing. The identification of controllable reasons for
departures from budget with managers responsible provides an
incentive for improving future performance.
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Provide a framework for authorisation
• Once the budget has been agreed by the directors and senior
managers it acts as an authorisation for each budget holder to incur
the costs included in the budget centre's budget. As long as the
expenditure is included in the formalised budget the budget holder
can carry out day to day operations without needing to seek separate
authorisation for each item of expenditure.
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Provide a basis for performance evaluation
• As well as providing a yardstick for control by comparison, the

monitoring of actual results compared with the budget can provide a
basis for evaluating the performance of the budget holder. As a
result of this evaluation the manager might be rewarded, perhaps with
a financial bonus or promotion. Alternatively the evaluation process
might highlight the need for more investment in staff development and
training.
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Responsibility accounting is a system of accounting that segregates

revenue and costs into areas of personal responsibility in order to
monitor and assess the performance of each part of an organisation.
A responsibility centre is a function or department of an organisation
that is headed by a manager who has direct responsibility for its
performance.
Functional budgets are the detailed budgets for each function or
department within an organisation.
Sometimes a function may be a cost centre, profit centre or
investment centre.
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Responsibility centres
• Cost centre – responsible for costs only

• Eg accounting department and advertising function
• Profit centre – responsible for costs and revenues
• Eg branch of a retail chain, computer department where users are
charged for processing
• Investment centre – responsible for costs, revenues and investment
Irrespective of whether they are called cost, profit or investment centres,

departments or functions, each needs a budget.
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Controllable costs
A controllable cost is 'a cost that can be controlled, typically by a cost,

profit or investment centre manager'.
Managers of responsibility centres should only be held accountable for
costs over which they have some influence.
Can be demoralising for managers who feel their performance is being
judged on the basis of something over which they have no influence.
Important from a control point of view – control reports should ensure that
information on costs is reported to the manager able to take action to
control them.
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Fixed and flexible budgets 1
A budget prepared for one level of activity is known as a fixed budget.

However, it can be useful to prepare budgets for several different levels
of activity.
Budget: sales = 100,000
This is known as a flexible budget.

It allows an organisation to assess the effect of different sales and
production schedules.
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Flexible budgets are very useful at the planning stage to explore the
effect of different activity levels.
• Eg what are the knock on effects on distribution costs if sales are very
high?
• Eg what are the effects on employment if we have low sales?
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Flexible budgets are also very useful for budgetary control.

If activity levels rise, many costs will rise and we need to be able to
compare these to a budget which reflects the higher costs.
There is little point looking back to a fixed budget where most estimates
are now irrelevant.
To draw up a flexible budget, you need to understand how costs behave

and how to forecast them.
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To prepare a flexible budget:
• Decide whether costs are fixed, variable or semi-variable

• Split semi-variable costs using the high/low or scattergraph methods
• Calculate the budget cost allowance for each item = budgeted fixed
cost* + (number of units  variable cost per unit)**
• * nil for variable cost ** nil for fixed cost
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Using flexible budgets for control
• Produce a flexible budget based on the actual activity level

• Compare the flexible budget with the fixed budget, and with actual
results
• Identify variances
• Volume variance = difference between fixed budget and flexible
budget
• Expenditure variance = difference between flexible budget and actual
results
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Chateau Larnaque has a bottling plant for its cola and has prepared
flexible budgets:
Flexible budgets
Bottles: 10,000 12,000 14,000
Production costs: $ $ $
Materials 30,000 36,000 42,000
Labour 27,000 31,000 35,000
Overhead 20,000 20,000 20,000
77,000 87,000 97,000
Required
If actual production was 12,350 what is the flexed budget production
cost?
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Answer
Output 10,000 12,000 14,000

Material cost/unit 3 3 3
Labour cost/unit 2.7 2.58 2.5
Overhead fixed at all activity levels
Materials Variable cost of $3/unit

 $3  12,350 = $37,050
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Answer (cont'd)
Labour Mixed cost High/low method
Output Cost
$
14,000 35,000
10,000 27,000
4,000 8,000
8,000
VC/unit = = $2/unit
4,000
TC = FC + VC/unit  Output
27,000 = FC + 2  10,000
FC = 7,000
$
VC $2  12,350 = 24,700
FC 7,000
31,700
Overheads Fixed cost 20,000

88,750
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Tackling the exam
In an exam do not fall into the trap of flexing fixed costs.

Do not forget that they remain unchanged regardless of the level of
activity.
Even if fixed overheads are initially expressed on a 'per unit' basis in a
question, remember that once you have calculated the total fixed cost for
a given activity level, it will remain unchanged when activity levels alter.
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Spreadsheets 1
Computers are used in budgeting to process large amounts of data and

recalculate changes in key variables.
Using spreadsheets is an essential part of the day-to-day work of an
accountant.
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Spreadsheets 2
Uses of spreadsheets
• Management accounts
• Revenue analysis and comparison
• Cash flow analysis and forecasting
• Cost analysis and comparison
• Reconciliations
• Budgets and forecasts
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Spreadsheets 3
Best use is 'what-if' analysis
• Changing one or two variables to see how results will be affected

• Eg changing the materials cost in a budget to see how profit would be
affected
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Spreadsheets 4
• Several different versions of Excel exist

• Basic 'worksheet' contains a row number and column letter to identify
each cell
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Spreadsheets 5
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Spreadsheets 6
Contents of cell
• Text – words or numbers not used in calculation (eg date)

• Values – numbers
• Formulae – referring to other cells in the spreadsheet
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Spreadsheets 7
Formulae can be used to perform a variety of calculations. Here are

some examples:
• =C4*5. This formula multiplies the value in C4 by 5.

• =C4*B10. This multiplies the value in C4 by the value in B10.
• =C4/E5. This divides the value in C4 by the value in E5. (*means
multiply and / means divide by.)
• =C4*B10-D1. This multiplies the value in C4 by that in B10 and then
subtracts the value in D1 from the result.
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Spreadsheets 8
• =C4*117.5%. This adds 17.5% to the value in C4. It could be used to

calculate a price including 17.5% sales tax.
• =(C4+C5+C6)/3. Note that the brackets mean Excel would perform
the addition first.
• = 2^2 gives you 2 to the power of 2, in other words 22. Likewise
= 2^3 gives you 2 cubed.
• = 4^ (1/2) gives you the square root of 4. Likewise 27^(1/3) gives you
the cube root of 27.
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Spreadsheets 9
Advantages
• Forecasting – different projections can be input

• Tax – the tax associated with various options can be easily calculated
• Profit projections – figures can be changed to deal with a variety of
options and their associated profit
• Easy to use – Excel can be learnt quickly and is easy to share with
others in the organisation
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Spreadsheets 10
Disadvantages
• Danger of corruption of data or variables

• Cannot incorporate qualitative factors
• Minor errors can creep in – the output is only as good as the input
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Provide the required formulae for the following spreadsheet

computations given the following:
A B C
1 Sales Value
2 January 150
3 February 120
4 March 100
5 Total
6 VAT
7 Gross Sales
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(a) In cell B5 calculate total sales value (150 + 120 + 100).

(b) In cell B6 calculate the VAT payable at a rate of 17.5% on the sum
calculated in B5.
(c) Calculate the gross sales value to invoice in Cell B7.
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Answer
(a) = B2 + B3 + B4 or = SUM(B2 : B4)
(b) = B5* 0.175
(c) = B5 + B6 or = B5* 1.175
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A B C D
2 VAT 0.175
4 Price (excl VAT) VAT Price (incl VAT)
5 12 = B5 + C5
6 15.5 = B6 + C6
7 35 = B7 + C7
What formula will be typed into C5 to calculate the VAT

(using absolute cell referencing)?
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Answer
Absolute cell referencing: = B5*$C$2
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Chapter summary 1
1. Planning and control cycle

▪ There are seven stages in the planning and control cycle.
2. Budgetary planning
▪ A budget is a quantified plan of action for a forthcoming period.
3. Forecast
▪ A forecast is an estimate of what is likely to occur in the future.
4. Controllable vs uncontrollable costs

▪ Managers (and divisions) should only be appraised on items which are
controllable.
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Chapter summary 2
5. Responsibility accounting
▪ Divisions are divided into types of responsibility centres: cost, revenue
and profit centres. These represent the level of control exercised by
that division on costs, revenues and investment.
6. Fixed and flexible budgets
▪ Fixed budgets are based on budgeted volumes and remain
unchanged.
▪ Flexible budgets enable a company to do 'what if?' analysis by
changing these volumes.
7. Spreadsheets
▪ A spreadsheet is an electronic piece of paper divided into rows and
columns. The intersection between a row and column is known as a
cell.
▪ A wide range of formulae and functions are available in Excel.
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Chapter 10b
• Budget administration
The budgetary • The budget process
process • Cash budgets

• Master budget
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• Explain the administrative procedures used in budgeting process.

• Describe the stages in the budgeting process.
• Explain the importance of the 'principal budget factor' in constructing
the budget.
• Prepare budgets for sales budgets.
• Prepare functional budgets.
• Prepare master budgets.
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Overview
Budget committee
The budgeting process
Timetable Budget manual
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Budget administration 1
The budget period is the time period to which the budget relates.
The budget manual is a collection of instructions governing the
responsibilities of persons and the procedures, forms and records
relating to the preparation and use of budgetary data.
Managers responsible for preparing budgets should ideally be the
managers who are responsible for carrying out the budget.
The co-ordination and administration of budgets is usually the
responsibility of a budget committee.
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Budget manual
Content Detail
Explanation of The purpose of budgetary planning and control
the objectives of The objectives of the various stages of the budgeting
the budgeting process
process The importance of budgets in the long-term planning and
administration of the enterprise
Organisational An organisation chart
structures A list of individuals holding budget responsibilities
Outline of the Relationship between them
principal budgets
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Budget manual
Content Detail
Administrative Membership, and terms of reference, of the budget
details committee
The sequence in which budgets are to be prepared
A timetable
Procedural Specimen forms and instructions for completing them
matters Specimen reports
Account codes (or a chart of accounts)
The name of the budget officer to whom enquiries must be
sent
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Functions of the budget committee:
• Co-ordination of the preparation of budgets, which includes the issue

of the budget manual
• Issuing of timetables for the preparation of functional budgets
• Allocation of responsibilities for the preparation of functional budgets
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• Provision of information to assist in the preparation of budgets

• Communication of final budgets to the appropriate managers
• Continuous assessment of the budgeting and planning process, to
improve the planning and control function
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The budget process 1
The budget process is as follows:
1 Communication of objectives
─ Budgets should be prepared in line with the overall objectives of the
organisation.
2 Identification of the principal budget factor
─ This is the limiting factor on the whole organisation and is typically
sales demand (although it could be materials or time or labour and
public sector is usually government funds).
3 Preparation of sales budget
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4 Finished goods, production, resources, overheads, raw material

inventory, raw materials purchases, OAR budgets
5 Negotiation of budgets
─ Budgets shown to superiors for approval
6 Coordination of budgets
─ Revision of one budget may affect all budgets
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7 Final acceptance of budgets and preparation of master budget

─ Contains budgeted statement of profit or loss, budgeted statement
of financial position and cash budget
8 On-going review of budgets
─ Actual performance is regularly compared to budget
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Let's look at the sales and functional budgets.
Sales budget
First, there will be the sales budget.

Everything else will depend on that, the principal budget factor.
The sales budget will be in terms of units and revenue.
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Production
Sales budget
budget
Once you know the sales budget, you can plan your production.
The units to be made will not necessarily equal the units that are sold.
The business may plan to make extra units to build up levels of inventory
or it might make fewer units to use up inventory.
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Labour budget
Materials
Sales budget Production budget
usage budget
Factory expenses budget

Once production is known, usage of many other resources is estimated.
Labour hours and cost will depend on production.
As will materials.
Some factory expenses such as machine running costs will also depend
on production.
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Labour budget
Materials Materials
Sales Production
usage purchases
budget budget
budget budget
Once material usage has been calculated, the business can decide what
it will have to purchase.
Purchases need not equal usage as the business may decide to increase
or decrease its raw material inventory.
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Labour budget
Materials Materials
Sales Production
usage purchases
budget budget
budget budget
Once these functional budgets have been worked out, the business will
usually have completed its most complex budgets
There are still many items that have to be calculated such as research
and development, fixed cost budgets and advertising.
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Once all functional budgets have been completed they will be reviewed
and co-ordinated and the master budget can be produced.
We will look at the master budget later.
You need some more detail on the functional budgets.
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As you know, we start with the sales budget.

We want to work out a production budget.
To connect production to sales use:
Units made = units sold + closing inventory units – opening inventory units
Think about this and you will get the inventory the right way around.
You have to make enough to account for the sales and the closing
inventory but you get a 'head start' from the opening inventory units.
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If sales are budgeted to be 67,000 units, opening inventory 10,000 units

and closing inventory 8,500 units, what is the budgeted production in
units?
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Answer
Production = sales + closing inventory – opening inventory
 production = 67,000 + 8,500 – 10,000
= 65,500
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If sales are budgeted to be 132,000 units, opening inventory 8,000 units

and budgeted production 126,500 units, what is the budgeted closing
inventory in units?
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Answer
Production = sales + closing inventory – opening inventory
 closing inventory = production – sales + opening inventory

 closing inventory = 126,500 – 132,000 + 8,000
= 2,500
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Labour budget
Materials
Sales budget Production budget
usage budget

Once we have obtained the production budget from the sales budget,
labour, material usage and factory expense budgets are easy to
calculate. Eg:
• Labour: 1,000 units @ 3 hours @ $5/hour
• Material usage: 1,000 units @ 2kg/unit
• Factory cost: 1,000 units @ 3 hours @ $3/hour
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Remember that material used will not normally be the same as material
purchased as inventory levels can change.
To connect usage to purchases use:
Material purchases = material used + closing inventory units – opening

inventory units
This is very similar to the formula we used to connect sales to production.
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If material usage is budgeted to be 63,000 units, opening inventory 4,000

units and closing inventory 8,500 units, what is the budgeted purchases
in units?
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Answer
Purchases = usage + closing inventory – opening inventory
purchases = usage + closing inventory –opening inventory

 closing inventory = 63,000 + 8,500 – 4,000
= 67,500
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Cash budgets 1
Cash budgets (or cash flow forecasts) are very important for
organisations.
When employees, suppliers or lenders cannot be paid, failure is usually
imminent.
A business which runs out of cash, even for a couple of months, will fail,
even if it is profitable.
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Cash budgets 2
The reasons why net profit and net cash flow differ are mainly due to
timing.
Purchase of non-current assets
• Suppose an asset is purchased for $20,000 and depreciation is

charged at 10% of the original cost.
• Cash payment during the year = $20,000 (and this does not affect the
statement of profit or loss).
• Depreciation charge = 10% × $20,000 = $2,000. This is charged to the
statement of profit or loss and will reduce overall profits.
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Cash budgets 3
Sale of non-current assets
• When an asset is sold there is usually a profit or loss on sale. Suppose

an asset with a net book value of $15,000 is sold for $11,000, giving
rise to a loss on disposal of $4,000.
• Increase in cash flow during the year = $11,000 sale proceeds. There
will be no effect on the statement of profit or loss.
• Loss on sale of non-current assets = $4,000. This will be recorded in
the firm's statement of profit or loss and will reduce overall profits.
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Cash budgets 4
Matching receipts from receivables and sales invoices raised
• If goods are sold on credit, the cash receipts will be the same as the
value of the sales (ignoring early settlement discounts and bad debts).
However, receipts may occur in a different period as a result of the
timing of payments.
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Cash budgets 5
Matching payments to payables and cost of sales
• If materials are bought on credit, the cash payments to suppliers will

be the same as the value of materials purchased. Again the payments
may be in different periods due to timing. Materials purchased are
matched against sales in a particular period to calculate profit,
demonstrating that profit and cash flow will differ in a particular period.
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Cash budgets 6
Loans, share issues and overdrafts
• Cash may be obtained from a transaction which has nothing to do

with profit or loss. For example, an issue of shares or loan stock for
cash has no effect on profit but is obviously a source of cash. Similarly,
an increase in bank overdraft or a loan provide a source of cash for
payments, but it are not reported in the statement of profit or loss.
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Cash budgets 7
The principle behind cash flow forecasts is simple.
Take the cash balance at the start of a period and add the receipts and
deduct the payments you expect for that period. The result is the
estimated balance at the end of that period.
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Cash budgets 8
For example, if your bank balance at the end of August was $500 and
you expect to receive $1,000 and to pay out $900 in September, your
cash flow budget for September would be:
September
$
Cash balance as at 1 Sep 500
Add expected receipts 1,000
Less expected payments (900)
Projected balance at month end 600
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Cash budgets 9
Say that in October you expect to receive $1,100 and to spend $1,500,
then the cash flow budget for October can be added:
September October
$ $
Cash balance as at 1st 500
Add expected receipts 1,000 1,100
Less expected payments (900) (1,500)
Projected balance at month end 600
What would the opening balance be for October?
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Cash budgets 10
The opening balance for October is the closing balance for September:
September October
$ $
Cash balance as at 1st 500 600
Add expected receipts 1,000 1,100
Less expected payments (900) (1,500)
Projected balance at month end 600 200
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Cash budgets 11
In practice, cash budgets can be difficult to work out.

Sales and purchases are usually on credit.
A company should know from experience the pattern of receipts from
receivables and payments to payables.
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Cash budgets 12
Example
A company discovered that its receipts from receivables are as
follows:
20% received in month of sale
50% received one month after sale
30% received two months after sale
Sales for November were $50,000 and were expected to increase by
$4,000 per month.
What are the receipts in January, February and March?
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Cash budgets 13
Example (continued)
November sales: 50,000
Received in month of sale 50,000  20% = 10,000
Received after 1 month 50,000  50% = 25,000
Received after 2 months 50,000  30% = 15,000
Actual cash receipts:
Nov $ Dec $ Jan $ Feb $ Mar $
Nov sales 10,000 25,000 15,000
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Cash budgets 14
Example (continued)
December sales: 54,000

Nov sales 10,000 25,000 15,000
Dec sales 10,800 27,000 16,200
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Cash budgets 15
Example (continued)
January sales: 58,000
Nov sales 10,000 25,000 15,000
Dec sales 10,800 27,000 16,200
Jan sales 11,600 29,000 17,400
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Cash budgets 16
Example (continued)
February sales: 62,000
The rest will be received in April.
Nov sales 10,000 25,000 15,000
Dec sales 10,800 27,000 16,200
Jan sales 11,600 29,000 17,400
Feb sales 12,400 31,000
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Cash budgets 17
Example (continued)
March sales: 66,000
The rest will be received in April and May
Nov sales 10,000 25,000 15,000
Dec sales 10,800 27,000 16,200
Jan sales 11,600 29,000 17,400
Feb sales 12,400 31,000
Mar sales 13,200
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Sales for the next few months are expected to be as follows.

$
January 60,000
February 70,000
March 55,000
April 65,000
10% of sales are expected to be cash. Of the credit sales, 80% are
expected to pay in the month after sale, and take a 2% discount. The
remaining 20% are expected to pay in the second month after the sale.
What is the value of sales receipts to be shown in the cash budget for
March?
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Answer
$
10% March sales for cash (10%  55,000) 5,500
80% February credit sales (80%  90%  98%  70,000)
49,392
20% January credit sales (20%  90%  60,000) 10,800
65,692
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Tackling the exam
Make sure that you read the following article on cash budgets from the
ACCA website:
www.accaglobal.com/gb/en/student/exam-support-
articles/cash-budgets.html
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Master budget
Once sales and functional budgets have been prepared, the master
budget can be drafted.
The master budget comprises the budgeted statement of profit or loss,
budgeted statement of financial position and the cash flow forecast.
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Chapter summary 1
1. Preparation of budgets
▪ The budget committee co-ordinates the preparation and administration
of budgets.
2. The budget preparation timetable

▪ You must be able to describe the steps stated in the budgeting
process.
3. Principle budget factor

▪ The principal budget factor should be identified at the start of the
process, and the overall budget constructed around this limiting factor.
This is often sales demand.
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Chapter summary 2
4. Initial preparation of budgets

▪ Care must be taken to ensure that all the components of a full
operating budget are consistent with one other.
5. Master budget
▪ This pulls together all the individual budgets and is usually comprised
of a budget income statement, statement of financial position and cash
budget.
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Chapter 11 • Behavioural implications
• Participation
Making budgets work • Using budgets as targets
• Motivation and the
management accountant
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• Explain the importance of motivation in performance management

• Identify factors in a budgetary planning and control system which
influence motivation
• Explain the impact of targets upon motivation
• Discuss managerial incentive schemes
• Discuss the advantages and disadvantages of a participative approach
to budgeting
• Explain top down, bottom up approaches to budgeting
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Overview
Making budgets work
Behavioural Performance
Participation
implications evaluation
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Behavioural implications 1
Budgets as a source of conflict
• Budgeting is a multi-purpose activity and so it means different things to

different people.
Budget purposes
• A forecast
• A means of allocating resources
• A yardstick
• A target
Conflict is therefore inevitable
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Negative affects of budgets include:
At the planning stage

• Managers may fail to coordinate plans with those of other budget
centres.
• They may build slack into expenditure estimates.
When putting plans into action

• There could be minimal cooperation and communication between
managers.
• Managers might try to achieve targets but not beat them.
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Negative aspects of budgets (continued)
Using control information

Resentment can occur when:
• Managers see the information as part of a system of trying to find

fault with their work
• There is scepticism as to the value of information (eg inaccurate,
too late or not understood)
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Other forms of resentment
• The managers who set the budget or standards are often not the
managers who are then made responsible for achieving budget
targets.
• The goals of the organisation as a whole, as expressed in a budget,
may not coincide with the personal aspirations of individual
managers.
• Control is applied at different stages by different people. Different
managers can get in each others' way, and resent the interference
from others.
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Motivation
• Motivation is what makes people behave in the way that they do.
• It comes from individual attitudes, or group attitudes.
• Individuals will be motivated by personal desires and interests.
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Motivation
• It is vital that the goals of management and the employees harmonise

with the goals of the organisation as a whole.
• This is known as goal congruence.
• You will come across this term frequently in your future studies if you
continue with ACCA exams.
• Dysfunctional decision making occurs when goal congruence does
not exist or is impaired.
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Motivation and pay
• Pay can be an important motivator.

• However, formal reward and performance evaluation systems can
encourage dysfunctional behaviour.
• Eg managers pad their budgets in anticipation of cuts.
• Targets must be challenging, but fair, otherwise individuals will become
dissatisfied.
• Pay can be a demotivator as well as a motivator.
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Participation 1
Participation
Budget setting styles
• Imposed (from the top down)

• Participative (from the bottom up)
• Negotiated
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Participation 2
Advantages of participative approach
• More realistic budgets

• Coordination, morale and motivation improved
• Increased management commitment to objectives
Disadvantages of participative approach
• More time consuming

• Budgetary slack may be introduced
• Can support 'empire building'
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Participation 3
Times when imposed budgets are effective
• In newly-formed organisations
• In very small businesses
• During periods of economic hardship
• When operational managers lack budgeting skills
• When the organisation's different units require precise coordination
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Participation 4
Advantages of imposed-style approach
• Strategic plans likely to be incorporated into planned activities

• Enhanced coordination between plans and objectives of divisions
• Use of senior management's awareness of total resource availability
• Decrease the input from inexperienced or uninformed lower-level
employees
• Decrease the period of time taken to draw up the budgets
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Participation 5
Disadvantages of imposed-style approach
• Dissatisfaction as it is hard to be motivated to achieve targets set by

somebody else.
• The feeling of team spirit may disappear.
• Acceptance of organisational goals may be limited.
• The feeling of the budget as a punitive device could arise.
• Managers who are performing operations on a day to day basis are
likely to have a better understanding of what is achievable.
• Unachievable budgets could result if consideration is not given to local
operating and political environments.
• Lower-level management initiative may be stifled.
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Participation 6
Negotiated style of budgeting
• 'A budget in which budget allowances are set largely on the basis of
negotiations between budget holders and those to whom they report'.
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Participation 7
• A well-designed control system can help to ensure goal congruence.

• Continuous feedback prompting appropriate control action should
steer the organisation in the right direction.
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Participation 8
Features of feedback
• Reports should be clear and comprehensive.

• The 'exception principle' should be applied so that significant
variances are highlighted for investigation.
• Reports should identify the controllable costs and revenues.
• Reports should be timely to allow control action before any adverse
results get much worse.
• Information should be accurate.
• Reports should be communicated to the manager who has
responsibility and authority to act on the matter.
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Participation 9
Budgetary slack
• The difference between the minimum necessary costs and the costs
built into the budget or actually incurred.
• Managers might deliberately overestimate costs and underestimate
sales so that they will not be blamed for overspending and poor
results.
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Using budgets as targets 1
Once decided, budgets become targets.

As targets, they can motivate managers to achieve a high level of
performance.
But how difficult should targets be?
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There is likely to be a demotivating effect where an ideal standard of

performance is set.
A low standard of efficiency is also demotivating, because there is no
sense of achievement in attaining the required standards.
As 'normal' (level that has been achieved in the past) might encourage
budgetary slack.
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To ensure managers are properly motivated, two budgets can be used:
• One for planning and decision making, based on reasonable

expectations (expectations budget)
• One for motivational purposes, with more difficult targets (aspirations
budget)
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Motivation and the management accountant 1
Management and the management accountant require strategies and

methods for dealing with tensions and conflict.
• For example, should targets be adjusted for uncontrollable and

unforeseeable environmental influence?
• But what is then the effect on motivation if employees view
performance standards as changeable?
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How senior management can offer support:
• Using a system of responsibility accounting

• Allowing managers to have a say in formulating their budgets
• Offering incentives to managers who meet budget targets
• Not regarding budgetary control information as a way of apportioning
blame
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The management accountant can aid budgetary control:
• Develop a working relationship with operational managers

• Explain the meaning of budgets and control reports
• Keep accounting jargon to a minimum
• Make reports clear and to the point
• Provide control information with a minimum of delay
• Make control information as useful as possible
• Make sure that actual costs are recorded accurately
• Ensure that budgets are up-to-date and ensuring that standards are
'fair' so that control information is realistic
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A profit sharing scheme is a scheme in which employees receive a

certain proportion of their company's year-end profits (the size of their
bonus being related to their position in the company and the length of
their employment to date).
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Disadvantages of a profit sharing scheme
• Employees must wait until the year end for a bonus.

• Factors affecting profit may be outside the control of employees, in
spite of their greater efforts.
• Too many employees are involved in a single scheme for the scheme
to have a great motivating effect on individuals.
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A share option scheme is a scheme which gives its members the right
to buy shares in the company for which they work at a set date in the
future and at a price usually determined when the scheme is set up.
An employee share ownership plan is a scheme which acquires

shares on behalf of a number of employees, and it must distribute these
shares within a certain number of years of acquisition
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Disadvantages
• The benefits are not certain, as the market value of shares at a future
date cannot realistically be predicted in advance.
• The benefits are not immediate, as a scheme must be in existence for
a number of years before members can exercise their rights.
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Chapter summary 1
1. Behavioural implications
▪ Motivation
▪ Goal congruence
▪ Behaviour problems
▪ Budgetary slack
2. Participation
▪ Top down vs bottom up
▪ Negotiated budgets
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Chapter summary 2
3. Performance evaluation
▪ Essential to inform employees how actual results are progressing.
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Chapter 12a
• Capital and revenue
expenditure
Capital expenditure
• Capital and revenue income
budgeting
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• Discuss the importance of capital investment planning and control.

• Define and distinguish between capital and revenue expenditure.
• Outline the issues to consider and the steps involved in the
preparation of a capital expenditure budget.
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Overview
Capital expenditure budgeting
Capital vs revenue Budgets
Expenditure Income Other
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Capital and revenue expenditure 1
Capital expenditure
• Acquisition of non-current assets

• Improvement in their earnings capacity
• Treated as non-current assets in the statement of financial position
• Depreciated through the statement of profit or loss
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Capital and revenue expenditure 2
Revenue expenditure
• For purpose of trade

• To maintain asset's existing earnings
• Expensed through the statement of profit or loss
• The correct/consistent calculation of profit depends on the correct/
consistent classification of items as revenue or capital
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Explain briefly the effect on the final accounts if capital expenditure is

treated as revenue expenditure.
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Answer
If capital expenditure is treated as revenue expenditure, profits will be

understated in the statement of profit or loss and non-current assets will
be understated in the statement of financial position.
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Capital and revenue income
• Capital income is the proceeds from the sale of non-trading assets.

• Revenue income is derived from
(a) The sale of trading assets
(b) Interest and dividends received from investments held by the
business
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Chapter summary
1. Capital versus revenue expenditure

▪ Capital expenditure involves investment in non-current assets with
longer term benefits for the company, eg new building.
▪ Revenue expenditure is for the purpose of trade, eg inventories for
sale or repairs to existing assets.
2. Capital versus revenue income

▪ Capital income is the proceeds from non trading activities, eg selling
non-current assets.
▪ Revenue income comes from trade, eg sales.
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Chapter 12b
• Project appraisal
Methods of project • Payback period
appraisal • The time value of money

• Discounted cash flow
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• 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 capital investment appraisal.
• Identify and evaluate relevant cash flows for individual investment
decisions.
• Explain and illustrate 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.
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Overview
Methods of project appraisal
Payback NPV IRR
Simple Discounted
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Tackling the exam
Example
Question
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Project appraisal 1
Investment appraisal techniques attempt to give advice about which

projects you should invest in.
Eg, if you had $100,000 how would you invest that?
You need to compare outlay to return.
Example
• If a construction company buys an excavator, the net inflows

generated by it will vary from year to year.
• As the machine ages, maintenance costs will rise and net income will
fall. Eventually the machine will be sold.
• The company needs some way of deciding whether the investment is
likely to be worthwhile.
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Project appraisal 2
The key methods of project appraisal are:
• The payback period

• Net present value
• Discounted payback period
• Internal rate of return (IRR)
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Payback period 1
The payback period is the time taken for the initial investment to be
recovered in the cash inflows from the project.
It's particularly relevant if there are liquidity problems, or if distant
forecasts are very uncertain.
It gives greater weight to cash flows generated in earlier years.
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Payback period 2
Eg, if a machine cost $40,000 and cash inflows generated from its use
were $8,000 each year, the payback would be:
$40,000 / $8,000 = 5 years
Target paybacks vary widely from business to business.
Note that cash flows are used, not profit.
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Payback period 3
If inflows are irregular you need to keep track of cumulative cash inflows.
Eg:
$ Cash flow $ Cumulative cash flow
Year 1 (80,000) Year 1 (60,000)
Year 1 20,000 Year 2 (35,000)
Year 2 25,000 Year 3 0
Year 3 35,000 Year 4 20,000
Year 4 20,000 Year 5 30,000
Year 5 10,000
You can see that the initial outlay has been recouped by the end of Year
3 – a payback of 3 years.
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Payback period 4
Example
P Q
$'000 $'000
Investment 60 60
Year 1 profits 20 50
Year 2 profits 30 20
Year 3 profits 50 5
Q pays back first, but ultimately P's profits are higher on the
same amount of investment.
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A machine was bought for $18,000 and can be sold for $3,000 at the end
of its life.
Pre-depreciation earnings for each of the next 8 years are expected to be
$300, $5,700, $4,200, $1,800, $3,900, $2,800, $4,200, $1,800.
What is the payback period in years and months?
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Answer
The payback period is 5 years and 9 months.
Year Cash flow Cumulative cash flow
1 (18,000)
1 300 (17,700)
2 5,700 (12,000)
3 4,200 (7,800)
4 1,800 (6,000)
5 3,900 (2,100)
6 2,800 700
Payback in year 6.
2,100 / 2,800 = 0.75 0.75  12 months = 9 months
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Payback period 5
Advantages
• Simple to calculate and understand

• Concentrates on short-term, less risky flows
• Can identify quick cash generators
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Payback period 6
Disadvantages
• Ignores total project return

• Ignores time value of money (see next slide)
• Ignores timing of flows after payback period
• Arbitrary choice of cut-off
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The time value of money 1
Would you rather have $1,000 now or $1,000 in one year's time?
Most people would say now.
It can be invested for future enjoyment.
There is less risk if it is taken now – despite hopes and promises it may
not appear in a year!
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Say current interest rates were 10%.

If $1,000 is offered now or in a year then the choice is really
$1,000 now worth $1,000 now worth

$1,100 in 1 year $1,000 in 1 year
So two amounts of cash, received or paid at different times cannot be

directly compared.
They must be adjusted for their different times.
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To compare amounts received at different times we convert the amounts

as at the present time – and we call these present values.
To calculate present values you need to understand compounding and
discounting.
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Compound interest is when the interest accumulates.

Interest is calculated on the original amount and on interest so far.
Eg:
• Year 1 $1,000  10% = $100
• Year 2 $1,100  10% = $110
• Year 3 $1,210  10% = $121
• Or we can use the formula.
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S = P(1 + r)n
Where S = future value of investment
P = amount invested now
r = rate of interest
n = number of years of investment
After three years at compound 10%, $1,00 will become:

$1,000  (1 + 0.1)3 = $1,331
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$800 is placed on deposit for five years at a rate of interest of 14%

compound.
How much will be in the account at the end of the period?
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Answer
$800  (1 + 0.14)5 = $1,540.33
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When interest is compounded at intervals of less than a year, an

effective annual rate can be worked out as:
12
n
(1+r) – 1
Or
(1+r)365/x – 1
Where
r is the rate for each time period
n is the number of months in the time period
x is the number of days in the time period
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So if you were told that interest was calculated at 3% compounded every

quarter, the effective rate would be:
(1 + 0.03)12/3 – 1 = 0.1255 or 12
12.55%
n
Note that this is higher than simply 4  3% as there is compounding

within the year.
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A nominal rate of interest is an interest rate expressed as a per annum

figure although the interest is compounded over a period of less than one
year.
12
The corresponding effective rate of interest
n is the annual percentage
rate (APR)
Eg a bank quotes an annual rate of 12% (nominal) for a loan but it

charges interest each quarter.
This means it charges 3% each quarter.
As we saw above, this is equivalent to 12.55%.
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Discounting is the reverse of compounding.

Remember the compounding formula was:
S = P(1 + r)n 12
n
We can rearrange this formula to calculate the amount we would have to
invest now to build up an investment to a particular size.
P = S / (1 + r)n
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We can use this discounting formula to find a present value.

For example, the present value of $1,000 received at the end of two
years using 10% is: 12
n
$1,000 / 1.12 = $826.45
P = S / (1 + r)n
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What is the present value of $1,000 received at the end of three years
using a 10% interest rate?
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Answer
$1,000 / (1 + 0.1)3 = $751.31
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Discounted cash flow 1
Discounted cash flow (DCF) is a technique for evaluating capital

investment projects, using discounting arithmetic to determine whether or
not they will provide a satisfactory return.
12
n
DCF can be used in:

• The net present value (NPV) method
• The internal rate of return (IRR) method
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The net present value method calculates the present value of all cash
flows, and sums them to give the net present value.
If this is positive, then the project is acceptable.
Eg:
• A machine costs $20,000 and will yield net cash inflows of $8,000,
$9,000 and $7,000 at the end of each of the next three years.
• Is the machine a worthwhile investment?
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If no account is taken to timing differences then:
• Cost = $20,000
12
• Cash inflows = $24,000 n
However we know that it is not valid to compare the cash flows without
adjusting for different timings.
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Time 0 means now.

A discount factor of 1 means no discount (because it is now).
12
Time Cash flow (A) Discount Present
n
factor (B) value (AB)
0 (20,000) 1 (20,000)
1 8,000 1 / 1.1 7,273
2 9,000 1 / 1.12 7,438
3 7,000 1 / 1.13 5,259
NPV: (30)
The present values are added to give an NPV of ($30).

As this is negative, the machine purchase is not worthwhile.
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To make discounted cash flow calculations easier we use discount tables.

These will be provided in the exam and look similar to this.
12
Period 1% 2% 3% 4% 5% n 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
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So if we had used the tables in our previous example, it would have

looked like this:
Time Cash flow (A) 12Discount Present
nfactor (B) value (AB)
0 (20,000) 1 (20,000)
1 8,000 0.909 7,272
2 9,000 0.826 7,434
3 7,000 0.751 5,257
NPV: (37)
• You can see that this gives a slightly different NPV.
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Tackling the exam
In the exam always use the discount factor tables where

possible.
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Annuities and perpetuities:
• Annuities are an annual cash payment or receipt which is the same

amount every year for a number of 12
years.
n
• Eg a cash flow of $8,000 every year

0 Nil 1 Nil
1 8,000 0.909 7,272
2 8,000 0.826 6,608
3 8,000 0.751 6,008
NPV: 19,888
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• This is the same as

12
$8,000  (0.909 + 0.826 + 0.751)
n = $8,000  2.486 = $19,888
0 Nil 1 Nil
1 8,000 0.909 7,272
2 8,000 0.826 6,608
3 8,000 0.751 6,008
NPV: 19,888
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• This is the same as

12
$8,000  (0.909 + 0.826 + 0.751)
n = $8,000  2.486 = $19,888
Or, we could use the annuity tables and look up the annuity factor for
three years at 10%.
The table gives us 2.487.
Notice that this is slightly different from adding up the discount factors
individually.
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A project would involve a capital outlay of $120,000. Profits (before

depreciation) would be $30,000 per year. The cost of capital is 12%.
Would the project be worthwhile if it lasts:
(a) Five years

(b) Seven years
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Answer
If the project lasts five years, it will not be worthwhile.
Years Cash flow Discount factor Present value

$ 12% $
0 (120,000) 1.000 (120,000)
1–5 30,000 pa 3.605 108,150
NPV (11,850)
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Answer (cont'd)
If the project lasts seven years, it will be worthwhile.
Years Cash flow Discount factor Present value

$ 12% $
0 (120,000) 1.000 (120,000)
1–7 30,000 pa 4.564 136,920
NPV 16,920
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• You may get a question with a more12complicated annuity.

n
• Eg what is the present value of $10,000 costs incurred each year from
years 3 to 6 when the cost of capital is 10%?
• We need to take the annuity factor for years 1 to 6 and deduct the
annuity factor for years 1 to 2. This will give us a factor for years 3 to 6
only.
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What is the present value of $10,000 costs incurred each year from years
3 to 6 when the cost of capital is 10%?
• Annuity factor for years 1 to 6 4.355

• Less annuity factor for years 1 to 2 (1.736)
• Annuity factor for years 3 to 6 2.619
• PV of costs = $10,000  2.619 = $26,190
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• A perpetuity is an annuity that lasts forever.

• The present value of a perpetuity of 'a' per annum, commencing in one
year, is PV = a / r where r is the cost of capital as a proportion.
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The internal rate of return (IRR) technique uses a trial and error
method to discover the discount rate which produces the NPV of zero.
12
n
The internal rate of return method of DCF involves two steps.
• Calculating the rate of return which is expected from a project

• Comparing the rate of return with the cost of capital
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 a 
• IRR = A +
 a − b  ( B − A) 
• Where A is the discount rate which 12

provides the positive NPV
n
• a is the amount of the positive NPV
• B is the discount rate which provides the negative NPV
• b is the amount of the negative NPV
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NPV and IRR comparison
• For conventional cash flows both methods give the same decision
12
n
NPV
• Simpler to calculate
• Better for ranking mutually exclusive projects
• Easy to incorporate different discount rates
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IRR
• More easily understood

12
• Ignores relative size of investmentsn
• May be several IRRs if cash flows not conventional
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Discounted payback method
• The discounted payback method applies discounting to arrive at a

payback period after which the NPV becomes positive.
• It is an adaptation of the payback technique.
• It takes some account of the time value of money.
• To calculate the discounted payback period, we establish the time at
which the net present value of an investment becomes positive.
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For example:
Time Cash flow (A) Discount Present value Cumulative
factor (B)
12 (AB) PV
n
0 (20,000) 1 (20,000) (20,000)
1 8,000 0.909 7,272 (12,728)
2 9,000 0.826 7,434 (5,294)
3 8,000 0.751 6,008 714
NPV: 714
Discounted payback = 2 years + 5,294 / 6,008

= 2.9 years
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Note
The discounted payback fails to take account of positive cash flows
occurring after the end of the payback period.
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Relevant costs
• Avoidable cost – is a cost which would not be incurred if the activity

to which it related did not exist
• Opportunity cost – benefit which would have been earned but which
was given up, by choosing one option instead of another
• Differential cost – is the difference in the cost of alternatives
• Controllable costs – an item of expenditure which can be directly
influenced by a given manager within a given time span
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Non-relevant costs
• Sunk cost – past (historical) cost which

12 is not directly relevant in
n
decision making
• Fixed costs – unless given an indication to the contrary, assume fixed
costs are irrelevant and variable costs are relevant
• Direct and indirect costs may be relevant or irrelevant depending on
the situation
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Past exam question
An investor has the choice between two investments. Investment Exe

offers interest of 4% per year compounded semi-annually for a period of
three years. Investment Wye offers one interest payment of 20% at the
end of its four-year life.
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What is the annual effective interest rate offered by the two

investments?
Investment Exe Investment Wye
A 4.00% 4.66%
B 4.00% 5.00%
C 4.04% 4.66%
D 4.04% 5.00%
(2 marks)
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The correct answer is C. The answer can be arrived at by calculation

(Investment Exe annual effective return = 1.022 – 1 = 0.0404 or 4.04%
and investment Wye annual effective return = 1.200.25 – 1 = 0.0466 or
4.66%). Alternatively the answer can be 'reasoned' out: investment Exe's
semi annual compounding must result in a higher effective annual rate
than 4% (2 × 2%) and a 20% return over a four-year period must have an
effective annual rate of less than 5% (20% ÷ 4 years) when the
compounding effect is allowed for. Just over 32% of candidates
incorrectly selected option D. This suggests that many find it difficult to
convert a multi year rate into an effective annual rate.
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Past exam question
A project has an initial outflow of $12,000 followed by six equal annual

cash inflows, commencing in one year's time. The payback period is
exactly four years. The cost of capital is 12% per year.
What is the project's net present value (to the nearest $)?
A $333
B -$2,899
C -$3,778
D -$5,926
(2 marks)
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The correct answer is A.

A four-year payback period implies an (equal) annual cash flow of
$12,000 ÷ 4 years = $3,000 per year. As these cash flows run for 6 years
the NPV is equal to $333 ( – $12,000 + annuity factor for 6 years @
12% × $3,000 = – $12,000 + 4.111 × $3,000 = $333).
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Chapter summary 1
1. Payback period
▪ Time taken for cash flows to repay the initial investment.
2. Time value of money

▪ Compensation for the time value of money, recognising that $ today is
worth more than $ in the future, due to inflation, interest and risk.
3. Compounding
▪ Earning interest on interest already received. Considered non annual
rates of interest – equivalent rates (EAR).
4. Discounted cash flows

▪ Opposite of compounding, using tables or formula.
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Chapter summary 2
5. Net present value

▪ The net total of the discounted cash flows of the project.
6. Annuities
▪ A constant sum of money for a fixed period of time, the present value
is calculated using the cumulative discount tables.
▪ Loan repayments, which included the annuities and the interest.
▪ Perpetuities – annuity paid or received forever.
7. Internal rate of return

▪ The discount rate that gives a NPV of zero.
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Chapter 13
Standard costing • Standards
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• Explain the purpose and principles of standard costing.

• Explain and illustrate the difference between standard, marginal and
absorption costing.
• Establish the standard cost per unit under absorption and marginal
costing.
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Overview
Standard costing
Definition Setting standards
Use in cost card Uses in business
Advantages/disadvantages
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Standards 1
A standard cost is an estimated unit cost built up from standards for

each cost element.
The total standard cost of a product is built up from standards for each
cost element.
Examples
• Standard quantities of materials at standard prices

• Standard hours of labour time at standard rates
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Standards 2
Standard costing has a variety of uses eg:
• To value inventories and cost production

• To act as a control device by establishing standards, highlighting
activities that are not conforming to plan and thus alerting
management to areas that need corrective action
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Standards 3
Standard costing involves:
• The establishment of predetermined estimates of the costs of products

or services
• The collection of actual costs
• The comparison of the actual costs with the predetermined estimates
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Standards 4
STANDARD COST CARD

PRODUCT LW
$
Direct material (standard quantity  standard price) X
Direct labour (standard time  standard rate) X
Standard direct cost X
Variable production overhead (standard time  standard rate) X
Standard variable cost of production X
Fixed production overhead (standard time  standard rate) X
Standard full production cost X
Administration and marketing overhead X
Standard cost of sales X
Standard profit X
Standard selling price X
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Standards 5
Types of standard
Ideal standard
• These are based on perfect operating conditions – no wastage,

spoilage, inefficiencies, idle time, breakdowns.
• Variances from ideal standards may identify areas where large
savings may be made.
• Ideal standards are likely to have an unfavourable motivational
impact as reported variances will be adverse.
• Employees will often feel that the goals are unattainable and therefore
not work so hard.
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Standards 6
Attainable standards
• Based on premise that a standard amount of work will be carried out

efficiently and effectively.
• Some allowance is made for wastage and inefficiencies.
• If well-set they provide a useful psychological incentive by giving
employees a realistic, but challenging, target of efficiency.
• The consent and co-operation of employees involved in improving the
standard are required.
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Standards 7
Current standards
• Based on current working conditions (current wastage, current

inefficiencies).
• The disadvantage of current standards is that they do not attempt to
improve on current levels of efficiency.
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Standards 8
Basic standards
• These are kept unaltered over a long period of time, and may be
out of date.
• They are used to show changes in efficiency or performance over a
long period of time.
• Basic standards are perhaps the least useful and least common type
of standard in use.
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Standards 9
Uses of standards as a control technique
• Standard costing is a control technique that compares standard costs

and revenues with actual results to obtain variances.
• These variances are then used to stimulate improved performance.
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Standards 10
Problems with setting standards
• Inflation
• Choice of an efficiency standard
• Materials quality versus wastage
• Accounting for price variations/discounts
• Behavioural problems/motivation
• Cost of setting up
• Time to set up
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Standards 11
Advantages of setting standards
• Facilitates budgetary control

• Leads to more accurate budgeting
• Assists performance measurement
• Assists in target setting for staff
• Assists in price setting
• Simplifies bookkeeping
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Standards 12
Direct material prices will be estimated by the purchasing department

from their knowledge of the following:
• Purchase contracts already agreed

• Pricing discussions with regular suppliers
• The forecast movement of prices in the market
• The availability of bulk purchase discounts
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Standards 13
Direct labour rates per hour will be set by discussion with the
personnel department and by reference to the payroll and to any
agreements on pay rises with trade union representatives of the
employees.
• A separate hourly rate or weekly wage will be set for each different
labour grade/type of employee.
• An average hourly rate will be applied for each grade (even though
individual rates of pay may vary according to age and experience).
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Tackling the exam
An exam question may give you actual costs and variances and require
you to calculate the standard cost.
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Chapter summary 1
1. Standards
▪ A standard is prepared by management in advance, and details their
expectations of the future.
▪ A standard cost is a predetermined estimated unit cost used for
inventory valuation and control.
▪ A standard cost card shows full details of the standard cost of each
product.
2. Standard setting
▪ Standards can be set at different overall levels – ideal, current, basic,
expected.
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Chapter summary 2
3. Uses of standards
▪ Standards can be used to assess and control actual performance
through the analysis of variances.
4. Advantages and disadvantages

▪ They can be timely and costly to set up, but they help to facilitate
budgetary control
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• Variances
Chapter 14a • Direct material cost variances
• Direct labour cost variances
Cost variances • Variable production overhead
variances
• Fixed production overhead
variances
• Flexed budgets and variances
• Reasons for variances
• Significance of variances
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• Calculate the following variances:

Materials total, price and usage
Labour total, rate and efficiency
Variable o/h total, expenditure and efficiency
Fixed overhead total, expenditure and where appropriate volume,
capacity and efficiency
• Interpret all of the variances above.
• Explain factors to consider before investigating variances, explain
possible causes of all of the variances above and recommend control
action.
• Explain the interrelationships between the variances above.
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• Calculate simple variances between flexed budget, fixed budget and

actual sales, costs and profits.
• Discuss the relative significance of variances.
• Explain potential action to eliminate variances.
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Overview
Basic variance
analysis
Variable cost Fixed cost

variances variances
Calculation
• Materials – Price Calculation
– Usage • Fixed o/h – Expenditure
• Labour – Rate – Volume
– Efficiency
• Variable o/h – Expenditure efficiency capacity
– Efficiency
Interpretation/
interdependence
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Tackling the exam
Example
Question
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Variances
A variance is the difference between an actual result and an expected

result.
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Direct material cost variances 1
Example
• Product LW has a standard direct material cost as follows:

• 10 kg of material M at $10 per kg = $100 per unit of M.
• During a period, 1,000 units of LW were manufactured, using
11,700 kg of material M, which cost $98,600
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• Direct material total variance

$
1,000 units should have cost 100,000
but did cost 98,600
Direct material total variance 1,400 (F)
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• Direct material usage
1,000 units should have used (× 10 kg) 10,000 kg

but did use 11,700 kg
Usage variance in kgs 1,700 kg (A)
× standard cost per kilogram × $10
Material M usage variance $17,000 (A)
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• Direct material price

$
11,700 kg of M should have cost 117,000
but did cost 98,600
Material M price variance 18,400 (F)
• Direct material cost variance = material price variance + material

usage variance
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Direct labour cost variances 1
Example
• The standard direct labour cost of product LW is as follows:

• 2 hours of grade A labour at $5 per hour = $10 per unit of product LW
• During a period, 1,500 units of product LW were made, and the direct
labour cost of grade A labour was $17,500 for 3,080 hours of work
• 100 hours were recorded as idle time
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Direct labour total variance

$
1,500 units of product LW should have cost (× $10) 15,000
but did cost 17,500
Direct labour total variance 2,500(A)
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Direct labour efficiency variance
1,500 units of product LW should take (× 2 hours) 3,000 hrs

but did take (3,080 – 100) 2,980 hrs
Direct labour efficiency variance in hrs 20 hrs (F)
× standard rate per hour × $5
Direct labour efficiency variance in $100 (F)
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Direct labour rate variance

$
3,080 hours of grade A labour should have cost (× $5)
15,400
but did cost 17,500
Direct labour rate variance 2,100 (A)
• Idle time variance = idle hours × standard rate per hour = 100 × $5
= $500 (A)
• Direct labour total variance = labour rate variance + labour efficiency
variance + idle time variance
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Variable production overhead variances 1
Example
The variable production overhead cost of product LW is as follows:

2 hours @ $1.50 = $3 per unit
During a period, 6,400 units of product LW were made.
The labour force worked 820 hours, of which 60 were recorded as idle
time.
The variable overhead cost was $1,230.
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Expenditure variance
$
760 hours of var prod o/h should cost
(× $1.50) 1,140
but did cost
1,230
Variable production overhead expenditure 90 (A)
variance
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Efficiency variance
400 units of product LW should take (× 2 hrs) 800 hrs

but did take (active) 760 hrs
Variable prod o/h efficiency variance in hrs 40 hrs (F)
× standard rate per hour × $1.50
Variable production overhead efficiency $60 (F)
variance in $
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Fixed production overhead variances 1
In an absorption costing system, fixed production overhead variances try

to explain the under or over absorption of fixed production overheads.
Method of calculating cost variances for variable cost items is essentially
the same for materials, labour and variable overheads.
Calculation of fixed production overheads is very different.
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In an absorption costing system, fixed production overhead variances are an

attempt to explain the under or over absorption of fixed production overheads.
Method of calculating cost variances for variable cost items is essentially same
for materials, labour and overheads.
Calculation of FIXED PRODUCTION

fixed production VOLUME
OVERHEAD TOTAL
overheads EFFICIENCY
VARIANCE
Is very different VARIANCE
VOLUME
EXPENDITURE VOLUME CAPACITY
VARIANCE VARIANCE VARIANCE
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Example
• Budgeted production 1,000 units of product A

• Actual fixed overhead expenditure = $20,450
• Time required to produce one unit of product A = 5 hours
• Actual production = 1,100 units of A
• Budgeted fixed overhead = $20,000
• Actual hours worked = $5,400
• Standard fixed overhead cost per unit of product A = $20 per unit
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$
Fixed overhead incurred 20,450
Fixed overhead absorbed (1,100 × $20) 22,000
Fixed overhead total variance 1,550 (F)
Over absorbed overhead
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$
Budgeted fixed overhead expenditure 20,000
Actual fixed overhead expenditure 20,450
Fixed overhead expenditure variance 450 (A)
• Adverse variance because actual expenditure was greater than

budgeted expenditure
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$
Actual production at std rate (1,100 × $20) 22,000
Budgeted production at std rate (1,000 × $20) 20,000
Fixed overhead volume variance 2,000 (F)
• Favourable variance because output was greater than expected
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The fixed overhead volume variance can be further subdivided into a

fixed overhead efficiency variance and a fixed overhead capacity
variance.
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Fixed overhead volume efficiency variance
X units should take X hrs

But did take X hrs
Fixed o/h volume efficiency var in hrs X hrs
× std fixed o/h absorption rate per hour ×$X
Fixed o/h volume efficiency var in $ $X
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Fixed overhead volume capacity variance
Budgeted hours of work X hrs

Actual hours of work X hrs
Fixed o/h volume capacity var in hrs X hrs
× std fixed o/h absorption rate per hour ×$X
Fixed o/h volume capacity var in $ $X
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Graph of fixed overhead costs and variances
Fixed overhead volume variance
Budgeted fixed overhead cost

Fixed Fixed overhead expenditure
overhead variance
cost Actual fixed overhead cost
$
Total fixed overhead variance
Actual no. of units

Standard
fixed overhead Number of
cost units produced
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Tackling the exam
Remember, in a marginal costing system, the only fixed overhead

variance is an expenditure variance.
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BUDGET Unit Total
$ $
Sales (8,000 units) 75 600,000
Production (8,700 units)
Materials 4 kg @ $4.50/kg 18 156,600
Labour 5 hrs @ $5/hr 25 217,500
Variable 5 hrs @ $2/hr 10 87,000

overheads
53 461,100
Closing inventory (700 units @ $53/unit)) (37,100)
424,000
Budgeted 176,000
contribution
Budgeted fixed
overheads 130,500
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ACTUAL $
Sales (8,400 units) 613,200
Materials purchased 35,464 kgs for $163,455 161,043
(used 34,928 kgs)
Labour (45,400 hours worked and paid) 224,515

Variable 87,348
overheads
472,906
Closing inventory (500 units @ $53/unit) (26,500)
446,406
Actual contribution 166,794
Actual fixed 134,074
overheads
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Required
(a) What is the materials price variance?

(b) What is the materials usage variance?
(c) What is the labour rate variance?
(d) What is the labour efficiency variance?
(e) What is the variable overhead expenditure variance?
(f) What is the variable overhead efficiency variance?
(g) What is the fixed overhead expenditure variance?
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Answer
Materials
(a) Price variance: based on actual purchases

$
35,464 kg should cost @ $4.50/kg 159,588
35.464 kg did cost 163,455
3,867 A
(b) Usage variance: based on actual production

Kg
8,900 units should use @ 4 kg 35,600
8,900 units did take 34,928
672 kg F
Valued at standard @ $4.5/kg 3,024 F
Total materials variance $843 A

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Answer (cont'd)
Labour
(c) Rate variance: based on actual hours paid

$
45,400 hours should cost @ $5/hr 227,000
45,400 hours did cost 224,515
$2,485 F
(d) Efficiency variance: based on actual production

Hrs
8,900 units should take @ 5 hrs 44,500
900 hrs A
Valued at standard @ $5/hr $4,500 A
Total labour variance $2,015 A

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Answer (cont'd)
(e) Expenditure variance: based on actual hours worked

$
45,400 hours should cost @ $2 90,800
45,400 hours did cost 87,348
3,452 F
(f) Efficiency variance: based on actual production
Hrs
8,900 units should take @ 5 hrs 44,500
900 hrs A
Valued at standards @ $2 $1,800 A
Total variable overhead variance $1,652 F
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Answer (cont'd)
Fixed overheads
(g) Expenditure variance:

$
Actual expenditure 134,074
Budgeted expenditure 130,500
3,574 A
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Flexed budgets and variances
Total variances are the difference between flexed budget figures and
actual figures.
Eg
No of units produced 1,000 Flexed

budget 1,000 Actual Total variance
$ $ $
Direct materials 100,000 98,600 1,400 (F)
Direct labour 10,000 8,900 1,100 (F)
Variable overheads 3,000 3,075 75 (A)
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Reasons for variances 1
Material price
Favourable
• Unforeseen discounts
• Change in material
Adverse
• Price increase
• Careless purchasing
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Materials usage
Favourable
• Higher quality material

• Effective use of material
Adverse
• Defective material
• Excessive waste
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Labour rate
Favourable
• Lower rate paid
Adverse
• Wage rate increase
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Labour efficiency
Favourable
• Motivated staff
• Quality materials
Adverse
• Lack of training
• Sub-standard material
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Variable and fixed overhead
Favourable
• Cost savings
Adverse
• Excessive use
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Significance of variances 1
Interdependence of variances
• The cause of one variance (adverse) might be wholly or partly

explained by the cause of another favourable variance
Examples
• Material price and usage variances

• Material price and labour efficiency variances
• Labour rate and efficiency variances
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Interdependence Significant variances should be investigated.

The cause of one Factors to take into account:
variance (adverse)
might be wholly or
partly explained by
the cause of another MATERIALITY CONTROLLABILITY
favourable variance.
• Material price and
usage variances
COSTS OF TYPE OF
• Material price and INVESTIGATION STANDARD
labour efficiency
variances INTERDEPENDENCE
• Labour rate and
efficiency variances
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When to investigate
Considerations
• Size of variance
• Controllability of variance
• Cost of investigation
• Interrelationships with other variances
• Level of standard
• Trend emerging
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ABC Co has found that it has had an increasing adverse labour efficiency
variance for the last three months.
You learn that the company is using lots of temporary workers in a bid to
keep up with increased demand for its single product, the Z.
Which of the following control actions could be implemented by the
company to try to eliminate this?
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A Increase the hourly rate paid to temporary workers

B Offer paid overtime to the company's existing skilled employees
C Implement training for the temporary employees
D Reduce the number of supervisors
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Answer
B and C may reduce the adverse labour efficiency variances.

B would mean that the company's existing workforce complete the work
and they are likely to be quicker as they have more experience.
C increased training should also improve the efficiency of production.
A There is no evidence that increasing their salary will make them worker
faster and D reducing the amount of supervision is likely to have the
opposite effect, ie increasing the time taken to make each unit rather
than decreasing it.
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Tackling the exam
Make sure that you read the following article on fixed overhead
absorption from the ACCA website:
articles/overhead-absorption.html
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Chapter summary 1
1. Variances
▪ Variances show the differences between actual results and expected
results and provide information for performance evaluation and control
purposes.
2. Cost variances
▪ Cost variances can be calculated for materials, labour and overheads.
3. Fixed overheads
▪ In absorption costing, further analysis can be done on the fixed
overhead variances to better understand the reason for any under or
over absorption.
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Chapter summary 2
4. Interpretation of variances
▪ The interpretation of variances is a crucial element of the control
process. Variances are often interdependent and this must be taken
into account when deciding on the control action to implement.
5. When to investigate
▪ Before deciding whether to investigate a variance, factors such as
size, trend and controllability should be considered.
▪ The interdependencies between variances should also be considered.
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Chapter 14b
• Sales variances
Sales variances and • Operating statements
operating statements • Working backwards
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• Calculate sales price and volume variances.

• Reconcile budgeted profit with actual profit under standard absorption
costing.
• Reconcile budgeted profit or contribution with actual profit or
contribution under standard marginal costing.
• Calculate actual or standard figures where the variances are given.
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Overview
Further variance
analysis
Sales variance Operating statements
Calculate
• Sales – price variance AC MC
– sales volume
variance
Interpretation
Backward variances
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Sales variances 1
Selling price variance is a measure of the effect on expected profit of a

different actual selling price to standard selling price.
Sales volume profit variance is the difference between actual units sold
and the budgeted quantity, valued at the standard profit per unit.
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Sales variances 2
Example
• The standard selling price of product H is $15.

• Actual sales in 2001 were 2,000 units at $15.30 per unit.
• Budgeted sales were 2,200 units and standard full cost per unit of H is
$12.30.
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Sales variances 3
Selling price variance $

Sales revenue from 2,000 units
should have been (× $15) 30,000
but was (× $15.30) 30,600
Selling price variance 600 (F)
• Favourable variance because the price was higher than expected
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Sales variances 4
• Sales volume profit variance $

Budgeted sales volume 2,200
Actual sales volume 2,000
200 (A)
× standard profit per unit ($15 – $12.30) × $2.70
Sales volume profit variance $540 (A)
• Adverse variance because actual sales were less than budgeted
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BUDGET Unit Total
$ $
Sales (8,000 units) 75 600,000
Materials 4 kg @ $4.50/kg 18 156,600
Labour 5 hrs @ $5/hr 25 217,500
Variable 5 hrs @ $2/hr 10 87,000

overheads
53 461,100
Closing inventory (700 units @ $53/unit)) (37,100)
424,000
Budgeted 176,000
contribution
Budgeted fixed
overheads 130,500
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ACTUAL $
Sales (8,400 units) 613,200
Materials purchased 35,464 kgs for $163,455 161,043
(used 34,928 kgs)
Labour (45,400 hours worked and paid) 224,515

Variable 87,348
overheads
472,906
Closing inventory (500 units @ $53/unit) (26,500)
446,406
Actual fixed 134,074
overheads
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Required
(a) What is the sales price variance?

(b) What is the sales volume contribution variance?
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Answer
Sales
(a) Price variance: based on actual units sold $

630,000
8,400 units should sell for @ $75 613,200
8,400 units did sell for 16,800 A
(b) Volume variance:

Units
Budgeted sales 8,000
Actual sales 8,400
400 units F
Value at standard contribution per unit ($22) $8,800 F
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Operating statements 1
An operating statement is a regular report for management of actual

cost and revenues, as appropriate.
It will usually compare actual with budget to show variances.
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Operating statement (absorption costing)

$ $ $
Budgeted profit X
Sales volume profit variance X
Standard profit from actual sales X
Variances
Sales price X
Materials X
Labour X
Variable overheads X
Fixed overhead expenditure X
Fixed overhead volume X
X X X
Actual profit X
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An organisation may use standard marginal costing instead of

standard absorption costing.
In this case there will be two differences in the way variances are
calculated.
In a standard marginal costing system, there will be no fixed overhead
volume variance.
• Sales volume variance under absorption costing, valued at standard
profit margin
• Under marginal costing valued at standard contribution margin
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There will also be a difference in the operating statement under marginal

costing.
The operating statement under absorption costing begins with budgeted
profit.
Under marginal costing it begins with budgeted contribution.
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Operating statement (marginal costing)
$ $ $
Budgeted contribution X
Sales volume contribution variance X
Standard contribution from actual sales X
Variances
Sales price X
Materials X
Labour X
Variable overheads X
X X X
Actual contribution X
Budgeted fixed costs X

Fixed cost expenditure variance X
Actual fixed overheads X
Actual profit X
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Tackling the exam
Remember:
• In the marginal costing system the only fixed overhead variance is

an expenditure variance.
• The sales volume variance is valued at standard contribution
margin, not standard profit margin.
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Working backwards
• Working from a set of variances back to actual or budgeted data
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The direct labour cost data relating to last month was as follows:
Actual hours worked 28,000

Total direct labour cost $117,600
Direct labour rate variance $ 8,400 (adverse)
Direct labour efficiency variance $ 3,900 (adverse)
Required
To the nearest thousand (in hours), what are the total standard
labour hours last month?
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Answer
$
(1) Labour rate variance β109,200
Actual hours should cost
28,000 x standard cost 117,600
Actual hours did cost $8,400 A
Therefore, Standard = 109,200 = $3.90/hour

cost 28,000
(2) Labour efficiency variance
Hours
Actual units should take β 27,000
Actual units did take 28,000
1,000 hours (A)
Value @ standard cost (from (1)) $3.90 /hour
3,900 (A)
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A company uses standard marginal costing. Last month the standard

contribution on actual sales was $23,000 and the following variances
arose:
$
Total variable costs variance 3,250 Adverse
Sales price variance 4,000 Favourable
Sales volume contribution variance 7,500 Adverse
What was the actual contribution for last month?
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Answer
$
Standard contribution on actual sales (flexed contribution) 23,000
Sales price variance 4,000 Favourable
Total variable costs variance 3,250 Adverse
The sales volume variance reconciles from the budget contribution to the
flexed contribution and therefore is not required in this calculation.
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Past exam question
A company calculates the following under a standard absorption costing

system:
(i) The sales volume margin variance

(ii) The total fixed overhead variance
(iii) The total variable overhead variance
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If a company changed to a standard marginal costing system, which

variances could change in value?
A (i) only
B (ii) only
C (i) and (ii) only
D (i), (ii) and (iii) (2 marks)
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The correct answer is C. In a standard absorption costing system the

sales volume margin variance is based upon profit per unit, whereas
under a marginal costing system it is based upon contribution per unit. In
a standard absorption costing system the total fixed overhead variance
includes expenditure and volume variances. Under marginal costing only
the expenditure variance is included. Variable cost variances are the
same under both systems. Only 15% of candidates selected the correct
alternative. The most frequent answers were A (37% of candidates), and
B (30% of candidates). This is essentially a knowledge based question,
and the poor results suggest that candidates need to do more work in
this area.
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Past exam question

A company uses a standard absorption costing system. The following
figures are available for the last accounting period in which actual profit
was $108,000.
$
Sales volume profit variance 6,000 adverse
Sales price variance 5,000 favourable
Total variable cost variance 7,000 adverse
Fixed cost expenditure variance 3,000 favourable
Fixed cost volume variance 2,000 adverse
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What was the standard profit for actual sales in the last accounting
period?
A $101,000
B $107,000
C $109,000
D $115,000 (2 marks)
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The correct answer is C, but was chosen by only a handful of candidates.

The correct answer can be obtained by working backwards by adding
appropriate adverse variances and subtracting appropriate favourable
variances from actual profit. Standard profit on actual sales is exactly
what it says, actual units multiplied by standard profit per unit. As it is
based on actual units, a profit adjustment for the difference between
budgeted and actual volumes is not required, and hence the sales
volume variance should be ignored. The calculation can be most easily
understood by looking at the standard cost operating statement below.
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Answer to past exam question (cont'd)

$
• Budgeted profit not required
• Sales volume variance not needed
• Standard profit on actual 109,000
• Sales price variance 5,000 favourable
• Total variable cost variance 7,000 adverse
• Fixed cost expenditure variance 3,000 favourable
• Fixed cost volume variance 2,000 adverse
• Actual profit 108,000
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Answer to past exam question (cont'd)
If candidates understand how the operating statement works the correct

answer can be quickly calculated as $108,000 + $2,000 – $3,000 +
$7,000 – $5,000 = $109,000.
Incorrect answers were fairly evenly spread across the other three
alternatives.
Performance on another question involving standard cost operating
statements in the same exam was also poor.
This suggests a lack of understanding in this area.
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Chapter summary 1
1. Sales variances
▪ Sales price variance and sales volume variance measure the effect on
profit of different selling prices and volumes to the standard.
2. Operating statements
▪ Operating statements show how the combination of variances
reconcile budgeted profit and actual profit. Be prepared to produce
part of the operating statement only, for example budgeted materials
cost to actual materials cost.
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Chapter summary 2
3. Absorption versus marginal costing variances

▪ The differences in variance calculations between using absorption and
marginal costing include:
▪ Under marginal costing
─ Only the fixed overhead expenditure variance is needed
─ Sales volume variance calculated based on standard contribution
─ Operating statement reconciles budgeted contribution to actual
contribution and then to actual profit
4. Backwards variances
▪ Sometimes an exam question may be set which requires you to work
from a set of variances back to actual or budgeted data.
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• Mission statements
Chapter 15
• Goals and objectives
• Benchmarking
Target setting • External influences
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• Discuss the purpose of mission statements and their role in

performance measurement
• Discuss the purpose of strategic and operational and tactical
objectives and their role in performance measurement
• Discuss the impact of economic and market conditions on
performance management
• Explain the impact of government regulation on performance
management
• Discuss critical success factors and key performance indicators and
their link to objectives and mission statements
• Establish critical success factors and key performance indicators in a
specific situation
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• Discuss the relationship between short-term and long-term

performance
• Discuss the role of benchmarking in performance measurement
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Overview
Target setting
Improving External conditions

Mission statement
performance affect performance
Market conditions
Goals and objectives Benchmarking
Economic conditions
Government
CSFs
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Tackling the exam
Example
Question
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Mission statements 1
Performance measurement is a vital part of control.

It aims to establish how well something or somebody is doing in relation
to a planned activity.
Elements that might be assessed include:
• A machine
• A factory/division
• An organisation as a whole
• An individual
• A group of people
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As part of control, actual performance is compared with a standard or

target.
For machines, processes, departments and individuals, targets are set by
the budget.
At a higher level, to control the whole organisation, a more complex
process is required.
The mission statement is the vision of top management, what they are
trying to achieve, and how they wish to achieve it.
It is an important part of the process of controlling the whole organisation.
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The importance of mission
• Values and feelings are integral elements of customers' buying

decisions.
• A sense of mission can help motivate employees.
• Some people believe that there is an empirical relationship between
strong corporate values and profitability.
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Characteristics of a mission statement
• Brevity – easy to understand and remember

• Flexibility – to accommodate change
• Distinctiveness – to make the firm stand out
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Devise a mission statement for an independent cafe.
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Answer
A good mission statement should state what is unique about the cafe.
Here are some suggestions:
• Provide tasty, homemade organic food in a relaxed cafe

environment
• Quick, speedy lunches for people on the go
• Nutritious meals and snacks homemade on site
• Providing a local welcome for all
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Goals and objectives 1
Goals are derived from the mission and vision
• Operational goals can be expressed as objectives

Eg operational goal: Cut costs
• Objective: 'Reduce budget by 5%'
• Non-operational goals
Eg a university's goal might be to 'seek truth'
• Not all goals can be measured
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Many objectives are SMART
• Specific
• Measurable
• Attainable
• Results-orientated
• Time bounded
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Objectives can also be classified as strategic, tactical or operational.
• Strategic objectives: set the overall long-term objectives for the

organisation as a whole
• Tactical objectives: the 'middle tier' of objectives, designed to plan
and control individual functions within the organisation. Tactical
objectives are then implemented by setting operational objectives
• Operational objectives: day-to-day performance targets to ensure
that the organisation's operations are carried out efficiently or
effectively
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A critical success factor is
• 'An element of the organisational activity which is central to its future

success. Critical success factors (CSFs) may change over time, and
may include items such as product, quality, employee attitudes,
manufacturing flexibility and brand awareness.'
• A critical success factor is a performance requirement that is
fundamental to competitive success.
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Critical success factor examples
• Profitability
• Productivity
• Personnel development
• Public responsibility
• Market share
• Product leadership
• Employee attitudes
• Balance between short-range and long-range goals
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A key performance indicator (KPI) is
• Measure how well organisation is achieving the critical success factors

through key performance indicators (KPIs).
• CSFs represent 'what' an organisation needs to do in order to be
successful.
• KPIs are the measures that are then used to assess whether or not
the CSFs are being achieved.
• KPIs are a vital part of the control system for reviewing how
successfully a strategy has been implemented and how well an
organisation is performing.
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How they link together
• Mission statement – The business's rationale for existing and

statement of aspirations
• Strategic objectives – Quantified embodiments of mission (timescales,

profitability)
• CSFs – Elements which are central to future success
• KPIs – Measures used to assess whether CSFs are being achieved
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Benchmarking 1
• Attempts to identify best practices and improve performance
• Internal benchmarking – comparing unit or functions within the same

organisation
• Competitive benchmarking – using information gathered about other

businesses (eg using reverse engineering)
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Benchmarking 2
• Functional benchmarking – internal functions are compared with

those of the best external practitioners of those functions, regardless
of the industry they are in
• Strategic benchmarking – a type of competitive benchmarking aimed

at strategic action and organisational change
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Benchmarking 3
Advantages
• Comparisons carried out by the managers who have to live with any
changes implemented as a result
• Focuses on improvement in key areas and sets targets which are
challenging but achievable
• Can provide early warning signs of competitive disadvantage
• Should lead to greater instances of teamworking and cross-functional
learning
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External influences 1
External conditions can affect performance.
• Market conditions
Eg new competitor
• General economic conditions
Eg raising and lowering overall supply and demand
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External influences 2
Government influence can affect performance.
• Taxation
• Encouraging new investments
• Encouraging a wider spread of ownership
• Legislation
• Economic policy
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Chapter summary 1
1. Mission
▪ Top management's vision
2. Goals and objectives

▪ SMART
▪ Strategic, tactical, operational
3. Critical success factors

▪ Things which are fundamental to competitive success
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Chapter summary 2
4. Benchmarking
▪ Internal (within the same company)
▪ Competitive (reverse engineering)
▪ Functional
▪ Strategic
5. External influences
▪ Market conditions
▪ General economic conditions
▪ Government
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• Performance measures
Chapter 16
• Profitability and productivity
• Management measures
Financial • Cost control and cost reduction
performance • Value analysis
measurement
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• Discuss and calculate measures of financial performance (profitability,

liquidity, activity and gearing) and non-financial measures
• Calculate return on investment and residual income
• Explain the advantages and limitations of return on investment and
residual income
• Compare cost control and cost reduction
• Describe and evaluate cost reduction methods
• Describe and evaluate value analysis
• Discuss measures that may be used to assess managerial
performance and the practical problems involved
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Overview
Financial performance
measurement
Cost control Types of

Value
and cost performance
analysis
reduction measurement
Financial Non-financial
Asset turnover, ROI, ROCE, ROE,

current ratio, quick profit margin, gross
ratio profit margin,
cost/sales ratio
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Tackling the exam
Example
Question
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Performance measures
A range of performance measures is useful:
Financial measures
• Profit
• Revenue
• Cost
• Share price
• Cash flow
And non-financial measures – see Chapter 17
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Profitability and productivity 1
• Profit (or net or sales) margin or operating profit % = Operating

profit/revenue) × 100%
• Key measure of efficiency for profit-making organisations
• Measure of the efficiency with which sales (input) have been used to
generate profit (value of output)
• Increased by charging higher prices or reducing costs
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Net profit margin
• Amount left after all direct costs and overheads have been deducted
from sales revenue
• Therefore concerned with profit over which operational management
can exercise day to day control
• May be an interdependency with the asset turnover ratio
Limitations
• Affected by different inventory valuation and depreciation policies and

fails to show differences in cost structures
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Asset turnover
• Calculated as revenue/capital employed using net current assets or

long-term liabilities + capital.
• Key measure of productivity measuring how intensively capital
employed has been used to generate sales.
• Again, the valuation of capital employed can have a significant effect
on the ratio reported.
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Asset turnover continued
• 'New' non-current assets and/or a large non-current asset base can

raise productivity but will reduce ROCE and asset turnover.
• Asset turnover is expressed as 'n times' so that assets generate n
times their value in annual turnover.
• ROCE = profit margin × asset turnover
• ROCE can be increased by improving the profit margin and/or
increasing asset turnover.
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Accounts receivable collection period
• Calculated as (receivables/turnover) × 365 days (or × 12 months).

• This gives a rough measure of the average length of time it takes for
a company's receivables to pay what they owe.
• Trend is important.
• Supermarkets' ratio should be low, exporting companies' probably
high.
Limitation
• Figure used for receivables at end of accounting period might not be

representative
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Accounts payable payment period
• Calculated as (payables/purchases) × 365 days (or × 12 months).

• Cost of sales can be used as an approximation for purchases.
• This gives a rough measure of the average length of time it takes for
a company to pay what it owes.
• It helps to assess a company's liquidity.
• An increase can be a sign of a lack of long-term finance or poor
management of current assets.
• This could result in use of extended credit from suppliers, increased
bank overdraft etc.
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Inventory turnover period
• Calculated as (inventory/cost of sales)× 365 days (or × 12 mths).

• Indicates the average number of days for which inventory is held.
• An increasing ratio indicates a slowdown in trading or a build up of
inventory.
• Inventory turnover (n number of times a year) is a measure of
business trading and is calculated as cost of sales/inventory.
• The type of organisation and systems operated will impact on both
ratios (eg JIT leads to high inventory turnover).
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Liquidity ratios
Current ratio
X : 1, where X = current assets
current liabilities
• Should be > 1 otherwise business may not be able to pay its debts on
time.
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Quick (or acid test) ratio

X : 1, where X = (current assets – inventory)
current liabilities
• The trend in the current and quick ratios is all important
• Non-standard ratios may be calculated which are relevant to a
particular organisation
• For example, you may calculate the percentage room occupancy for
assessing the performance of a hotel
• Or the average age of rent arrears in months for a student housing
society (which is simply the average age of receivables)
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Past exam question

A company has current assets of $1.8m, including inventory of $0.5m,
and current liabilities of $1.0m.
What would be the effect on the value of the current and acid test ratios if
the company bought more raw material inventory on three months'
credit?
Current ratio Acid test
A Increase Increase
B Decrease Increase
C Increase Decrease
D Decrease Decrease
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The correct answer is D, both ratios will decrease. The opening current
ratio (current assets/current liabilities) is $1.8m / $1.0m = 1.8, and the
opening acid test (current assets less stock/ current liabilities) is $1.3m /
$1.0m = 1.3. Purchasing (say) $1.0m of inventory on short term credit will
decrease the current ratio to ($1.8m + $1m) / ($1.0m + $1.0m) = 1.4. The
acid test would also decrease to $1.8m / ($1.0m + $1.0m) = 0.9. Only
23% of candidates selected this alternative. The most frequently chosen
alternative was C (41% of candidates). On this type of question if the
answer is not immediately clear candidates should substitute in some
simple numbers to test out the effects of a transaction.
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Past exam question
An investment centre earns a return on investment of 18% and a residual

income of $300,000. The cost of capital is 15%. A new project offers a
return on capital employed of 17%.
If the new project were adopted, what would happen to the investment
centre's return on investment and residual income?
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Return on investment Residual income

A Increase Decrease
B Increase Increase
C Decrease Decrease
D Decrease Increase
(2 marks)
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The correct answer is D. The new project's return on investment is less

than that of the investment centre and this will result in a reduction in its
return on investment. However because the project offers a return higher
than the cost of capital it will increase the investment centre's residual
income. The most popular answer was C, with 29% of candidates
mistakenly believing that the new project would result in a decrease in
both return on investment and residual income. This mistake suggests a
lack of understanding of residual income.
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Tackling the exam
Make sure that you read the following article on ratio analysis from the
ACCA website:
articles/ratio-analysis.html
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Management measures 1
It is difficult to devise performance measures that relate specifically to a

manager to judge his or her performance as a manager.
Possible management performance measures include the following:
• Subjective measures
• Judgement of outsiders
• Upward appraisal
• Accounting measures
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Subjective measures
• Eg ranking performance on a scale of 1 to 5.

• It's imprecise but does measure managerial performance rather than
divisional performance.
• The process must be perceived by managers to be fair.
• The judgement should be made by somebody impartial, but close
enough to the work of each manager to appreciate the efforts made.
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Judgement of outsiders
• Eg an organisation might set up a bonus scheme for directors under

which they would receive a bonus if the share price outperforms the
FTSE 100 index for more than three years.
• This is fair in that the share price reflects many aspects of
performance.
• However, it is questionable whether they can all be influenced by the
directors concerned.
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Upward appraisal
• This involves staff giving their opinions on the performance of their

managers.
• To be effective this requires healthy working relationships.
Accounting measures
• These can be used, but must be tailored according to what or whom is

being judged.
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Cost control and reduction 1
Cost reduction aims to reduce costs below a previously accepted level.

However this must be done without adversely affecting the quality of the
product/service being provided.
In contrast cost control techniques (budgetary control/standard costing)
deal with keeping costs within acceptable limits.
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Common sense approaches
• Improve efficiency of materials usage by reducing wastage

• Improve labour productivity by giving pay incentives
• Reduce material costs by improving stores control
• Reduce labour costs by replacing people with machines
• Save on finance costs by taking advantage of early payment
discounts
• Improve control over spending decisions
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What difficulties might there be in introducing a cost reduction

programme?
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Answer
Difficulties introducing a cost reduction programme:
• There may be resistance from employees to the pressure to

reduce costs – they may feel threatened by change.
• The programme may be limited in a small area of the business

and so costs get reduced in one cost centre, but appear
elsewhere in another cost centre.
• Cost reduction campaigns are often introduced as a rushed,

desperate measure instead of a carefully organised, well
thought-out exercise.
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Methods of cost reduction
• Material usage efficiency, eg better materials

• Labour productivity, eg pay incentives
• Machine efficiency, eg regular maintenance
• Material costs, eg lower purchase price
• Labour costs, eg changing methods of work
• Finance costs, eg early settlement discounts
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Rationalisation
• Elimination of unnecessary duplication

• Concentration of resources
• Carefully evaluating capital expenditure
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Value analysis 1
Value analysis (VA) is a planned, scientific approach to cost reduction.

It reviews the material composition of a product and the production
design.
Modifications and improvements can be made which do not reduce the
value of the product to the customer/user.
Benefits
• Lower costs
• Better products
• Higher profits
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Value analysis 2
These benefits are achieved by:
• Cost elimination/prevention
• Cost reduction
• Improving product quality and so selling more at the same price
• Improving product quality and so increasing selling price
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Value analysis 3
Aspects of a product's value to consider
• Cost value – cost of producing/selling it

• Exchange value – its market value
• Use value – what it does
• Esteem value – prestige customer attaches to it
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Value analysis 4
Conventional cost reduction techniques v value analysis
• Conventional cost reduction techniques – to achieve the lowest

production cost for a specific product design
• Value analysis – tries to find the least cost method of making a
product that achieves its desired function
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Value analysis 5
Typical consideration in VA
• Can a cheaper (but as good or better) substitute material be found?

• Can unnecessary weight or embellishments be removed without
reducing the product's attractiveness/desirability?
• Is it possible to use standardised or fewer components?
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Value analysis 6
Steps in a VA study
• Select a product/service for investigation.

• Obtain and record information about it.
• Analyse this information and evaluate the product, considering each
aspect of value in turn.
• Consider alternatives.
• Select the least-cost alternative for recommending to management.
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Value analysis 7
Steps in a VA study (continued)
• Make a recommendation.
• If accepted, implement the recommendation.
• After a period, evaluate the outcome and measure the cost savings.
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Value analysis 8
Value engineering
• The application of similar techniques to those of VA to new products

• The aim is to design and develop new products of a given value at
minimum cost
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Chapter summary 1
1. Performance management
▪ Comparing performance to previously agreed targets or standards
2. Measuring profitability and productivity

▪ Ratios
3. Management measures
▪ Subjective
▪ Judgement of outsiders
▪ Upward appraisal
▪ Accounting measures
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Chapter summary 2
4. Methods of cost reduction

▪ Improved efficiency
▪ Material efficiency
▪ Labour productivity
▪ Machinery efficiency
5. Value analysis
▪ Planned scientific approach to cost reduction. There are four aspects
of value:
Cost value, Exchange value, Use value, Esteem value
▪ The value of the product may therefore be kept the same or else
improved at a reduced cost
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• Non-financial measures
Chapter 17
• Manufacturing businesses
• The balanced scorecard
Assessing non- • Economy, efficiency and
financial effectiveness
performance • Contract and process costing
• Services
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• Discuss the advantages and limitations of the balanced scorecard

• Describe performance indicators for financial success, customer
satisfaction, process efficiency and growth
• Explain the concepts of economy, efficiency and effectiveness
• Describe performance indicators for economy, efficiency and
effectiveness
• Establish performance indicators for economy, efficiency and
effectiveness in a specific situation
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• Discuss the meaning of each of the efficiency, capacity and activity

ratios
• Calculate the efficiency, capacity and activity ratios in a specific
situation
• Describe performance measures which would be suitable in contract
and process costing environments
• Describe measures of performance utilisation in service and
manufacturing environments
• Establish measures of resource utilisation in a specific situation
• Distinguish performance measurement issues in service and
manufacturing industries
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• Describe performance measures appropriate for service industries

• Discuss the importance of non-financial performance measures
• Discuss the measurement of performance in service industry
situations
• Discuss the measurement of performance in non-profit seeking and
public sector organisations
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Overview
Non-financial objectives and performance

measures
Manufacturing Non-profit making

businesses organisations
3Es
Balanced
Services
scorecard
businesses
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Non financial measures 1
Objectives
• Welfare of employees
• Welfare of society
• Responsibilities towards customers and suppliers
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Non financial measures 2
Non-financial measures are leading indicators of financial performance.

Eg if customer satisfaction is low then this could imply a future fall in
profits.
Non-financial measures
• Quantitative
• Qualitative
• Non-financial indicators
• Ratios
• Percentages
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Manufacturing businesses 1
• Performance measures for sales

─ Traditionally measured in terms of price and volume variances
• Performance measures for materials

─ Traditional measures are standard costs, and price and usage
variances
• Performance measures for labour

─ Traditionally measured in terms of standard performance (ideal,
attainable) and rate and efficiency variances
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Performance measures for overheads
• Machine down time: total machine hours. This ratio provides a

measure of machine usage and efficiency.
• Value added time: production cycle time.
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Non-financial performance measurement for manufacturing
• Cost: cost behaviour

• Time: bottlenecks, inertia
• Quality: factors inhibiting performance
• Innovation: new product flexibility
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Capacity ratio
• Similar to the fixed o/hd capacity variance and compares actual

hours worked with budgeted hours
• Measures the extent to which planned available resources have been
used
• (Actual hours worked / budgeted hours) × 100%
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Activity (production volume) ratio
• Similar to the fixed o/hd volume variance and compares standard

hours produced and budgeted hours
• (Standard hours produced / budgeted hours) × 100%
Efficiency ratio
• Similar to the fixed o/hd efficiency variance

• Measures the efficiency of the labour force by comparing standard
hours produced and actual hours worked
• (Standard hours produced / actual hours worked) × 100%
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Barnes Co budgeted to make 12,000 standard units of output during a

budget period of 36,000 hours (each unit should take 3 hours each).
During the period, the company actually made 14,000 units which took
40,000 hours.
Required
Calculate the efficiency, capacity and production volume ratios to one
decimal place.
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Answer
(14,000  3) hours  100% = 105%

Efficiency ratio =
40,000 hours
40,000 hours  100% = 111%

Capacity ratio = 36,000 hours
(14,000  3) hours  100% = 117%

Production volume ratio = 36,000 hours
E  C = PV ie 105%  111% − 117%
The production volume ratio of 117% (more output than budgeted and
more standard hours produced than budgeted), is explained by the 111%
capacity working, and by good efficiency of 105%.
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The balanced scorecard 1
Balanced scorecard
• A way of measuring performance which integrates traditional financial

measures with operational, customer and staff issues.
• It is 'balanced' in the sense that managers are required to think in
terms of all four perspectives.
• This is to prevent improvements being made in one area at the
expense of another.
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Customer perspective
• Measures relating to what actually matters to customers

• For example time, quality, performance of product
Examples
• Customer complaints
• On-time deliveries
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Internal business perspective
• Measures relating to the business processes that have the greatest

impact on customer satisfaction
• For example quality, employee skills
Examples
• Average set-up time

• Quality control rejects
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Innovation and learning perspective
• Measures to assess the organisation's capacity to maintain its

competitive position through the acquisition of new skills/development
of new products
Examples
• Labour turnover rate

• % of revenue generated by new products
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Financial perspective
• Measures that consider the organisation from the shareholder's point

of view
Examples
• ROCE
• RI
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Economy, efficiency and effectiveness 1
Comparing non-profit seeking entities with the private sector raises

several problems.
The difficulties in valuing outputs led to the creation of the 3E approach.
Economy, efficiency and effectiveness can be studied and measured
with reference to inputs, process and outputs.
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Economy, efficiency and effectiveness 2
• Inputs
─ Money
─ Resources
• Process
─ Usually some ratio of economy and effectiveness measure
• Outputs (ie results of an activity)

─ Measurable as the services actually produced and the quality of the
services
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Using the 3 Es suggest a range of performance measures for a public

sector higher education college.
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Answer
Economy
• Value for money in sourcing lecture staff of appropriate quality
Competitive tendering for computers, security, cleaning
Efficiency
• Cost of books per student
• Staff hours per student
• Teaching cost per student
• Total cost of producing a graduate
Effectiveness
• Achieving target pass rates of grade
• Proportion of graduates employed within a year
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Contract and process costing 1
In a contract environment each contract undertaken is unique.

This has a number of implications for performance measurement.
• Detailed planning should be undertaken and performance targets set.
• Suppliers may be different for each contract, making it harder to set
standards for quality and speed of delivery.
• Customer satisfaction measures are particularly important in this
environment.
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• Because each contract will be different the organisation will have to be

extremely flexible.
• It is likely that the contract will need to be completed within a certain
time and therefore an ongoing check must be kept of performance in
relation to the deadline.
• The size and consequences of overspending may be huge.
• The long timescale means that progress must be measured very
carefully, since there is more likelihood of slippage if deadlines seem a
long way off.
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• The high degree of standardisation in a process costing environment

means it is ideal for setting performance standards.
• However, costs, materials usage/wastage, labour inefficiencies and
machine breakdowns cannot be traced to a specific item.
• These features can only be measured on an average per unit basis.
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Services 1
Service organisations do not produce a physical product. Instead, they

provide services.
Types of service measurement
• Qualitative measures
• Quantitative measures
• Resource utilisation measures
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Services 2
Characteristics of services (SHIP)
• Simultaneous
• Heterogeneous
• Intangible
• Perishable
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Services 3
A range of performance measures covering six 'dimensions' are used:
• Competitive performance
• Financial performance
• Quality of service
• Flexibility
• Resource utilisation (productivity)
• Innovation
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Chapter summary 1
1. Performance measures
▪ Quantitative evaluation via ratios
▪ Non-financial measures more useful in modern environment with
multiple factors
2. Performance measures for manufacturing industries

▪ Key indicators:
Sales, Materials, Labour Overheads
▪ Ratios:
Efficiency, Activity, Capacity
3. The balanced scorecard

▪ Customer perspective, internal business perspective, innovation and
learning perspective, financial perspective
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Chapter summary 2
4. 3 Es
▪ Performance is often evaluated using the 3 Es
▪ Economy, Effectiveness and Efficiency
5. Performance measures for service industries

▪ 6 dimensions
▪ SHIP characteristic:
Simultaneous
Heterogeneous
Intangible
Perishable
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Copyright notice
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise,
without the prior written permission of BPP Learning Media Ltd.
The contents of this book are intended as a guide and not professional advice. Although every effort has
been made to ensure that the contents of this book are correct at the time of going to press, BPP
Learning Media makes no warranty that the information in this book is accurate or complete and accept
no liability for any loss or damage suffered by any person acting or refraining from acting as a result of
the material in this book.
BPP LEARNING MEDIA

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Foundations in Accountancy /

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Syllabus Case study

Technical content Real world example

Question to consider Diagram

Answer Key model

Past exam question Tackling the exam

Answer to past exam Summary

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A The nature, source and purpose of management information

B Data analysis and statistical techniques

C Cost accounting techniques

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This syllabus is assessed by a two-hour examination.

Section A: Thirty five two-mark objective test questions: 70 marks

Section B: Three ten-mark multi-task questions: 30 marks

Total: 100 marks

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The question types in the exam are:

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• Ensuring that you study all areas of the syllabus

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• Examining team's articles – Student Accountant archives

The specimen exam can be found on the ACCA website.

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• Distinguish between data and information.

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Role of management Data and Information for

Comparison with Qualities

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The successful management of any organisation depends on

For example management need information for:

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Information is used in any type of organisation:

• Non-profit seeking organisations such as charities, clubs and local

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Information is sometimes referred to as processed data.

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Qualities of good information

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What information may the managers of a business need?

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External information Internal information

Competitors – Service offered Management accounts

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Most organisations need:

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Non-financial information is becoming more important to managers.

For example, suppose a business decides to provide a staff canteen.

Non-financial information examples:

• Managers need to know how staff morale is affected by the

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Management require information to help them to plan and control

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Organisations should never be surprised by developments which