MANAGEMENT ACCONUTING ONE

ACCT 303. LECTURE NOTE

INTRODUCTION

The word “management accounting” contains two words namely ‘management’ and
accounting’. Understanding of these two words can assist us to know the scope of
management accounting.

The word ‘management’ entails getting things done through other people, but looking at the
definition of management given by E.F.L. Brench, he defined management as a social science
or process entailing responsibility for the effective and economical planning and regulation of
the operation of an enterprise in fulfilment of a given purpose or talk, such responsibility
involving

(i) Judgement and decision in determining plans and in using data to control
performance, progress and plans.
(ii) The guidance, integration, motivation and supervision of the personnel comprising the
enterprise and carrying out an operation.

There are several definitions of ‘accounting’, it has been d

efined as the language of business, i.e. a language that communicates economic information
to people who have an interest in an organisation such as managers, shareholders, potential
investors, employees, creditors and the government.
The American Accounting Association defines accounting as the process of identifying,
measuring and communicating economic information to permit judgement and decision to
users of the information.

Three major functions of management accounting are that it provides information for
planning, control and decision making.

What is Management Accounting?

Management accounting is a means of providing information that assists in planning,

controlling and making decisions. The main purpose of management accounting is to assist
managers to make an informed decision.

Management accounting is the process of gathering information to assist managers in helping

the organisation in planning, controlling and decision making.

Differences between Management and Financial Accounting.

Here, we want to look at the differences between management and financial accounting
information.
Financial accounting is a part of management accounting but we shall discover there are still
some differences that can be noticed such as:

1) Users: The users of financial accounting information include the public, government,
trade unions, potential investors, shareholders, managers, employees, creditors etc.
While the users of management accounting information is the management.
2) Rules & Regulations: In preparing financial accounting information, there is need to
comply with certain regulations such as IFRS and some statutory laws (acts and
decrees) but in the preparation of management accounting information, you don’t
need to meet/comply with any rules and regulations only management requirement.
3) Time Focus: Financial accounting information is historic. That is, reporting what has
happened in the past, while management accounting information is predictive and
futuristic. It should be noted that management accounting information makes use of
what happened in the past to predict the future in line with the management functions.
4) Degree of Details: Financial Accounting information are normally prepared to cover
the organisation as a single entry while management accounting information is
prepared to centre on a single unit of the organisation which may be a product or the
price or department, region or segment.
5) Objective: The main objective of financial accounting information is to present the
financial position of an organisation at a specific point in time and compliance with
necessary statutory in other words, ‘stewardship accounting’ while the objective of
management accounting information is to assist management in carrying out their
responsibilities of managerial activities.
6) Period Covered: By statutes, financial accounting information is expected to cover 12
months i.e. annually for a continuous company whereas management accounting
information will be prepared in line with management requirement which may be
daily, weekly, monthly, etc.
7) External Audit: By statutes, financial accounting information requires external
verification in form of audit whereas management accounting does not require such.
8) Inter-disciplinary Relationship: preparation of financial accounting information
requires only the knowledge of accounting where management accounting
information makes use of knowledge of other extinguished disciplines such as
economics, quantitative analysis, sociology, computing, operation research, etc.
9) Format of Income Statement: Financial accounting information makes use of gross
profit from trading activities to present the income statement whereas the
management accounting information income statement could be prepared using the
contribution statement.

Management Accounting Guidelines

In management accounting, there are 3 basic guidelines that assist management accountants
in discharging their responsibility of problem solving, score keeping and attention direction.

1) Cost Benefit Approach:

 In giving information to the management on whether to acquire an asset or not, a cost
benefit approach is normally employed. A cost benefit approach should be used in a
decision, whether to acquire an asset will promote the attainment of organisational
goals in relation to the cost of those resources.
The expected benefit from spending such money should be higher than the cost that
will generate such benefit.
2) Behavioural and Technical Approach:
It is true that some decisions may be cost effective but in discharging their
responsibility, management account will consider the behavioural effect of such
decision as well as the technical implication of such decision.
3) Different Cost for Different Purpose:
A cost concept used for the external reporting purpose may not be an appropriate
concept for internal routine reporting to management.
Principles Used In Assisting Managerial Function.
Management accounting helps management to understand and take a stand on
accounting related subjects that have direct relationship with planning, controlling and
decision making. The various functions of management and accounting principles
used to assist in these functions can be briefly reviewed as follows:
1) Planning: A management accountant is expected to make budgets, plans, forecast
through the use of cost estimation technique, break-even analysis, standard costing,
etc. Which are future predictions of a financial expectation which forms the major
item for planning.
2) Controlling: Variance analysis, budgetary control reports, performance evaluation
reports, etc. are some of the reports prepared by the management accountant which
compares actual performance with plans for purpose of management, future corrective
action. The budget equally serves as a guide for future actions.
3) Decision Making: Principles such as investment appraisal pricing decision, marginal
costing for short-term or one-off decision, make or buy decision, special pricing
decision, dropping a centre, etc. are designed to assist management in strategic as well
as tactical decision making process.
4) Organising: This is done through the establishment of a sound accounting system and
preparation of budgets or income statements presenting and unifying the whole
organisation as a single entity and giving a global field of all organisational activities.
5) Directing: Management accountants prepare reports of historical events such as
contribution report statements, variance analysis, budgetary control, performance
evaluation, reports, etc. which presents to management areas of strength and
weakness, hereby directing their direction to areas that desire attention or
management by exception. Management by exception is a situation where
management gives more attention to areas where weakness is observed for the overall
benefit.
6) Communication: Various reports and information are prepared and presented by the
management accountants, so the managers are meant to assist management in their
communication function, because management is expected to communicate such
reports or information to the end users.
 The Value Chain of Business Functions.

Planning and control decisions focus on one or more business functions in which both
managers and management accountants perform various roles. The term value chains refer to
the sequence of business functions in which usefulness of the product or service increases, so
is its value to the customers. Management accountants provide decision support for
management in each of these

● Research and development

● Design of products, services and processes
● Production
● Marketing
● Distribution
● Customer Services.

Enhancing the Value of Management Accounting

Management accounting can play a key role in helping managers to focus on these four
teams:

1) Customer Focus: The Challenge facing managers is to continue investing sufficient

resources in consumer satisfaction such that profitable customers are attracted and
retained.
2) Key Success Factor: These operational factors directly affect the economical viability
of the organisation. Customers are demanding ever improving level of performance
regarding the following:
● Costs
● Quality
● Time
● Innovation
3) Continuous improvement by competitors creates a never ending search for higher
levels of performance within many organisations. To compete, many companies are
concentrating on continually improving different aspects of the organisation.
4) Value Chain and Supply Chain Analysis: These team has two:
● Treating each of the business functions as an essential and value contributor
● Integrating and co-ordinating the effort of all business functions in addition
the development in the capabilities of each individual functions.

The term supply chain described the flow of goods, services and information from cradle to
grave regardless of whether those activities occur in the same organisation of different
organisations.

Standards of Ethical Conduct of Management Accounting.

*HANDOUT

Management Accounting and Management Information System.

What is Information?

Data are facts and figures that are not presently being useful to a decision process and are
usually in the form of historical data that are recorded and filed away; examples include
journals, ledgers, bin cards, supporting documents, etc.

Information on the other hand, is the data that is retrieved, processed and useful for
informative and inference purposes, arguemental premise or serve as a basis of forecasting
and decision making. Examples include setting price from past records, profit planning and
control, etc.

Information is a fact or perception that adds to human knowledge. In a world of uncertainty,

information reduces uncertainty and changes in probability attached to an expected output in
decision making situation. This is the reason it is possible to measure the value of information
which is given as the differences between expected values and value under uncertainty and
expected value under certainty*

Information can either be quantitative or qualitative. There are many quantitative information
which accounting information is usually expressed in monetary terms that distinguishes it
from other types of information. Accounting information can be further subdivided into the
following:

● Operational information
● Financial accounting information
● Management accounting – planning and control information.

Levels of Information

Management accounting reports are strictly prepared for internal users. For management
accountants to be effective there must be good management information in place. Levels
within an organisation to which information can be provided can be analysed into three:

1) Strategic Information: This is used by senior managers to plan the objectives of their
organisation and to assess whether the objectives are being met. Much of the
information for this level is generated from the external environment although
internally generated information will be used from time to time. Examples of such
information include profitability, future market prospect, availability and cost of
raising new capital, working capital requirement, capital budgeting requirements, etc.
Strategic information is used for the management’s decision making process called
the strategic planning.
2) Tactical Information: This is used by middle management to ensure that the resources
of the business are effectively and efficiently employed to achieve strategic objective
of the organisation. Much of this information is generated from within the
organisation, i.e. as feedback and is likely to be accounting biased. Examples include
productivity measurement, variance analysis, cash flow forecast, labour turnover
report, etc. Tactical information is prepared regularly; weekly, monthly and is used
for the decision making process called management control.
 3) Operational Information: This is used by the front line managers for programmed
decision to ensure that specific tasks are planned and properly executed within a
factory. Much of this information is generated within the immediate environment of
the tax being performed, e.g. hours worked each week by each employee. This
information is required on an urgent and regular basis and is used for the decision
making process called operational control.
The figure on the next page shows the level and details of information in an
organisation.

STRATEGIC
INFORMATION

TACTICAL INFORMATION

OPERATIONAL INFORMATION

Pyramid of information in an organisation.

What Is A System?

A system is a set of elements joined together for a common objective. It’s a group of
things or parts working together in a regular relation. A sub-system is a part of a
larger system. Viewing an organisation as a system, it will have the following as sub-
systems:
● Divisions
● Departments
● Functions
● Sections
● Units
● Individual

An Integrated System View of Business Enterprises.

The internal relationship in a business is seen as comprising of several major sub-systems,

and the business enterprise itself forms the sub-system of the society in which it is existing.
The larger society expects some goals and values from the business enterprise. The business
enterprise receives inputs from the society, processes them and sends them back to the
society as output.

The Components of A System

● Environment
● Goals and Values
● Technical management
● Psycho-social
● Structural.

Goal and Values: These are the dynamic equilibrium between the environment and the sub-
systems constituting the systems.

Technical Management/Sub-systems: This is the knowledge required for performing tasks

within an organisation, this include the techniques of production management. The relevant
technology is determined by the task requirement of the organisation.

Psycho-social Sub-system: This comprises of individuals and groups. It relates to their

behaviour, motivation, attitude, status. It concerns the behavioural and human relationship in
the organisation.

Structural Sub-system: This involves division of tasks within an organisation and how these
tasks are co-ordinated. In the formal sense, structure is determined by the organisational chart
and position by job description.

Managerial Sub-system: This is the machinery which relates the organisation to its
environment by setting goals, developing strategic and organisational plans and establishing
control process. The managerial sub-system co-ordinates the different activities of an
organisation, so as to afford the organisation’s opportunity to achieve its goals and objectives.
The management sub-system relies on a sound management information system to effectively
perform its functions. The system concept of MIS is that which may optimise the output of
the organisation by connecting the operating systems through the medium of information
exchange.

Qualities of Good Management Accounting Information System.

A key role of a good management accounting is to generate information to different levels of

management. The information generated must however meet the following minimum
qualities:

a) Relevance: Information must be relevant to the purpose for which a manager wants to
use it. In practise, far too many reports fail to keep to the point and contain
 purposeless and irritating paragraphs which only serve to vex the managers reading
them.
b) Completeness: An information user should have all the information he needs to do his
job properly. If he doesn’t have a complete picture of the situation, he might well
make bad decisions.
c) Accuracy: Information should obviously be accurate because using incorrect
information could have serious and damaging consequences. However, information
should only be accurate enough for its purpose and there is no need to go into
unnecessary detail for pointless accuracy.
d) Confidence: Information must be trusted by the managers who are expected to use it.
However, not all information is certain. Some information has to be certain, especially
operating information, for example, related to a production process. Strategic
information especially relating to the environment is uncertain. However, if the
assumptions underlying it are clearly stated, this might enhance the confidence with
which the information is perceived.
e) Clarity: information must be clear to the user, if the user doesn’t understand it
properly, he can’t use it properly. Lack of clarity is one of the causes of a breakdown
in communication. It is therefore important to choose the most appropriate
presentation medium or channel of communication.
f) Communication: Within any organisation, individuals are given the authority to do
certain tasks and they must be given the information they need to do them. An office
manager might be made responsible for controlling expenditures in his office and
given a budget expenditure unit for the year. As the year progresses, he might try to
keep expenditure in check but unless he is told throughout the year what is his current
total expenditure till date, he will find it difficult to judge whether he is keeping
within budget or not.
g) Volume: There are physical and mental limitations to what a person can read, absorb
and understand properly before taking action. An enormous mountain of information,
even if it is all relevant, cannot be handled. Reports to management must therefore be
clear and concise and in many systems, control actions worked basically on the
exception principle.
h) Timing: information which is not available until after a decision is made will be
useful only for comparism and longer term control, and may serve no purpose even
then. Information prepared too frequently can be a serious disadvantage. If for
example, a decision is taken at a monthly meeting about a certain aspect of a
company’s operation. Information to make decisions is only required once a month
and weekly reports will be a time consuming waste of effort.
i) Channel of Communication: There are occasions when using one particular method of
communication will be better than others. For example, job vacancies should be
announced in a medium where they will be brought to the attention of people most
likely to be interested. The channel of communication might be the company’s in-
house journal, a national or local newspaper, a professional magazine, a job centre or
school career’s office. Some internal memoranda may be better sent by electronic
mail. Some information is best communicated internally by telephone or words of
 mouth, whereas other information ought to be formally communicated in writing or
figure.
j) Cost: information should have some value otherwise it will not be worth the cost of
collecting and filing it. Benefits obtainable from information must also exceed the
cost of acquiring it, and whenever management is trying to decide whether or not to
produce information for a particular purpose (for example whether to computerize an
operation or to build a financial planning model). A cost/benefit study ought to be
made.

PLANNING, CONTROLLING AND DECISION MAKING.

Most information generated by the management accountant is likely to be for planning,

controlling and decision making.

PLANNING.

An organisation should never be surprised by developments which occur gradually over an

extended period of time because the organisation should have implemented a planning
process. Planning involves the following:

1) Establishing objectives
2) Selecting appropriate strategies to achieve those objectives.

Planning therefore forces management to think ahead systematically in both the short and
long terms.

LONG-TERM STRATEGIC PLANNING

Long-term planning also known corporate planning involves selecting appropriate strategies
so as to prepare a long-term plan to attain the objectives. The time span covered by a long-
term plan depends on the organisation, the industry in which it operates and the particular
environment involved. Typical periods are two, five, seven or ten years, although longer
periods are frequently encountered. Long-term strategic planning is a detailed, lengthy
process, essentially incorporating three stages and ending with a corporate plan. The diagram
on the next page provides an overview of the process and shows the link between short and
long terms planning.

SHORT-TERM TACTICAL PLANNING

The long-term corporate plan serves as the long-term framework for the organisation as a
whole, but for operational purposes, it is necessary to convert the corporate plan into series of
short-term plans, usually covering one year, which relates to sections, functions or
departments. The annual process of short-term planning should be seen as stages in the
progressive fulfilment of the corporate plan as each short-term plan stirs the organisation
towards its long-term objectives. It’s therefore vital that to obtain maximum advantage from
short-term planning, some sorts of long-term plan exists.

THE PLANNING PROCESS

 ASSESS THE ASSESS THE ASSESS THE ASSESS
EXTERNAL ORGANISATION FUTURE EXPECTATION
ENVIRONMENT

EVALUATE CORPORATE OBJECTIVES

CONSIDER ALTERNATIVE WAYS OF ARCHEIVING OBJECTIVES

AGREE A CORPORATE PLAN

PRODUCTION RESOURCE PRODUCT RESEARCH AND

PLANNING PLANNING PLANNING DEVELOPMENT
PLANNING

DETAILED OPERATIONAL PLANS WHICH IMPLEMENTS THE CORPORATE PLAN ON A MONTHLY, QUATERLY
ORGANISATIONAL BASIS. OPERATIONAL PLANS INCLUDE SHORT-TERM BUDGETS, STANDARDS AND
OBJECTIVES.

CONTROL PROCESS

There are two stages in the control process:

a. The performances of the organisation that are set out in the detailed operational plans
is compared with the actual performance of the organisation on a regular and
continuous basis. Any deviations from the plans can then be identified and corrective
action taken.
b. The corporate plan is reviewed in the light of the comparisons made and any changes
in the parameters on which the plan was based (such as new competitors, government
 t instructions, etc.) to assess whether the objectives of the plan can be achieved. The
plan is modified as necessary before any serious damage to the organisation’s future
success occurs. Effective control is therefore not practical without planning, and
planning without control is pointless.

DECISON MAKING

Management is decision making. Managers of all levels within an organisation take

decisions. Decision making always involves a choice between alternative and it’s the role of
the management accountant to provide information so that management can reach an
informed decision. Its therefore vital that the management accountant understands the
decision making process, so that he can supply the appropriate type of information.

Decision Making Process

Example:

Anthony, a leading writer on organisational control, has suggested that the activities of
planning, control and decision making should not be separated since all managers make
planning and control decisions. He has identified three types of management:

● Strategic Planning: The process of deciding on objectives of the organisation, on

changes in these objectives, on the resources used to attain these objectives and on the
policies that are to govern the acquisition, use and disposition of these resources.
● 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.
● Operational Control: The process of assuring that specific tasks are carried out
effectively and efficiently.

STRATEGIC PLANNING.

Whilst these strategic planning are those which set or change the objectives or strategic
planning of an organisation. They would include such matters as the selection of products and
markets, the required levels of company profitability, the purchase and disposal of subsidiary
companies or major fixed assets, etc.

MANAGEMENT CONTROL.

Whilst strategic planning is concerned with certain objectives and strategic targets,
management control is concerned with decisions about the effective and efficient use of an
organisation’s resources to achieve their objectives or targets.

⮚ Resources: often referred to as the ‘4Ms’ i.e. men, materials, machines and money.
 ⮚ Efficiency: in the use of resources means that optimum output is achieved from the
input resources used. It relates to the combinations of men, land and capital (for
example how much production work should be automated) and to the productivity of
labour and material usage.
⮚ Effectiveness: in the use of resources means that outputs obtained are in line with the
intended objectives or targets.

OPERATIONAL CONTROL.

The third and lowest tier in Anthony’s hierarchy of decision making consists of operational
control decision. As we have seen, operational control is the task of ensuring that specific
tasks are carried out effectively and efficiently. Just as management control, plans are set
within the guidelines of strategic plans, so too is operational control. Plans set within the
guidelines of those strategic planning and management control consider the following:

a. Senior management may decide that the company should increase sales by 5% per
annum for at least five years – A strategic plan.
b. The sales director and the senior sales managers will make plans to increase sales by
5% in the next year, with some provisional planning for future years. This involves
planning direct sales resources, advertising, sales promotion, etc. Sales quotas are
assigned to each sales territory – A tactical plan (management control)
c. The managers of a sales territory specify the weekly sales targets for each sales
representative. This is operational planning: individuals are given task which they are
expected to achieve.

Types of Information.

Information within an organisation can be analysed into three levels assumed in Anthony’s
hierarchy strategic information is used by senior management to plan the objectives of their
organisation and to assess whether the objectives are being met in practice. Such information
includes overall profitability, the profitability of different segments of the business, capital
equipment needs and so on.

Strategic information therefore has the following features:

1. It is derived from both internal and external sources.

2. It is summarized at a high level.
3. It is relevant to the long term.
4. It deals with the whole organisation (although it might go into some detail).
5. It is often prepared on an Ad-hoc basis.
6. It is both quantitative and qualitative.
7. It can’t provide complete certainty given that the future can’t be predicted.

TACTICAL INFORMATION.

It’s used by middle management to decide how the resources of the business should be
employed and to monitor how they are being and have been employed. Such information
includes productivity measurements (output per man hour or per machine hour), budgetary
control or variance analysis report and cash flow forecast and so on. Tactical information
therefore has the following features:

1. It’s primarily generated internally.

2. It’s summarised at a lower level.
3. It’s relevant to the short and medium term.
4. It describes or analyses activities or departments.
5. It’s prepared routinely and regularly.
6. It’s based on quantitative measures.

OPERATIONAL INFORMATION.

It’s used by front line managers such as foremen or head clerks to ensure that specific tasks
are planned and carried out properly within a factory or office and so on. In the payroll office,
for example, information at this level will relate to day-rate labour and will include the hours
worked each week by each employee, his rate of pay per hour, details of his deduction, and
for the purpose of wages analysis, details of the time each man spent on individual jobs
during the week. In this example, the information is required weekly, but more urgent.
Operational information such as the amount of raw materials being used as input to a
production process may be required daily, hourly or in the case of automated production,
second by second. Operational information has the following features:

1. It is derived almost entirely from internal sources.

2. It is highly detailed being the processing of raw data.
3. It relates with the immediate term.
4. It is task specific.
5. It is prepared constantly or very frequently.
6. It is largely quantitative.

COSTING.

What is cost?

Cost is the amount of expenditure incurred on or attributable to a specified thing or activity.

Mathematically, cost is the product/quantity of a given resource use and the price per unit of
the quantity. Cost is usually ascertained in respect of cost unit/objective.

What is a cost unit?

This is a quantitative unit of a product or service in relation to which costs are ascertained
e.g. tonnes of cocoa, barrels of oil, bags of rice, etc.

What is a cost objective?

This is any activity for which a separate measurement for cost is desired. A cost unit is a cost
objective. However, there are some cost units which are not cost objectives.

What is a cost centre?

This is a location, person or an item of equipment, or a group of these in relation to which

costs are ascertained and further related to a cost unit (or a group of these in relation) for
example, canteen, managing director, etc. cost centres are broadly classified into two:

⮚ Production cost centres

⮚ Service cost centres

What is a profit centre?

This is a centre which not only incurs costs but also generates revenue.

Classification of Costs.

Costs can be classified variously for different objectives

● Classification according to element of cost: there are three basic elements of cost
namely material, labour and overhead.
● Classification as direct or indirect cost: direct costs are costs that can be directly
identified and charged to a cost unit without apportioning e.g. direct labour cost,
direct materials, and direct expenses.
Indirect costs are those costs which can’t be identified with and allocated to a cost
unit but that has to be apportioned to a number of cost centres and further absorbed
by cost units. Another term for indirect cost is the overhead cost which comprises of:
i. Indirect labour cost
ii. Indirect material cost
iii. Indirect expenses
● Classification according to function: all indirect costs can also be classified
according to function. Thus, overhead can also be divided into production overhead,
research and development, administrative overhead, etc.
● Classification according to behaviour: all indirect costs can also be classified
according to the way they behave in relation to activity level. In this regard, cost may
be classified into fixed, variable, semi-variable or mixed cost.
● Classification as product cost or period cost: * either product/period cost, product
costs are costs identified with goods produced or purchased for resale. These usually
are the production or manufacturing costs. They are costs used for valuation of stocks
or work-in-progress e.g. production wages, etc.
⮚ Classification of product cost:
Expired Product Cost: This is the portion of product cost which relates to
products that have realized revenue and do not have future revenue generating
potential.
 Unexpired Product Cost: These are the costs of resources acquired which are
expected to contribute to future revenue. They are normally recorded in the
balance sheet. E.g. cost of material not sold.
Period cost: These are costs incurred and charges against cost for a period and
not included in costs for stock valuation purposes. These are usually not
manufacturing costs e.g. selling and distribution overheads, administrative
overheads. They are charged in full to the Profit and Loss a/c for the period.
● Classification according to controllability: these are costs and revenue that are
reasonable subjects to regulation by a given responsibility centre manager. They are
costs or revenue whose amounts are influenced by the actions or inactions of a
responsibility centre manager. All costs/revenue are controllable at some level of
management, some level of management, some costs/revenue aren’t controllable. In
preparing control reports, it is very necessary to have costs/revenue classified as
controllable and non-controllable.
● Classification of costs as relevant and irrelevant: Relevant costs and revenue are
those future costs and revenue which can be altered by a given decision. Irrelevant
costs and revenues are those costs that won’t be affected by a given decision.
Irrespective of what decision is taken, the cost will not alter.
● Other classification of costs:
Avoidable: These are costs that maybe saved by the adoption of a given alternative
option.
Unavoidable: These are costs that can’t be saved or eliminated by the adoption of a
given alternative.
Normal: These are costs planned for and expected at a given level of activity under
specified number of scrap and loss of items.
Abnormal: These are costs not planned for and therefore not expected to be incurred
at a given level of activity under specified conditions in which that level of activity is
normally achieved.
Sunk Cost: These are costs of resources already acquired. They are costs created by
decision made in the past and can’t be altered by decision to be made in future e.g. the
written value of a plant previously acquired.
Opportunity Cost: These are the values of benefits forgone or sacrificed in favour of
alternative causes of action.
Future Cost: These are costs estimated and are reasonably expected to be incurred in
the future.
Incremental Cost: These are the additional costs or revenue that arises from the
production or sales of a group of additional unit. They are sometimes called
Inferential Costs.
Marginal Costs: These are the additional costs that arise from the production of one
additional unit of output or service.
Conversion Cost: These are the costs of transforming raw materials into finished
goods or the cost of converting raw materials from one stage of production cycle to
the next. It is the total cost of production less cost of bought-in-materials.
Attributable Costs: These are costs that could be avoided on average if a product or a
function is discontinued entirely.
Policy Costs: These are costs additional to normal requirements incurred in
accordance with the policy of an undertaking. They are also termed discretional costs.
These are costs of research into improving the production of goods and services.
Pre-production Costs: These are the parts of development cost relating to making trial
production run preliminary to formal production.
Committed Costs: These are costs that are expected to be incurred and for which
resources have been earned marked or allocated as a result of contractual agreement
or an earlier decision to have the cost incurred.
Value Added: This is the increase in market value of a product as a result of changing
in form, location, etc. of that product. It is the total market value of the product less
costs of bought-in-materials and services.
Pre-determined Costs: These are the costs estimated or computed in advance of
production on the basis of * all the factors affecting costs.
Standard Costs: These are costs estimated and expected to be incurred per unit of
activity under efficient production conditions.
Budgeted Costs: These are costs estimated and planned for a given activity level,
functions or segments of the organisation within a specified time horizon.
Actual Costs: These are costs actually incurred in the production process. They are
not estimates but are historical or past costs.
Cost Objectives and Possible Cost Classification.
Depending upon the cost objective that is intended to be achieved, costs could be
classified as already been outlined. Three cost objectives can be identified together
with the classification to suit such cost objectives:
i. Cost Objectives: Costs for stock valuation
Possible methods of cost classification
⮚ Period costs and product costs
⮚ Elements of costs
⮚ Manufacturing, selling distributing and administration costs
ii. Cost for Planning and Decision Making:
Possible methods of cost classification.
⮚ Cost behaviour; fixed/variable, etc.
⮚ Relevant and irrelevant costs
⮚ Avoidable and Unavoidable costs
⮚ Sunk costs
⮚ Opportunity costs
⮚ Incremental, differential and marginal cost.
iii. Cost Objectives: Cost for control

Possible methods of cost classification

 ⮚ Controllable and non-controllable costs
⮚ Cost behaviour – fixed and variable
⮚ Normal and Abnormal cost.

Cost Behaviour.

Problems Associated with the Conventional Classification of Cost According to Behaviour.

1. The overall simplistic assumption of cost linearity of variable cost per unit is not
practical. In addition to the possibility that variable cost may be linear, it is also
possible that they may be non-linear. The behaviour of cost should be established by
the analysis of the cost in question and not by some overall simplistic assumption.
2. Fixed cost can change as activity levels change. Some costs could be classified as
fixed or variable in different organisations e.g. depreciation cost. But for proper
analysis it is better to sub-divide fixed cost into four categories:
⮚ Time related fixed cost: rent and rates
⮚ Volume related fixed cost: these are same as step costs e.g. costs of plants
⮚ Policy related fixed cost: e.g. advertising cost, production and distribution
costs. These types of fixed costs are known as programme fixed costs.
⮚ Joint fixed costs:
i. The classification of costs as variable and fixed cost may not hold for
certain items of costs. Some cost items contain variable and fixed
elements. There are methods that could be applied to separate fixed
and variable costs:
a. Statistical method
b. Non-statistical method (judgement)
ii. Costs do not necessarily behave in regular pattern. For example, a
variable cost may be linear between 90% to 115% of normal activity
level and thereafter has a curvy linear function
iii. Variable costs are assumed to vary at activity levels but there are
causes of the variation. Different variable costs react to different
activity measures e.g. direct wages may vary with the number of direct
workers engaged, distribution costs may vary with the deliveries made,
etc. The simplicity assumption that all variable costs vary with the
same measure of activity level is misleading.

In summary, conventional classification of fixed and variable costs being

defined in relation to one factor, that of production volume is simplistic and at
best only at a crude approximation of reality.
 Typical Cost Pattern.

Variable Cost Pattern Linear:

Cost. Cost.

Activity level. Activity level.

Examples of costs that behave in this linear pattern are:

a. Direct materials cost

b. Royalties per unit of production
c. Power usage (without the fixed element)

A perfectly linear variable cost over all activity levels is extremely unlikely. More
realistically, a cost may be linear only over the relevant range of activity level.

Cost.

Activity level.

This is a normal curve.

Activity Range.

The cost function variable cost is Y= bx where b is the slope of the curve i.e. variable cost per
unit.

Variable Cost Patter (curvy-linear):

These are cost patterns where the costs don’t vary in direct proportion with activity level e.g.
cost

Variable Cost Curve.

Activity level.

The previous diagram is called a convex curve.

Implications:

An extra unit of activity causes less than proportionate increase in the cost i.e. economies of
scale operates.

Cost

Variable cost curve.

Activity level.

The diagram above is called a concave curve. The function is termed parabola.

Implication:

An extra unit of activity causes more than proportionate increase in cost i.e. diminishing
returns operate. Mathematically, the function of a parabola is gives as: Y = bx + Cx2 + ..... +
Pxn

Where: b, c and p are constant, and x is the activity level, while y is the variable cost.

Other Cost Pattern.

Fixed Cost Pattern:

i. Cost

Activity level.
 Cost

Normal activity range

Activity level.
e.g. rates, rents, time based depreciation, salaries, etc.
Mathematically, fixed cost function is given as: Y = a.

Semi-variable Cost Pattern:

ii.

Cost

Linear semi-variable cost pattern

Activity level.

iii. Cost

Curvy linear semi-variable cost.

Activity level.

Examples include cost of electricity, telephone charges, computer bureau cost,

some direct wage scheme with a piece of work and a guaranteed minimum
payment system.
Mathematically, a semi-variable function is given as:
Linear: Y = a + bx
 Curvy Linear: Y = a + bx + cx2 + ... + pxn

Stepped Cost:
Cost. Cost.

Output Output

Cost.

Output.

Examples are bought-in materials when they are at discounts, supervisory salary.

Factors Influencing Cost Behaviour.

1. Activity Level:
● Production Volume
● Sales Volume
● Hours of work
● Number of invoices processed, etc.
2. Time: the passage of time.
3. Non-Volume Factors:
● Technologies
● Methods of production
● Levels of efficiency
● Price levels

COST ESTIMATION TECHNIQUES / FORECATING TECHNIQUES.

Cost estimation is a term used to describe the measurement of historical cost with a few to
helping in the prediction of future costs for management decision making, i.e. historical
information is analysed to provide estimates on which to base future expectations. Not all
costs behave in the same way. Certain costs, such as direct material cost vary in proportion to
changes in volume of activity. Other costs don’t change regardless of the volume; an
understanding of cost behaviour is very useful for:

1. Planning: e.g. break-even analysis

 2. Short-term decision making; e.g. make or buy decision, acceptance or rejection of
special order.
3. Performance appraisal using contribution approach.
4. Flexible budgeting i.e. for planning and controlling.
5. For purposes of various types of cost analysis, semi-variable costs must be broken
down into their fixed and variable components.
6. Since semi-variable costs contain both fixed and variable components, the analysis
takes the following mathematical form called the cost volume formula i.e. Y = a + bx.
Where; a = total fixed cost; b= variable cost per unit; x = number of units; Y= total
costs.

Cost Estimation Techniques

There are basically five methods that can be used to predict future cost/figures from the
analysis of past data:

● Industrial Engineering Method

● Account Analysis Method/Inspection of Accounts Method
● High-Low Analysis Method
● Scatter Diagram
● Regression Analysis.

Engineering Method.

This method is based on the use of engineering analysis of the technological relationships
between inputs and outputs in physical terms. Analyses are made based on direct
observations of the underlined quantities required for an activity and the final results are then
converted into cost estimates. This procedure is as follows:

1. Established quantities of inputs required of:

● Material usage
● Labour units
● Equipments needed, etc.
2. Applied prices and rates to the physical measurement to obtain cost estimate.

Application of Engineering Method

1. Where there are no previous cost methods

2. Where inputs have relationship and are closely defined
3. Where direct cost forms a large portion of the total cost.
Advantages:

1. The main merit of the engineering method of forecasting is that standards are
established to be used as a basis to measure efficiency.

Disadvantages:

1. It requires skilled labour

2. It is time consuming
3. It is expensive
4. It is inappropriate for estimating costs that are difficult to associate differently with
individual units of output e.g. fixed overhead cost items.

Account Analysis Method

This method is based on an inspection of the account for different activity levels. The
prediction of cost based on this method is only valid within given assumptions:

1. That the time period should be relatively short

2. Where there are only small variations outside the normal activity level.
3. Where production methods, technology and management policy are constant.

This method involves the classification of costs into fixed and variable components, semi-
variables/semi-fixed costs.

Advantages:

1. The data for analysis is readily available.

Disadvantages:

1. The initial classification has a considerable subjective element.

2. The method of dealing with semi-variable costs is often arbitrary.
3. By their nature, stepped costs are either to be forced to either a fixed or variable
category with a subsequent loss of accuracy.
4. It uses past data which may not be representative of future conditions.

High-Low Method

This method as the name indicates uses two extreme data points to determine the values of:

a= fixed proportion of cost

b= the variable rate.

In this equation Y= a + bx, the method has a forecast of lowest and highest and comparing
the changes in the costs that result from the changes in the two activity levels. It involves the
following steps:
 1. Select the highest output level and the related cost (this may not necessarily be the
highest cost).
2. Select the lowest output and the related cost (this may not necessarily be the lowest
cost).
3. Compute the variable rate using this formula:

Variable Rate= Difference in cost (Y) / Difference in activity (x).

4. Compute the fixed cost portion as:

Total fixed cost= Total cost – Total variable cost.

It must be noted that for the fixed cost to be correct, you must use either the total cost of the
highest level or the total cost of the lowest level.

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

Illustration:

AB ltd. has kept the following records of output and total costs for the past six months.

MONTH OUTPUT TOTAL COST (N)

1 7,000 250,000

2 8,000 230,000

3 6,200 194,000

4 7,700 222,000

5 8,200 229,000

6 7,800 212,000

Estimate the cost equation in the form of Y = a + bx.

OUTPUTS RELATED COST (N)

HIGHEST OUTPUT 8,200 229,000

LOWEST OUTPUT 6,200 194,000

2,000 35,000

Variable Rate = 35,000/2,000

Variable Rate (b) = 17.5

Fixed cost (a) = ₦229,000 –( 8,200x₦ 17.5) =₦85,500.00.

Fixed cost (a) =₦ 85,500

Y = 85,500 + 17.5 (x)

The effect of inflation

When trying to find the cost characteristics from past data, the recurring problem is the effect
of inflation on the cost. The inflation affects all costs, both fixed and variable and to be able
to get the real underlined cost characteristics, the effect of inflation must be allowed for. This
has to be done whatever estimation technique of cost is used whether high-low, scattered,
account analysis, regression or engineering analysis.

Illustration:

EB ltd. recorded the following total costs in the last five years:

YEAR OUTPUT UNIT TOTAL COST (N) AVERAGE PRICE

LEVEL INDEX

2011 97,500 362,500 100

2012 120,000 440,000 112

2013 135,000 522,750 123

2014 90,000 504,000 144

2015 112,500 620,000 160

Required:

1. Estimate the cost equation expected in 2016 when the average price index level will
be 180.
2. What will be the resulting total cost in 2016 if 175,000 units were produced?

Solution:

Output Related cost₦ Average price index.

Highest: 135,000 522, 750 123

Lowest 90,000 504,000 144

Working:

522,750 X (180/123) =₦ 765,000 (inflated cost)

504,000 X (180/144) =₦ 630,000 (inflated cost)

Output Inflated Cost₦.

Highest Output: 135,000 765,000

Lowest Output: 90,000 630,000

45,000 135,000

Variable rate = 135,000/45,000

Variable rate = N3

Total Fixed Cost = N765,000 –(135,000 X N3)

Total Fixed Cost = N360,000

Y = 360,000 + 3x

Y = 360,000 + 3(175,000)

Y = 360,000 + 525,000

Y = N885,000

1. Y = 360,000 + 3x
2. N885,000

Illustration.

Kayode’s company total overhead cost constrained from year to year according to number of
direct labour hours worked in the factory. These costs at high and low levels of activity for
recent years are given below:

LEVELS OF ACTIVITY LOW HIGH

Direct labour hours 60,000 80,000

Total factory O/H cost N244,000 N282,000

The factory overhead cost above consists of indirect materials, rent and maintenance. The
company has analysed the cost 60,000 direct labour hours level of activity and has
determined that at this activity level, the costs exist in the following proportions:

Indirect Materials (variable) N90,000

Rent (fixed) N100,000

Maintenance (mixed) N54,000

Total factory overhead. N244,000

For planning purposes, the company wants to break down the maintenance cost into its
variable and fixed cost elements.

1. Determine how much of the 282,000 factory O/H cost of the high level of activity
above consists of maintenance cost.
2. By means of the high-low method of cost analysis, determine the fixed cost present /
portion in the maintenance cost.
3. Express the company’s maintenance cost in the linear equation Y = a + bx
4. What total O/H cost will you expect the company to incure at an operating level of
70,000 direct labour hours?
5. What is the major criticism on the high-low method of segregating the mixed cost into
fixed and variable elements?

Solution.

1. Variable point : 90,000/60,000 = N1.50K

Indirect materials (N1.50 X 80,000) N120,000
Rent (fixed) N100,000
Balance (N220,000)
N282,000
Mixed cost@ 80,000 level
Maintenance cost N62,000

For presentation,

N N

Total overhead cost 282,000

Less:

Indirect materials 120,000

Rent (fixed) 100,000 (220,000)

Maintenance cost @

the highest level 62,000

2.

OUTPUT RELATED COST (N)

Highest 80,000 62,000

Lowest 60,000 54,000

20,000 8,000

Variable Rate = 8,000/20,000

Variable Rate (b) = N0.40k

Fixed Cost = 62,000 –(N0.40k X 80,000)

Fixed Cost = N30,000

3. Y = 30,000 + N0.40
Y = 30,000 + N0.40x
Y = 100,000 + 1.5x (rent and indirect materials)
Y = 130,000 + N1.9x
Y = 130,000 + (N1.9 X 70,000)
Y = 263,000

Illustration

Must Associated ltd manufacture a single product as ACA. The company’s total overhead
cost fluctuates considerably from diet according to the number of students admitted to the
school. The costs at high and at low level of activity for recent diets are given below:

HIGH LOW

Student Population 40,000 30,000

Total Overhead cost (N) 141,000 122,000

The total overhead cost above consists of indirect cost materials, rent and maintainable cost.
The company has analysed the cost of 30,000 students and has determined that at this activity
level the costs exist in the following proportion: N

Direct materials/packages (variable cost) 45,000

Rent of classroom (fixed cost) 50,000

Maintenance (mixed) 27,000

122,000

For planning purposes, the company wants to break the maintenance cost into variable and
fixed components.

a. Identify how much of the N141,000 of the overhead cost at the high level of the
activity consists of maintenance cost.
b. By means of high and low method cost analysis; determine the fixed cost element for
maintenance cost.
c. Express the company’s cost in a linear equation form Y = a + bx.
d. What total overhead cost will you expect the company to incur at an operating level
of 20,000 , 25,000 , 29,000 , 35,000 and 50,000 students.

Solution.

a. Low: variable cost per unit = 45,000/30,000 = N1.50k

High: 40,000 student population
Direct materials/packages (N1.5 X 40,000) 60,000
Rent of classroom 50,000
(110,000)
141,000

Maintenance (mixed cost @40,000 level) N31,000

b.

Highest 40,000 31,000

Lowest 30,000 27,000

10,000 4000

Variable Rate: 4,000/10,000 = N0.40k

Total fixed cost = N31,000 –(0.4 X 40,000)
= N31,000 – 16,000
= N15,000
c. Maintenance cost: Y = N15,000 + N0.40x
Direct materials and rent: Y = 50,000 + 1.5x
Company’s cost: Y = 65,000 + 1.9x
 d. 20,000 students:
Y = 65,000 + (1.9 X 20,000)
65,000 + 38,000
Y = N103,000
25,000 students:
Y = 65,000 + (1.9 X 25,000)
Y = 65,000 + 47,500
Y = N112,500
29,000 students:
Y= 65,000 + (1.9 X 29,000)
Y = 65,000 + 55,100
Y = N120,100
35,000 students :
Y= 65,000 + (1.9 X 35,000)
Y= 65,000 + 66,500
Y = N131,500
50,000 students :
Y= 65,000 + (1.9 X 50,000)
Y= 65,000 + 95,000
Y= N160,000

Advantages of High-Low Method.

1. It is capable of providing consistent result from different users

2. It eliminates subjectivity
3. Unlike regression analysis, this method is simple to calculate.

Disadvantages of High-Low.

1. The method relies solely on two extreme values i.e. highest and lowest which may be
recorded at an abnormal period to the organisation.
2. The final result of the method may not represent actual cost position of the
organisation.

Scatter Diagram / Scattered Graph Method

Due to the limitation noticed in the high-low method of segregating mixed cost into fixed and
variable element, it was thought wise that there was a need to consider all the available
observations when drawing a line to establish a cost estimate. The graphical method makes
use of all the available observation in arriving at the cost estimate, the total cost of each
activity level is plotted on the graph then the line of best fit is drawn observing the following
rules:

a. If the number of observed data on the graph is even then the line of best fit is drawn
across the graph in such a way that the data are equally divided into two parts.
 b. If the number of observation data is odd, then the line of best fit is drawn in such a
way that one of the data is completely ruled out while the remaining data are equally
divided into two parts. The intercession of the line of best fit along the Y axis
represents the constant factor or total fixed cost while the gradient of the line of best
fit represents the variable cost element.

Line of best fit

Cost x x variable cost

x x

x x x
Fixed costs

Activity level.

Illustration.

Kikelomo ltd decided to relate total factor overhead cost to direct labour hours to develop a
cost volume formula in the form of Y = a + bx. 12 monthly observations were collected. They
are given below:

MONTH DIRECT LABOUR FACTORY O/H (Y)’OOO

(X)’OOO HOURS (N)

January 9 15

February 19 20

March 11 14

April 14 16

May 23 25

June 12 20

July 12 20

August 22 23

September 7 14

October 13 22

November 5 18
December 17 18

174 hours N225

Least Square Regression Analysis

This method uses series of past data to estimate or forecast the trend of past datacc’ obtained
and used to make the forecast by determining the value for a and b. The value for a and b can
be determined by using any of these formulas.

1. ∑ Y = Na + b ∑ x
∑xy = a ∑x + b∑x2
The value for a can be obtained by solving the simultaneous equation.
2. b = N∑xy - ∑x∑y a = ∑y - b∑x
2 2
N∑x – (∑x) N N
3. b = ∑ (x – x ) (y – y ) a = ∑y - b∑x
∑ (x – x)2 N N
It should be noted that formula number 3 is very useful when data collected are too
voluminous.

Illustration

You are provided with the following historical data in respect of a manufacturing company.

MONTH OUTPUT (UNIT) TOTAL PRODUCTION COST (N)

January 80 10,200

February 90 10,900

March 100 12,100

April 80 10,800

May 120 13,700

June 110 12,500

Solution:

∑y = Na + b∑x

∑xy = a∑x + b ∑x2

OUPUT UNITS TOTAL PRODUCTION COST (Y) XY X2

(X)
80 10,200 816,000 6,400

90 10,900 981,000 8,100

100 12,100 1,210,000 10,000

80 10,800 864,000 6,400

120 13,700 1,644,000 14,400

110 12,500 1,375,000 12,100

∑X = 580 ∑Y = 70,000 ∑XY= 6,890,000 57,400

70,200 = 6a + 580b

6,890,000 = 580a + 57,400b

After elimination,

-624,000/-8,000 = -8,000b/-8,000

b = 78.

40,716,000 = 3480a + 336,400b

40,716,000 = 3480a + 336,400(78)

40,716,000 = 3480a + 26,239,200

40,716,000 - 26,239,200 = 3480a

14,476,800/3480 = 3480a/3480

a= 4160.

Regression Statistics

Unlike the high-low method, regression analysis is a statistical method. It uses a variety of
statistics that tell us about the accuracy and reliability of the regression result.

Correlation co-efficient r determines the extent of relationship between two or more

variables. It should be noted that:

1. Where r = 1, there is a perfect positive relationship between variables.

2. Where r = -1, there is a perfect negative relationship between variables.
3. Where r = 0. There is no relationship at all between variables.
4. The closer r is to 1 or -1, the closer r is to 0, the less close the relationship.
Correlation co-efficient ‘r’ is calculated using the following formula:
r = N∑xy - ∑x∑y
√N∑x2 – (∑x)2 X N∑y2 X (∑y)2
Illustration

Use the data in the previous illustration to find correlation co-efficient ‘r’.

Solution

r= 6(6,890,000) – (580 X 70,200)

√6(57400)-336,400 X 6(829,840,000) – 49,280,400

r= 624,000

√8000 X 51,000,000

r= 0.9769~0.98.

Co-efficient of determination of ‘r’ is the measure of goodness of fit of *

Therefore, the higher the r2, the more confidence we have in our estimated cost formula.
More specifically, the co-efficient of determination represents the proportion of the total
variation required in y (dependent variable). It has a range of values between zero and one. In
our illustration,

R2 = 0.982

R2 = 0.96 or 96%

This result is telling us that 96% of the variation in the total production cost of * for the 6
months period or accounted for although not necessarily caused by changes in the level of
output produced during the same period, the remaining 40% is explained by random variation
and also by the effect of the others, interacting but unknown variables.

Assumptions of the Breakeven Analysis.

1. Total fixed cost is constant.

2. It is assumed that there will be no uncertainty.
3. All variable costs per unit remain constant.
4. All costs can be accurately divided into fixed and variable element.
5. There are no stock level changes i.e. stock level remains constant.
6. The analysis applies to the relevant range only.
7. It assumes that the only factor that affects revenue and cost is the activity level.
8. It assumes that there is only one product and where there is more than one product, it
has a constant mix.
9. Constant technology will not change.
10. Costs and revenues behave in a linear version.

Contribution = sales – total variable cost or (selling price per unit – variable cost per unit).
Application of Break Even Analysis.

a. To determine breakeven point in units, the total fixed cost of the organisation would
be divided by the contribution per unit.
BEP = Total fixed cost/contribution margin ratio OR
(Total fixed cost/contribution per unit) X selling price.

The level of sales in unit required to achieve the predetermined profit before tax will
represent the solution of fixed cost and profit before tax divided by the contribution per unit.

Sales in unit to achieve a predetermined profit before tax:

TFC + PBT / contribution per unit.

The level of sales value to result in target profit before tax is determined as follows:

Sales in volume to achieve a predetermined profit before tax:

TFC + PBT / Contribution margin ratio.

To determine level of sales unit required to achieve a predetermined profit after tax, apply
this formula:

Sales volume in units to achieve a predetermined profit after tax:

Total fixed cost + (Profit after tax / 1 – Tax rate ) / contribution per unit.

To determine the level of sales value in naira that will result in the following target profit:

TFC +(PAT / 1 – Tax rate)) / CMR

OR

TFC + (PAT/1 – Tax rate) ) / CPU X Selling price per unit

CONTRIBUTION MARGIN RATIO.

The word contribution represents the difference between the selling price and the marginal
cost or summation of fixed cost with the net profit.

The ratio of contribution to a particular sales value is described as contribution margin ratio.
It can also be referred to as profit volume ratio. It is designed to measure the level of
contribution derivable from a specified amount of sales.

CMR will be determined according to the nature of information provided as follows:

1. CMR in units: (selling price – Variable cost per unit) / selling price per unit
 2. CMR in total: (total sales – total variable cost) / total sales
3. It is also possible to compute CMR where net profit is presented at different activity
levels as follows:
CMR = changes in profit/changes in sales volume
4. When the existing information are to be altered as a result of additional fact, then
CMR in unit: (Revised selling price – Revised variable cost) / revised selling price.
CMR in total: (Revised total sales – Revised variable cost) / Revised total sales.

MARGIN OF SAFETY.

This represents the difference between the break-even point and the budgeted level of activity
level. Margin of safety indicates by how much sales may decrease before a company suffers
loss.

Margin of safety may be determined either in units or in sales volume as follows:

Margin of safety in units: budgeted unit/BEP unit

Margin of safety in Naira: budgeted sales value in Naira/BEP in naira.

Reduction in the level of activity until the company makes a loss. But if you want to use
graphical approach, the number of units represented on the chart by the distance between the
BEP and the budgeted sales in units. It indicates the margin of safety i.e. the number of units
by which the anticipated sales can fall before the business makes a loss.

Illustration

The following figures relate to a company manufacturing a varied range of products.

Year Total sales Total cost

1 39,000 34,800

2 43,000 37,600

Required:

Assuming stability in price with the variable cost controlled to reflect pre-determined
relationship and an unvarying figure for fixed cost. Calculate:

a. The fixed cost

b. The profit volume ratio
c. Breakeven point
d. Margin of safety for year 1 and 2.

Solution
Variable cost per N1 sales Total sales Total cost

High 43,000 37,600

Low (39,000) (34,800)

4,000 2,800

2,800/4,000 = N0.7 per unit.

a. For fixed cost,

Highest lowest

Total cost 37,600 34,800

Variable cost (0.7 X 43,000) (30,100)

(0.7 X 39,000) (27,300)

Fixed cost 7,500 7,500

b. PVR = (sales – variable cost)/sales

= (N1-N0.70k) / N1
= 0.3
c. BEP = TFC/CMR

7,500/0.3

BEP = N25,000

d. Margin of safety = N39,000 – N25,000 = N14,000

= N43,000 – N25,000 = N18,000

BREAK-EVEN POINT OF MULTIPRODUCT FIRM.

In our earlier discussion on this topic, one of the assumptions says that there is only one
product in the firm and where the products are more than one, the mix of these products are
constant. But in reality, hardly can a firm be producing one product. It will be wrong to use
the break-even point of one of the products as the BEP of the firm when the firm produces
more than one product. This is due to the fact that individual product is expected to operate
under different cost structure; marketing, strategy and different markets altogether. It is
however possible to identify the organisation’s BEP by applying the following set of
predetermined rules:

1. Identify the total fixed cost for the entire organisation irrespective of the number of
the product line.
2. Compute CMR for the entire organisation using total value method.
3. Use the information obtained in 1 and 2 above to determine the BEP in sales value for
the entire organisation irrespective of the number of products.
4. Determine the individual product sales proportion as a percentage of the total
turnover.
5. Apply the individual product sales percentage to the BEP in sales value obtained in 3
above.

The effect of the analysis will be individual product BEP in sales value. In order to identify
the individual product BEP unit, divide the individual product BEP in sales value by the
corresponding or associated selling price.

Illustration

For the forthcoming year, the management of Action Time ltd has projected that sales and
contribution will have the following pattern:

product Sales (N) Selling price(N) Contribution (N) CMR

A 180,000 18 54,000 0.5

B 42,000 21 (4,200) 0.1

C 90,000 45 - -

D 168,000 42 67,200 0.4

E 120,000 30 60,000 0.5

Required:

Determine the number of units of each product to be sold in order to earn an after tax profit of
N116,400. Assuming the total fixed cost is N120,000 and tax rate is 20%

Solution

Action Time ltd.

1. Contribution: 54,000 + (4,200) + 67,200 + 60,000 = N177,000

Sales: 180,000 + 42,000 + 90,000 + 168,000 + 120,000
= N600,000
CMR: Total contribution/Total sales

CMR = 177,000/600,000
 CMR = N0.295 ~ N0.3

Sales in value = (TFC + (PAT/1-Tax rate)) / CMR

Sales in value = (120,000 + (116,400/1-0.2)) / 0.295

Sales in value = (120,000 + 145,500) / 0.295

Sales in value = 265,500/0.295; = N900,000.

2. Percentage of individual product sales to turnover:

Product A: (180,000/600,000) X 100 = 30%
Product B: (42,000/600,000) X 100 = 7%
Product C: (90,000/600,000) X 100 = 15%
Product D: (168,000/600,000) X 100 = 28%
Product E: (120,000/600,000) X 100 = 20%
3. Percentage sales required to achieve a sales of 900,000

Products Total sales Selling Price Units

A- O.3 X 900,000 270,000 18 15,000

B- 7% X 900,000 63,000 21 3,000

C- 15% X 900,000 135,000 45 3,000

D- 28% X 900,000 252,000 42 6,000

E- 20% X 900,000 180,000 30 6,000

LIMITATIONS OF BEP ANALYSIS.

1. The result of analysis can only be relied upon within the relevant range i.e. within the
activity level that the associate cost can be accurately determined.
2. The assumption that fixed cost will remain the same at all levels of activity may be
faulty. This is because fixed cost is likely to change at different activity levels.
3. It is also improper to calculate the variable cost and sales will be linear because the
effect of extra discount, special pricing contract, etc. which makes variable cost and
revenue as a curve rather than a straight line.
4. The CVP analysis represents relationships which are essentially short-term. It means
that this analysis cannot handle long-term.
5. The concept of CVP analysis relies heavily on behavioural classification of cost to say
only activity level determines the changes in revenue and cost whereas in practice,
there are several factors that influence changes in revenue and cost apart from
activity level.
6. It is true that revenue and variable cost vary with level of activity but the reaction of
individual components such as material cost
7. It is incorrect to assume that there is a perfect market i.e. the firm is a price taker.
 8. BEP also ignores risk and uncertainty.
9. CVP analysis also assumes a single product or constant product mix and this is an
over simplification of reality of life.

ABSORPTION AND MARGINAL COSTING

In preparing financial / operating statement, there are two methods:

1. Absorption costing method

2. Marginal costing method

Absorption Costing

All costs which include fixed cost and variable costs are ultimately charged or allocated to
cost and total overheads are then absorbed according to a given level of activity in order to
ascertain a total given level of activity.

The cost to be absorbed may be production cost only or all functions whether production or
otherwise.

Advantages:

1. It is approved by tax authority

2. The computation based on marginal costing may lead to under pricing of products
3. Where production is constant but sales fluctuates, net profit fluctuations are less with
marginal costing.

Format:

N N

Sales XX

Less production costs

Opening stock XX

Direct materials XX

Direct wages XX

Direct expenses XX

Variable production cost XX

Fixed production cost XX

Goods available for sale XX

Less closing stock (XX)

Add under absorption of fixed prod. o/h XX

Less over absorption of fixed prod. o/h (XX) (XX)

Gross profit XX

Less non production cost:

Selling and distribution XX

Administrative cost XX

Other costs XX (XX)

Net income before tax XX

Less income tax (XX)

Net income after tax XX

Disadvantages:

1. The cost figures attributed to each unit of production are dependent on each level of
cost incurred as well as the volume of production.
2. Fixed overheads are difficult if not impossible to accurately attribute to each unit.
Hence, the result is not genuine being dependent on the various allocations method.

Marginal Costing ( when you here marginal is only variable)

Only variables cost are charged (direct costs and variable overheads) to cost units and the
marginal cost of a product is its variable cost. It can be defined as the accounting system in
which variable costs are charged to cost unit and fixed cost for the period are charged in full
against the aggregate contribution. Its special values are in decision. For any product, the
difference between sales value and variable cost is known as its contribution towards

1. The general fixed cost of the business

2. The actual net profit
The actual net profit of the period will represent the difference between the total
contribution and the period cost

Contribution means recovering of fixed cost and net profit .

Advantages

1. It is simple to operate
2. It ignores the arbitrary apportionment of fixed cost
3. Accounts prepared using marginal costing are likely to be based on actual cash flow.
4. For fixed costs incurred on likely basis and do not relate to activity level, it is ideal to
write them off in the period they are incurred.
FORMAT: N N

Sales xx

Less production cost:

Opening stock xx

Direct material xx

Direct wages xx

Direct expenses xx

Variable production cost xx

Cost of goods available for sale xx

Less closing stock xx (xx)

Add variable non-prod. Exp.

Selling and distribution xx

Administrative expenses xx

Other costs xx

Commission xx xx

CONTRIBUTION xx

Less period costs:

Fixed production cost xx

Fixed non-production cost xx (xx)

Net profit xx

DECISION MAKING UNDER CERTAINTY.

In taking short-term, medium or long term decision, management in both the public and
private sectors of the economy must adopt some tools that will aid better decision making for
the achievement of organizational goals. In accounting, there are many tools to be used in the
decision making by the management. Two of the most popular decision making techniques
are Marginal costing and Absorption costing methods.
Making decisions requires that only those costs and revenues that are relevant to the
alternatives are considered. If irrelevant cost and revenue data are included, the wrong
decisions may be made. It is therefore essential to identify the relevant costs and revenues
that are applicable to the alternatives being considered.

But for short term tactical decision such as:

-Special selling price decisions;

-product mix decisions when capacity constraints exists;

-decisions on replacement of equipment;

-outsourcing (make or buy) decisions;

-discontinuation decisions.

Costs and Revenues to be considered in short term tactical Decisions.

The relevant costs and revenues required for decision making are only those that will be
affected by the decision.

RELEVANT COSTS FOR DECISION MAKING

Although an existing structure of costs analyzed between fixed and variable items, will
remain valid over a defined range of existing activities, the purpose of decision making will
normally be to alter some aspect of the business "when this is done then the pre-existing
levels of variable cost per unit or relevant fixed costs will cease to be applicable. 'It will be
necessary, therefore, to define in relation to each decision which item of cost or revenue will
be changed as a result of taking the decision. In other words, to define which costs and
revenues are relevant to the particular decision and to calculate the differential costs or
benefit caused by the decision. Instead of "differential" it is also possible to use any of the
following term:

I Incremental cost II Relevant cost III Separable cost

IV. Illuminable cost V. Avoidable cost VI Attributable cost
VII. Controllable cost VII Direct cost IX. Specific cost
X. Traceable cost
a) Historical Cost: Every decision deals with the future. The function of the decision
maker is to select courses of action for the future and this decision must by its
nature be based on predictions. Historical costs are therefore irrelevant to decisions
though they may be die best available basis for predicting future cost,
b) Past Cost: Cost incurred in the past i.e. sunk coasts will always be irrelevant. The
decision maker has no opportunity to alter what has already happed. Some specific
examples of this are:
(i) Obsolete Stock: The cost of stock already held and now proved to be
obsolete, has no relevance to a decision regarding its disposal or other use.
(ii) Old equipment: The cost of new equipment and the disposal value of old
equipment are relevant future transactions. The book value of old
equipment is irrelevant to any decision making technique.
c) Other terms that may also apply to historical or past costs are:
(i) General cost (ii) Indirect cost (m) Unavoidable cost
(iv) Allocated cost (v) Apportioned cost (vi) Prorated cost
(vii) Uncontrollable cost.
d) Variable Cost: This will represent those categories of cost that cannot be referred
to as either labour or material yet varied with the activity level. As a result of this
relationship with the activity, variable cost constitute a relevant cost to any
decision.
Relevant cost in this context are only those expected future cost that will differ
under alternative courses of actions.
e) Fixed Cost: Cost which have been classified as fixed by convention or on die basis
of past experience may in fact be affected by a particular decision. This may be for
two reasons:
a. The Costs are fixed in relation to the level of activity previously
experienced, but a decision may extend the range of activity and thus cause
certain fixed costs to be stepped up to new level.
b. The costs are fixed in relation to the normal time horizon for forecasting
but if the time span of an action exceed the normal period, then fixed costs
may change.
Therefore, a fixed cost will be relevant to a particular decision, if that decision
will, influence the actual cost to increase as stated above. But where there will
be no alteration in the position of a fixed cost, then such cost will not be
relevant in future decisions.
f) Direct Cost: This will represent total cost that will be directly incurred in the course of
manufacturing a product or rendering a service e.g. Material Cost, Labour Cost and
Direct expenses.
▪ Material Cost: For the purpose of valuing raw material for decision making
different values will require attention as follows:

❖ Replacement Value: This will represent the current market price of the
items. It will be required in valuing raw material, if it can be ascertained that
the raw material is frequently used by the organization.

❖ Net Releasable Value: This will also represent the current disposable value
of an item or raw material presently held in store. This amount would be
relevant in pricing decision in it can be established that the purpose of
acquiring the material initially is no longer achievable.

❖ Historical Price: This will represent the actual cost of obtaining the raw
material as at the time of purchase. In decision making, historical cost are
sunk cost, therefore irrelevant in any present or future decision.

▪ Labour Cost: This will represent the total remuneration payale to workers for their
productive services to the organization. However, for the purpose of decision
making, labour may be categorised into two:

❖ Full-Time worker:- Also referred to as salaried worker. The remuneration

of this cadre of labour represent a fixed cost to the organization since it is
payable at the end of a specified period. This labour cost will not be relevant
in present or future decisions except the increase in the present amount as a
result of that decision.

❖ Ad-hoc worker: Under any circumstance, the remuneration of casual worker

will represent a relevant cost to the organization. This is because such cost is
directly attributable to the decision on whether or not a particular order
should be accepted or not.

g) Sunk costs
Past costs, which are not relevant to a decision, are called sunk costs. The CIMA
Official Terminology describes sunk costs as costs that have been irreversibly
incurred or committed prior to a decision point and which cannot therefore be
considered relevant to subsequent decisions. Sunk costs may also be termed
'irrecoverable costs.'

h) Committed Costs
 Not all future costs are relevant to a future decision - some future costs will arise
as a result of decisions that have already been taken. These are called committed
costs. Typical committed costs are staff salaries and the rent for equipment and
buildings where these relate to contractual obligations made in the past.

Example: Committed cost

A company bought a machine one year ago and entered into a maintenance
contract for ₦20,000 for three years. The machine is being used to make an item
for sale. Sales of this item are disappointing and are only generating ₦15,000 per
annum and will remain at this level for two years. The company believes that it
could sell the machine for ₦25,000. The relevant costs in this decision are the
selling price of the machine and the revenue from sales of the item. If the
company sold the machine it would receive ₦25,000 but lose ₦30,000 revenue
over the next two years – an overall loss of ₦5,000 The maintenance contract is
irrelevant as the company has to pay ₦20,000 per annum whether it keeps the
machine or sells it. Leases normally represent a committed cost for the full term of
the lease, since it is extremely difficult to terminate a lease agreement

i) Future Cash Costs

All future cash expenditure specifically identified with a decision is relevant to

that decision. It is easy to identify specific future cash costs as they will arise from
a precise documentation sequence, such as purchase orders followed by suppliers
invoices that are then paid for by cheque.
j) Differential Costs
Additional future costs may be differential (or incremental) costs. These are the
increases or decreases in costs that result from a decision to choose one
alternative over another.

The term differential cost and 'incremental cost' are interchangeable. CIMA
Official Terminology defines differential /incremental cost as 'the difference in
total costs between alternatives; calculated to assist decision making.

Example: Incremental fixed cost (stepped fixed costs) A company owns a factory
which has the capacity to produce 100,000 units per annum. The factory is
operating at 80% of this capacity (i.e. 80,000 units per annum are being made but
 the company could make an additional 20,000 units if required). The variable
cost per unit is ₦60. The company has received an enquiry to supply 30,000 units
per annum for the next 5 years at a sales price of ₦100. In order to fulfil this
order the company would have to rent additional premises to make the 10,000
units which it is unable to make in its current premises. The rent of the additional
premises is a fixed cost but it is incremental to the project and must be included
in the decision making process. What would the decision be if the rent were: a)
₦300,000 b) ₦500,000?

a b

Incremental annual amounts ₦ in ‘000

₦ in ‘000

Revenue (10,000 units  ₦100) 1,000

1,000

Variable costs (10,000 units  ₦60) (600)

(600)

400
400

Fixed costs (300)

(500)

100 (100)

Decision Accept the offer Reject the offer

Making and selling 10,000 extra units would generate extra contribution of
₦400,000. However, the company must also consider the incremental fixed costs
in order to make the correct decision.

k) Avoidable Costs
Avoidable costs that result from a decision are relevant to that decision. For
instance, the cost of running a. credit control department is an avoidable cost. It
is not absolutely obligatory for a business to have a credit control department, but
 it is not possible to dispense with the Chief Executive (or whatever job title that
person may have).

So, the costs involved in employing a Chief Executive can be classed as

unavoidable costs. Another term for avoidable costs is 'specific costs'.

l) Contribution
Contribution is defined in CIMA Official Terminology as 'Sales value less
variable cost of sales' but this is a rather restrictive definition. In many
management accounting contexts contribution is the term used to refer to the
extra profit resulting from a decision, action or plan. In such cases contribution
will be the difference between sales value and the sum of the variable costs and
any other costs that are specific to the decision, action or plan.

m) Opportunity Costs

Opportunity costs are non-cash costs that are relevant to a decision. Taking a
decision means making a choice, so at least one alternative course of action must
be rejected. That alternative course of action may have a value. The opportunity
cost of a particular decision is the value of the benefit scarified when one course
of action is chosen in preference to an alternative.
CIMA Official Terminology defines Opportunity cost as 'The value of the benefit
scarified when one course of action is chosen in preference to an alternative. The
opportunity cost is represented by the foregone potential benefit from the best
rejected course of action.

Example: Opportunity costs A company has been asked by a customer to carry

out a special job. The work would require 20 hours of skilled labour time. There
is a limited availability of skilled labour, and if the special job is carried out for
the customer, skilled employees would have to be moved from doing other work
that earns a contribution of ₦600 per labour hour. A relevant cost of doing the
job for the customer is the contribution that would be lost by switching
employees from other work. This contribution forgone (20 hours × ₦600 =
₦12,000) would be an opportunity cost. This cost should be taken into
consideration as a cost that would be incurred as a direct consequence of a
decision to do the special job for the customer. In other words, the opportunity
 cost is a relevant cost in deciding how to respond to the customer’s request.
What would the decision be if the special job would generate a contribution of: a)
₦15,000 b) ₦10,000?

a b

₦ ₦

Contribution earned 15,000

10,000

Contribution lost (12,000) (12,000)

3,000 (2,000)

Decision Accept the offer Reject the

offer

n) Shadow price
Shadow price is a special type of opportunity cost. A shadow price is the extra
contribution that could be achieved by having one extra unit of a scarce resource.
CIMA Official Terminology's definition of shadow price is 'An increase in value
which would be created by having available one additional unit of limiting resources
at its original cost. This represents the opportunity cost of not having the use of the
one extra unit. It is usually quite easy to identify the specific future cash costs
involved in a business problem. Opportunity costs and shadow costs can be identified
once you have had some practice. It is sometimes more difficult to identify
differential (incremental) costs and avoidable costs. However, the really hard part of
relevant costing is to identify any sunk or committed costs and to have the confidence
to ignore them.

IDENTIFYING RELEVANT COSTS

There are certain rules or guidelines that might help you to identify the relevant costs for
evaluating any management decision.
Relevant cost of materials The relevant costs of a decision to do some work or make a
product will usually include costs of materials. Relevant costs of materials are the additional
cash flows that will be incurred (or benefits that will be lost) by using the materials for the
purpose that is under consideration. If none of the required materials are currently held as
inventory, the relevant cost of the materials is simply their purchase cost. In other words, the
relevant cost is the cash that will have to be paid to acquire and use the materials. If the
required materials are currently held as inventory, the relevant costs are identified by
applying the following rules:
Are the materials currently in use?
If yes, the relevant cost will be current replacement cost
If no, the relevant cost will the opportunity cost; higher of scrap value and net benefit from
alternative use.
Note that the historical cost of materials held in inventory cannot be the relevant cost of the
materials, because their historical cost is a sunk cost.
The relevant costs of materials can be described as their ‘deprival value’. The deprival value
of materials is the benefit or value that would be lost if the company were deprived of the
materials currently held in inventory.
 If the materials are regularly used, their deprival value is the cost of having to buy more
units of the materials to replace them (their replacement cost).
 If the materials are not in regular use, their deprival value is either the net benefit that
would be lost because they cannot be disposed of (their net disposal or scrap value) or the
benefits obtainable from any alternative use. In an examination question, materials in
inventory might not be in regular use, but could be used as a substitute material in some other
work. Their deprival value might therefore be the purchase cost of another material that could
be avoided by using the materials held in inventory as a substitute
Relevant cost of labour
The relevant costs of a decision to do some work or make a product will usually include costs
of labour. The relevant cost of labour for any decision is the additional cash expenditure (or
saving) that will arise as a direct consequence of the decision.  If the cost of labour is a
variable cost, and labour is not in restricted supply, the relevant cost of the labour is its
variable cost. For example, suppose that part-time employees are paid ₦180 per hour, they
are paid only for the hours that they work and part-time labour is not in short supply. If
management is considering a decision that would require an additional 100 hours of part-time
labour, the relevant cost of the labour would be ₦180 per hour or ₦18,000 in total.  If
labour is a fixed cost and there is spare labour time available, the relevant cost of using labour
is zero. The spare time would otherwise be paid for idle time, and there is no additional cash
cost of using the labour to do extra work. For example, suppose that a new contract would
require 30 direct labour hours, direct labour is paid ₦200 per hour, and the direct workforce
is paid a fixed weekly wage for a 40-hour week. If there is currently spare capacity, so that
the labour cost would be idle time if it is not used for the new contract, the relevant cost of
using 30 hours on the new contract would be zero. The 30 labour hours must be paid for
whether or not the contract work is undertaken.  If labour is in limited supply, the relevant
cost of labour should include the opportunity cost of using the labour time for the purpose
under consideration instead of using it in its next-most profitable way. The cost of an hour of
labour would be the pay per hour plus the lost contribution.
Relevant cost of overheads Relevant costs of expenditures that might be classed as overhead
costs should be identified by applying the normal rules of relevant costing. Relevant costs are
future cash flows that will arise as a direct consequence of making a particular decision.
Fixed overhead absorption rates are therefore irrelevant, because fixed overhead absorption is
not overhead expenditure and does not represent cash spending However, it might be
assumed that the overhead absorption rate for variable overheads is a measure of actual cash
spending on variable overheads. It is therefore often appropriate to treat a variable overhead
hourly rate as a relevant cost, because it is an estimate of cash spending per hour for each
additional hour worked. The only overhead fixed costs that are relevant costs for a decision
are extra cash spending that will be incurred, or cash spending that will be saved, as a direct
consequence of making the decision.

The relevant costs for specific types of decision

We am now look at the typical business decisions described above, and consider which
of the costs described are likely to be relevant. You will need to be able to extract these
caste from the information contained in a practical situation.
Pricing decisions
Managers will want to know what change in contribution will result from a change in
selling price. The relevant costs will be the variable cost of any extra output, or the savings
in variable costs, which may occur if volume falls. If there are constraints on the availability
of a particular resource then its shadow price may also be relevant to the pricing decision.
Sunk costs, such as past marketing expenditure, or committed costs, such as an existing
contract for a future series of IV advertisements, will not be relevant.
Short-term output decisions
The relevant cost involved in short-term output decisions to increase or reduce output will
be:
▪ the extra variable costs incurred or saved;
 ▪ the shadow price of any extra or saved resources, if there are constraints on their
availability.
The variable costs and shadow prices will be compared with the revenue gained or lost to
obtain a figure for the net change in contribution caused by the decision to alter output
levels. Sunk costs, such as depreciation on the plant and machinery involved, and
committed costs, such as supervision salaries, will not be relevant.
Make or buy decisions
Make or buy decisions are where a business has the option to produce a product, or provide
a service itself or to buy the product or service in from an outside supplier, i.e. to
subcontract the work. The relevant costs in such cases are likely to be:
1. the cash costs paid to the outside supplier/subcontractor;
2. any avoidable internal costs which can be saved by subcontracting;
3. the shadow price of any internal resources saved by subcontracting which may be
used for other work if other work is available.
The (km should subcontract the manufacture of the product (or provision of the service) if
the cash costs paid to a subcontractor are less than the avoidable internal costs plus my
shadow price. However, if the avoidable internal costs plus any shadow price are less than
the cash costs paid to the subcontractor, the firm should manufacture the product (or provide
the service) itself. There can be non-financial drawbacks that may I arise from the decision
to employ subcontractors. Sunk costs, such as any previous investment in equipment (or
depreciation) would not be relevant though, if the firm could sell any assets which became
surplus as a result of I the decision to subcontract the cash received from the sale would be
relevant.
Outsourcing Decisions
Outsourcing decisions are those where a business is trying to decide whether to cease
providing an internal service, such as accounting, credit control or payroll, and to buy it from
outside. Outsourcing decisions require much the same information as make or buy decisions.
Accept or reject a special order decisions
Accept or reject a special order decisions arc where a business needs to decide whether to
accept a one-off order from a customer. The relevant costs in such accept or reject
decisions am:
1. the variable cash costs involved, such as extra labour and materials;
 2. any avoidable costs, such as extra power and supervision costs caused by working
at nonstandard times;
3. any opportunity costs, such as the contribution lost when other work has to be
cancelled in order to do the job;
4. the shadow price of any scarce resources which will be used for. the order - if these
have not already been identified as an opportunity cost.

A special order should be accepted if the revenue from the order exceeds the sum of the
cash costs, avoidable costs, opportunity costs and/or shadow prices involved.

Sunk costs, such as depreciation, or committed costs, such as rent, would not be relevant.

Deciding whether or not to launch a new product

The relevant costs in decisions whether or not to launch a new product are:

1. the variable cash costs involved;

2. any avoidable costs, such as specific marketing costs or increases in overheads;
3. the shadow price (or opportunity cost) of any scarce resources used;
4. the company's cost of capital (the discount rate).

It would be economic to launch the product if the discounted revenue from the new
product is greater than the sum of the discounted relevant costs.

Sunk costs, such as past research and development expenditure, or unavoidable costs such
as corporate administration, would not be relevant.

Product withdrawal decisions

Product withdrawal decisions involve identifying whether a product (which may be
service) is no longer economic, in which case it should no longer be produced - unless
there are valid strategic reasons for selling at a loss. The relevant costs in such cases are:

1. the contribution lost by ceasing to produce the product;

2. any avoidable fixed costs, such as specific overheads, which will be saved if t product
is withdrawn;
3. the shadow prices of any scarce resources released by dropping the product;
 4. the company's cost of capital (die discount rate).

A. product should be dropped if its discounted future contribution is less than the avoidable
fixed costs plus any shadow prices saved (discounted at the same rate).

Sunk costs, such as the past investment in the machinery used to produce the produce and
committed costs, such as the factory manager's salary, would not be relevant.

Capacity expansion decisions

Capacity expansion decisions involve increasing the business' ability to produce new existing
products. Typical relevant costs would be:

1. the cash investment in extra buildings, plant and equipment;

2. any increase in overhead costs;
3. the company's cost of capital (the discount rate).
The expansion would be worthwhile if the discounted contribution from the extra annual
output (less any relevant overhead costs) exceeds the initial investment.
Closure decisions
Closure decisions involve identifying departments or sites for possible closure. The relevant
costs to be considered when deciding whether a department or a factory should be closed will
include:
1. any specific cash costs, such as redundancy payments;
2. the contribution lost from any products which cannot be made elsewhere;
3. the avoidable costs which can be saved by closing the site;
4. the company's cost of capital (the discount rate).
It may make sense to close a department or factory if the proceeds of disposing of the site
plus the discounted avoidable costs saved are greater than the sum of the cash costs of
closure and the discounted contribution lost. However, there may be other relevant costs
involved, such as the loss of a government subsidy.
Any sunk costs, such as the past investment in plant are not relevant.

Cost-saving investment decisions

Earlier in this section, we looked at two types of cost-saving decision. These were make or
buy decisions and whether to outsource decisions. We should now consider two more types
of cost-saving decisions. The first is when management must decide whether it is worth
investing in machinery or other types of equipment, such as computers, to replace manual
activities. The second is the decision to replace existing equipment or machinery with a more
efficient version. When deciding whether to invest in cost-saving equipment, for either
reason, management will need to balance the expected savings against the costs of achieving
those savings. The relevant costs will include:
1. the cash investment in machinery or other types of capital equipment;
2. any cash savings;
3. the organisation's cost of capital.
An investment in cost-saving equipment will be worthwhile, provided the discounted savings
exceed the initial investment. The cost (or written-down value) of any equipment being
replaced is a sunk cost and so is not relevant.
Compliance decisions
When compliance with regulations involves significant extra expenditure, such as installing
fire prevention equipment, management will want to make the most cost-effective
investment. Where there is a choice of supplier or method, the relevant costs will be the
differential costs between the various options. It may be necessary to compare discounted
cash flows where the differential cash flows vary from year to year.
PRACTICE QUESTIONS

1) RELEVANT COSTING

The Telephone Co (T Co) is a company specialising in the provision of telephone systems for
commercial clients. There are two parts to the business: – installing telephone systems in
businesses, either first time installations or replacement installations; – supporting the
telephone systems with annually renewable maintenance contracts. T Co has been
approached by a potential customer, Push Co, who wants to install a telephone system in new
offices it is opening. Whilst the job is not a particularly large one, T Co is hopeful of future
business in the form of replacement systems and support contracts for Push Co. T Co is
therefore keen to quote a competitive price for the job. The following information should be
considered:

1. One of the company’s salesmen has already been to visit Push Co, to give them a
demonstration of the new system, together with a complimentary lunch, the costs of which
totalled $400.

2. The installation is expected to take one week to complete and would require three
engineers, each of whom is paid a monthly salary of $4,000. The engineers have just had
their annually renewable contract renewed with T Co. One of the three engineers has spare
capacity to complete the work, but the other two would have to be moved from contract X in
order to complete this one. Contract X generates a contribution of $5 per engineer hour.
There are no other engineers available to continue with Contract X if these two engineers are
taken off the job. It would mean that T Co would miss its contractual completion deadline on
Contract X by one week. As a result, T Co would have to pay a one-off penalty of $500.
Since there is no other work scheduled for their engineers in one week’s time, it will not be a
problem for them to complete Contract X at this point.

3. T Co’s technical advisor would also need to dedicate eight hours of his time to the job. He
is working at full capacity, so he would have to work overtime in order to do this. He is paid
an hourly rate of $40 and is paid for all overtime at a premium of 50% above his usual hourly
rate. 4. Two visits would need to be made by the site inspector to approve the completed
work. He is an independent contractor who is not employed by T Co, and charges Push Co
directly for the work. His cost is $200 for each visit made.
5. T Co’s system trainer would need to spend one day at Push Co delivering training. He is
paid a monthly salary of $1,500 but also receives commission of $125 for each day spent
delivering training at a client’s site.

6. 120 telephone handsets would need to be supplied to Push Co. The current cost of these is
$18·20 each, although T Co already has 80 handsets in inventory. These were bought at a
price of $16·80 each. The handsets are the most popular model on the market and frequently
requested by T Co’s customers.

7. Push Co would also need a computerised control system called ‘Swipe 2’. The current
market price of Swipe 2 is $10,800, although T Co has an older version of the system, ‘Swipe
1’, in inventory, which could be modified at a cost of $4,600. T Co paid $5,400 for Swipe 1
when it ordered it in error two months ago and has no other use for it. The current market
price of Swipe 1 is $5,450, although if T Co tried to sell the one they have, it would be
deemed to be ‘used’ and therefore only worth $3,000.

8. 1,000 metres of cable would be required to wire up the system. The cable is used
frequently by T Co and it has 200 metres in inventory, which cost $1·20 per metre. The
current market price for the cable is $1·30 per metre. 9. You should assume that there are
four weeks in each month and that the standard working week is 40 hours long.

Required: (a) Prepare a cost statement, using relevant costing principles, showing the
minimum cost that T Co should charge for the contract. Make DETAILED notes showing
how each cost has been arrived at and EXPLAINING why each of the costs above has been
included or excluded from your cost statement. (14 marks)

(b) Explain the relevant costing principles used in part (a) and explain the implications of the
minimum price that has been calculated in relation to the final price agreed with Push Co. (6
marks)

2) MAKE OR BUY DECISION

Robber Co manufactures control panels for burglar alarms, a very profitable product. Every
product comes with a one year warranty offering free repairs if any faults arise in this period.
It currently produces and sells 80,000 units per annum, with production of them being
restricted by the short supply of labour. Each control panel includes two main components –
one key pad and one display screen. At present, Robber Co manufactures both of these
components in-house. However, the company is currently considering outsourcing the
production of keypads and/or display screens. A newly established company based in
Burgistan is keen to secure a place in the market, and has offered to supply the keypads for
the equivalent of $4·10 per unit and the display screens for the equivalent of $4·30 per unit.
This price has been guaranteed for two years. The current total annual costs of producing the
keypads and the display screens are:

Keypads Display screens

Production 80,000 units 80,000 units

$’000 $’000

Direct materials 160 116

Direct labour 40 60

Heat and power costs 64 88

Machine costs 26 30

Depreciation and insurance costs 84 96

Total annual production costs 374 390

Notes: 1. Materials costs for keypads are expected to increase by 5% in six months’ time;
materials costs for display screens are only expected to increase by 2%, but with immediate
effect.

2. Direct labour costs are purely variable and not expected to change over the next year.

3. Heat and power costs include an apportionment of the general factory overhead for heat
and power as well as the costs of heat and power directly used for the production of keypads
and display screens. The general apportionment included is calculated using 50% of the direct
labour cost for each component and would be incurred irrespective of whether the
components are manufactured in-house or not.

4. Machine costs are semi-variable; the variable element relates to set up costs, which are
based upon the number of batches made. The keypads’ machine has fixed costs of $4,000 per
annum and the display screens’ machine has fixed costs of $6,000 per annum. Whilst both
components are currently made in batches of 500, this would need to change, with immediate
effect, to batches of 400. 5. 60% of depreciation and insurance costs relate to an
apportionment of the general factory depreciation and insurance costs; the remaining 40% is
specific to the manufacture of keypads and display screens.

Required: (a) Advise Robber Co whether it should continue to manufacture the keypads and
display screens in-house or whether it should outsource their manufacture to the supplier in
Burgistan, assuming it continues to adopt a policy to limit manufacture and sales to 80,000
control panels in the coming year. (8 marks)

(b) Robber Co takes 0·5 labour hours to produce a keypad and 0·75 labour hours to produce a
display screen. Labour hours are restricted to 100,000 hours and labour is paid at $1 per hour.
Robber Co wishes to increase its supply to 100,000 control panels (i.e. 100,000 each of
keypads and display screens).

Advise Robber Co as to how many units of keypads and display panels they should either
manufacture and/or outsource in order to minimise their costs. (7 marks)

(c) Discuss the non-financial factors that Robber Co should consider when making a decision
about outsourcing the manufacture of keypads and display screens. (5 marks)

MAKE OR BUY DECISION.

In manufacturing organisations, it is a common phenomenon for the top management to be

contemplating on whether a particular raw material, sub-assembly or a major component
required in the production of the final production either to be manufactured internally or
purchased from an outside supplier. In practice, this may be described as a critical decision
especially in an industry where the level of competition is very high.

This type of decision is also strategic as a result of the need to protect the degree of secrecy
considered to be adequate for the company’s product or to guarantee uninterrupted supply of
the components. However, on applying the concept of marginal costing, there are two basic
factors to be considered:

1. Economic/Quantitative Factors
 2. Qualitative Factors.

Economic/Quantitative Factors

Management will be interested in analysing whether any of the two functions will result into
economic saving or deficit to the organisation. To achieve this, supplier quotation will be
compared with the relevant cost of producing the components using the following format:

Saving or Deficit From Making the Component:

N N

Supplier’s Quotation (A) XXX

Less: Relevant cost of making (B)

Direct materials XX

Direct labour XX

Direct expenses XX

Variable production XX

Opportunity cost XX

Incremental fixed cost XX (XXX)

Saving/Deficit XXX

Decision Criteria.

1. If A > B = Make
2. If A < B = Buy
3. If A = B = Consider the qualitative factors

Qualitative Factors to Be Considered In Making A Make or Buy Decision.

a. Will the company be ready to expose the secret of the company to other organisation?
b. Do we have a reliable supplier who can supply to specification?
c. Is it possible for the reliable supplier to satisfy our existing capacity?
d. Do we have the technical-know-how to manufacture the components?
e. Do we have the man power required to manufacture the components in addition to the
actual final product?
f. Are we permitted by law to manufacture the components in addition to the final
product?
g. Do we have the financial capacity to embark in production of the goods?

Illustration.

Matt company which manufactures past M6 for use in its production of 25,000 units
 N

Direct materials 5

Direct labour 20

Manufacturing O/H 24

49

It has been established that 2/3 of overhead is fixed. Abubakar company ltd has offered to sell
25,000 units N45 per unit. If Matt company ltd accepts Abubakar’s offer, some of the
facilitates presently used to manufacture part M6 could be rented to a third party at an annual
rate of N65,000. In addition, N6 per unit of the fixed overhead cost apply to past M6 will be
totally eliminated. The managing director of Matt company ltd has called on you to advice
whether he should accept Abubakar’s company offer or not.

Solution.

Saving or Deficit from Making The Components.

N N

Supplier’s Quotation 1,125,000

Less: Relevant cost of making

Direct material 125,000

Direct labour 500,000

Manufacturing O/H 200,000

Fixed O/H 150,000

Opportunity cost 65,000 (1,040,000)

Saving. 85,000

Therefore, it is advisable that the company should make part M6.

Illustration.

Femur ltd produces and sells to wholesalers a highly sufficient line of summer lotion
and insect repellent and has decided to diversify in order to stabilize savings
throughout the year. A natural area for the company to consider is the production of
lotions and creams to prevent dry and chapped skin. After considerable research, a
product has been developed. However, because of the conservative nature of the
company’s management, Femur’s management has decided to introduce only one of
the new products for this coming section. If the product is successful, further
expansion for the future years will be initiated. The product selected is called chap-
 off. It is a lip-balm to be sold in a lip stick type tube. Product will be boxed. Because
of the available capacity, no additional fixed charges will be incurred to produce the
product. However, a N100,00 fixed charge will be absorbed by the product to indicate
fair share of the company’s present fixed cost to the new product. Using the estimated
sales and production of 100,000 boxes of ‘chap-off’ at the expected volume, the
accounting department has development has developed the following cost per box:

Direct materials 3

Direct labour 2

Total overhead 1.5

6.50

Femur ltd has approached a cosmetics manufacturer to discuss the possibility of

purchasing the tools of ‘chap-off’. The purchase price of 24 empty tools in a box from
a cosmetics manufacturer is N0.90k with this purchase proposal, it is predicted that
direct labour and variable overhead cost will be reduced by 10% and direct material
cost will be reduced by 20%.

Required:

a. Should Femur ltd make or buy the tools? Show calculations for your answer.
b. What will be the maximum purchase price acceptable to Femur ltd for the tools?
Show calculation to support your answer with appropriate explanation.
c. Instead of sales of 100,000 boxes, revised estimates show sales volume of 125,000
boxes. At any volume about 100,000 boxes, additional equipment at an annual
rental of N10,000 must be acquired. Under these circumstances, should Femur ltd
make or buy the tubes? Show calculation to support your answer.
d. The company has the option of making and buying at the same time. What will be
your answer to requirement C if this alternative was considered? Show calculation
to support your answer.

Solution.

Saving or Deficit from Making the Components.

N N

Supplier’s Quotation (A) 0.90

Less: the cost of making (B)

Direct materials (20%of 3) 0.60

 Direct labour (10% of 2) 0.20

Direct O/H (10% of 0.5) 0.05 (0.85)

Savings. 0.05

N100,000/100,000= N1(Variable/Direct O/H); N1 – N1.5= N0.5

a. It is advisable for Femur ltd to make the tools.

b. Maximum purchase price is N0.85k because it is the marginal cost.
c. N N

Supplier’s Quotation (A) 0.90 X 125,000. 112,500

Less: Cost of making (B)

Initial cost (0.85 X 125,000) 106,250

Incremental fixed cost 10,000 (116,250)

Deficit (3,750)

It is advisable that he should buy.

d. Make some, buy some

Make 100,000 and buy 25,000
Make = 100,000 X 0.85 ; = N85,000
Buy = 0.9 X 25,000 = N22,500
N85,000 + N22,500 = N107,500.
The company should make 100,000 tubes and buy 25,000 tubes from the cosmetic
manufacturer.
Acceptance of Special / Extra Sales Order.
Sometimes in a manufacturing organisation, the activity may be below the
capacity of the organisation by not being able to sell the entire production in the
market at a prevailing market rate. Acceptance of special order entails that there
are several * of an order which * capacity contribution only available at a lower
than normal price is quoted. The procedure for solving this kind of problems is by
consideration the economic factor.

Incremantal Analysis for Acceptance of Special Order (Economic/Quantitative

Factor)
N N
Increase in sales revenue(A) XX

Less: Incremental cost of

accepting sales order(B)

Direct materials XX
 Direct labour XX

Direct expenses XX

Variable production O/H XX

Incremental fixed cost XX

Any other cost XX (XX)

Incremental profit/loss XX

Decision Criteria

If A > B = Accept

If A < B = Reject

If A = B = Consider qualitative factors.

Qualitative Factors:

1. Is it possible that the fixed cost will remain unchanged even with the
acceptance of the special order?
2. If an order/requisition order is accepted, will other customers not ask for
price reduction?
3. Is this special order the most profitable alternative? Can’t we find a better
usage for the idle capacity?
4. Will the acceptance of this special order not disturb our full capacity in
future?

Illustration
The united products company ltd produces a single product its maximum * productive
capacity is 480,000 labour hours. Currently, it is producing at an annual rate of 375,000
labour hours. Normal volume (the basis of absorption of fixed O/H) is 450,000 hours. The
company has received an offer of 70,000 units at a special price of N12 per unit. The regular
selling price is N15 per unit. The standard cost sheet of 1 unit of the products is as follows:

Direct material (10kg @ N0.5) 5

Direct labour (15 hrs @ N2) 2

Variable O/H (1.5 hrs @N2) 3

Fixed O/H (1.5 hrs @ N1) 1.5

12.5

Required:
In the short-run, will it be profitable to accept the offer?

Solution.

N N

Increase in sales revenue A (12 X 70,000) 840,000

Less: Incremental cost of accepting

sales order (B)

Direct materials(5 X 70,000) 350,000

Direct labour (3 X 70,000) 210,000

Direct O/H (3 X 70,000) 210,000 (770,000)

Contribution 70,000

A > B, so we should accept the offer.

Illustration

Although Majidun ltd has capacity to produce 16,000 units per month; current plants call for
monthly production and sales of 10,000 units @ N15 each. Costs per unit are as follows:

Direct materials 5

Direct labour 3

Variable Factory O/H 0.75

Fixed Factory O/H 1.50

Variable selling expenses 0.25

Fixed administrative expenses 1.05

11.50

Required:

1. Should the company accept or reject a special order for 4,000 units at N10 per unit?
2. What is the maximum price the company should be willing to pay to an outsider
supplier who is interested in manufacturing his product?
3. What will be the effect on the monthly contribution margin if the sales price was
reduced to N14 resulting in a 10% increase in sales volume.

Solution.
 1. Acceptance of 4,000 units of special order:
N N
Increase in sales revenue (A) 10X4,000 40,000
Less: Avoidable cost of accepting (B)
Direct material (5X4,000) 20,000
Direct labour (3X4,000) 12,000
Variable factory O/H(0.75X4,000) 3,000 (35,000)
Consideration 5,000
The company should accept the special order.
2. The maximum price the company should be willing to pay is N35,000 generally, but
per unit the maximum price that this period will be bought is N8.75k
N
Direct materials 5.00
Direct labour 3.00
Variable factory O/H 0.75
8.75
3. Effect on Monthly Contribution if Sales Price was Reduced to N14, increasing sales
volume by 10%.

Present Position:

N N

Sales revenue (N15 X 10,000) 150,000

Less: Avoidable cost

Direct materials (N5X10,000) 50,000

Direct labour (N3X10,000) 30,000

Variable selling exp.(0.25X10,000)2,500

Variable factory O/H (0.75X10,000)7,500 (90,000)

Contribution 60,000

Proposed Position:

N N

Sales Revenue (N14X11,000) 154,000

Less: Avoidable cost

Direct materials (N5X11,000) 55,000

Direct labour (N3X11,000) 33,000

Variable O/H(0.75X11,000) 8,250

 Variable selling exp.(0.25X11,000) 2,750 (99,000)

Contribution 55,000

The monthly contribution will reduce if these changes are made. Therefore they
should maintain the present condition.

Dropping or Retaining a Centre.

Taking a decision to drop a centre shouldn’t be based on information prepared by the

financial accountant. Because such information should have been prepared with arbitrary
absorption fixed overhead, instead a quantitative factor prepared by a management
accountant using the marginal costing will be of help because such information would have
considered the relevant costs of the centre and equally considered the relevant cost to
determine whether there will be a net benefit or loss from the centre. If it is a net benefit, it is
advisable to retain the centre, but if it is a net cost, it is advisable to drop the centre.
Information prepared by a management accountant will be different from that prepared by a
financial accountant.

Joint or general fixed overhead would be unaffected by our decision to drop a particular
centre to the extent that if a centre is having a possible contribution is dropped, the
company’s profit would be reduced, the quantity of the positive contribution*. Basically,
there are two approaches to this problem:

1. Quantitative Consideration Format:

N N

Sales from the department/centre(A) XX

Less: Relevant cost of sale (B)

Direct materials XX

Direct labour XX

Direct expenses XX

Incremental fixed cost XX

Opportunity cost XX (XX)

C XX

If C is positive, don’t drop

If C is negative, drop
If C = 0, continue
 2. Qualitative Factors to Be Considered:
a. Should we close it down?
b. What will be the reaction of the investors and creditors of the company?
c. The reaction of the employee and trade union.
d. Redundancy cost and terminal benefit of the employees you want to terminate.
e. Identify the nature of the demand of her product.
f. Effect on goodwill of the company.
g. The elasticity of the product and other products in the competitive market.
h. Nature of the product and the stage of the production in the product life cycle.
i. Fate of employees producing the product of engineering in the department.

Illustration

A company provides you with the information about its 3 product line:

Product A B C

Sales 200,000 300,000 28,000

Cost of goods sold 180,000 220,000 19,000

Selling expenses 10,000 20,000 3,000

Sales Volume units 500,000 300,000 400,000

A company is considering the dis-continuation of product A, because it is not a generation of

sufficient product. You are further informed of each product as given as follows:

product A B C

Variable cost of goods sold 70% 80% 60%

Variable selling expenses 20% 30% 40%

If product A is dropped, general fixed cost would be reduced by 20,000 while the fixed rate
of the cost of goods sold of product B will increase by 5% and the selling expenses of product
C will increase by 2% in its variable expenses. Should product A be dropped?

Analysis:

Product A B C

Cost of goods sold 180,000 220,000 19,000

Variable expenses on goods (126,000) (176,000) (11,400)

sold

Fixed cost of goods sold 54,000 44,000 7,600

Total selling expenses 10,000 20,000 3,000

Variable selling expenses (2,000 ) (6,000) (1,200)

Fixed selling expenses 8,000 14,000 1,800

PRODUCT A N N

Sales 200,000

Less: Cost of sales

Variable cost of goods sold 126,000

Variable selling expenses 2,000

Decrease in general fixed cost 20,000

Increase in fixed cost of B(5%of44,000) (2,200)

Increase in variable cost of C(2%of1,200) (24) (145,776)

Contribution 54,224

OPTIMAL PRODUCT MIX WITH KEY LIMITING FACTORS

Optimal Product Mix with key limiting factors involves the choice of products where
a constraint in resources exists and is one of the areas where Marginal Costing Technique
(MCT) is applicable. MCT can be used to determine optimal product mix especially when
management is faced with some restrictions.

A limiting factor is a scarce resource which is in short supply to the extent that the
summation of the opportunities existing for profitably employing the scarce resource is
greater than the amount of the resource available.

When an organization provides a range of products or services to its market, but has a
restricted amount of resources available to it, then it will have to make a decision about what
product mix or (mix of services) it will provide. Its volume of output and sales will be
constrained by the limited resources rather than by sales demand, and so management takes a
decision about how scarce capacity should best be used.

Optimal product mix decision therefore involves the process of identifying the appropriate
production mix that will maximize the total contribution of the organization after the
available limited resources must have been judiciously allocated among the various
competing product lines.
It is however, instructive to posit that the specific approach to be adopted in allocating the
scarce resources will depend largely on the nature of constraints.

A resource is scarce if the organization does not have enough to undertake every available
opportunity for making more contribution towards profit. Thus, materials would be a scares
resource if at full capacity the raw materials is utilized without any additional kilogram to
meet sales demand in full, the scares resource(s) might be any of all of the following:

i) Restricted supply of item of raw material, sub-assembly or component

ii) Maximum capacity of machine time
iii) Limited amount of cash and a bank overdraft limit
iv) Maximum amount of available labor hours for a particular grade of labor

Under normal circumstances, it is possible to identify two types of constraints situation as

follows:

a) Single Constraint: Also refers to as a key limiting factor situation. This implies that
out of various factor of production only a resource is limited in supply while the other
factors are distributed among the different product line in order to maximize its
overall profitability through increased contribution. This approach is referred to as
contribution margin per key limiting factor.
b) Multiple Constraints: This will represent a situation where two or more resources of
the organization are limited in supply. This decision problem will require the
application of linear programming techniques.

BASIC STEPS INVOLVED IN OPTIMAL PRODUCT MIX DECISION INVOLVING

A SINGLE CONSTRAINT
 1. Identify the key limiting factor among the various factors of production of the
organization. This can be achieved by comparing the total resource required to
produce the budgeted unit with the total resource available. If unit available is below
the unit required, then the resource is considered to be the key limiting factor.
2. Calculate contribution, savings or relevant cost per unit for each of the product line.
3. Divide the contribution or saving or relevant cost per unit by the key limiting factor
also per unit.
4. Rank the result obtained in ‘3’ above in a descending order.
5. Identify the maximum unit demanded by each of the product lines. This may be
obtained by dividing the budgeted sales with the associated selling prices.
6. Consider whether management intends to give priority to certain product line or
intend to ensure that certain minimum allocation is given to all the product lines. In
this case, comply with this requirement first before proceeding to the next step.
7. Prepare an allocation table using the following format if you so desire.

Key Key Optima

Unit Cumulativ
Rankin Produc Facto Factor Balanc l
Demande e
g t r per Allocate e Product
d Allocation
unit d Mix

8. Allocate the available key factor among the various competing product line based on
the order of ranking established in step ‘4’ above.
9. Identify the optimal product mix from the allocation table prepared in step ‘7’ above.

ILLUSTRATION 1

The Lagos Bottling Company Plc produces four products, A, B, C and D with the following
information:

A B C D

N N N N

Material 2 3 5 4
Labor 6 8 7 3

Variable O/H 4 3 2 2

Fixed Cost 1 2 3 1

Total 13 16 17 10

Profit 20 25 21 15

Labor Cost Unit (Hour) 1 2 1.5 0.5

Budget Sales (Unit) 20,000 16,000 24,000 10,000

The personnel department has recently informed management that only 300,000 labor hours
can be obtained in the labor market.

You are required to determine the optimal product mix showing the allocation of resources
and calculate the maximum profit derivable from your allocations.

SOLUTION

Step 1: Identify contribution per key factor

A B C D

N N N N

Profit 20 25 21 15

Fixed Cost 1 2 3 1

Contribution 21 27 24 16

Key Factor per unit (6/1) 6 (8/2) 4 (7/1.5) 4.67 (3/0.5) 6

Contribution per labor 21/6 27/4 24/4.67 16.6

= N3.50 N6.75 N5.14

N2.67

Ranking 3 1 2 4

Step 2: Allocation Table for 300,000 hours

Key Key
Unit Optimal
Produc Factor Factor Cumulative
Ranking Balance Product
t Demand Per Allocation
Allocation Mix
Unit

1 B 16,000 4 64,000 64,000 236,000 16,000

2 C 24,000 4.67 112,080 176,080 123,920 24,000

3 A 20,000 6 120,000 296,080 3,920 20,000

4 D 10,000 6 3,920 300,000 - 653

Workings:

Product D = 3,920/6 = 653 Units

Step 3: Optimal Product Mix

A = 20,000 units

B = 16,000 units

C = 24,000 units

D = 653 units

Step 4: Income Statement Showing Profit

A B C D
 N N N N

Total Contribution (W1) 420,000 432,000 576,000

10,448

Less: Total Fixed Costs (W2) 20,000 32,000 72,000 10,000

Profit 400,000 400,000 504,000

448

The maximum profit derivable from the distribution of 300,000 is N1,304,448

(w1) Total Contributions

A = N21 x 20,000 = N420,000

B = N27 x 16,000 = N432,000

C = N24 x 24,000 = N576,000

D = N16 x 635 = N10,448

(w2) Total Fixed Cost

FC/p.u x Budget (Units)

A = N1 x 20,000 = N20,000

B = N2 x 16,000 = N32,000

C = N3 x 24,000 = N72,000

D = N1 x 10,000 = N10,000
ILLUSTRATION 2

BAMAIYI (NIG.) LTD., manufactures products W, X, Y, Z, all of which have 100% import
content for materials. The budget for the month of Jan. 2017 is given as follows:

W X Y Z

N N N N

Direct Materials 32 60 60 30

Direct Labor 12 18 12 12

Period Costs 4 12 12 6

Profit 36 30 56 27

Sales 210,000 264,000 420,000

202,500

The budget may not be achieved because the company now faces shortage of funds to import
the required raw materials. Based on it’s cash flow projection which has been prepared using
the average exchange rate for the past two months, the company can only afford to purchase
N452,000 worth of the required materials.

The company’s management has decided to produce at least 2,000 units of each product and
the balance of the fund if any to be utilized for products that give the highest contribution to
their profits.

You are required to:

a) Advise the management on the quantities of the product to produce.

b) Prepare the Revised Income Statement showing the Total Profit from each product
based on 1(a) above.

SOLUTION TO ILLUSTRATION 2

BAMAIYI NIG. LTD.

Determination of contribution for each product:

W X Y Z
 N N N N

Profit 36 30 56 27

Add: Fixed Costs 4 12 12 6

Contribution 40 42 68 33

Limiting Factor 32 60 60 30

Contribution to Limiting

Factor 1.25 0.10 1.13

1.10

Ranking 1st 2nd 3rd 4th

MANDATORY PRODUCTION SCHEDULE

Units Raw Material Raw

Material

Required/Units
Consumed

N N

W 2,000 32 64,000

X 2,000 60 120,000

Y 2,000 60 120,000

Z 2,000 30 60,000

364,000

Raw Materials available 452,000

Raw Materials consumed for mandatory production 364,000

Balance 88,000

Determining Maximum Demand for each product:

W X Y Z
 N N N N

Sales 210,000 264,000 420,000

202,500

Selling price/unit 84 120 140 75

Maximum demand;

(Units) (Budgeted Production) 2,500 2,200 3,000

2,700

Utilization of Raw Material Balance of (N88,000)

Ranking Production Raw Material Extra Units Total Raw/M

Raw/M

Required p.u. Produced Consumed Balance

1st W 32 500 16,000 72,000

2nd Y 60 1,000 60,000 12,000

3rd Z 30 400 12,000 -

4th X 60 - - -
Optimal Production Plan (Actual Production)

W - 2,500 units

X - 2,000 units

Y - 3,000 units

Z - 2,400 units

Revised Income Statement:

W X Y Z

N N N N

Total Contribution 100,000 84,000 104,000 79,000

Less: Fixed Costs 10,000 26,400 36,000 16,000

90,000 57,600 68,000 63,000

ILLUSTRATION 3

Nightingale (Nig.) Ltd. manufactures two products K and L; the prices of which are N48 and
N72. Standard cost data are as follows:

Product Product

Per Article K L

N N

Direct Material 10 12

Direct Wages (N4/hr)

Dept. 1 8 12

Dept. 2 4 8

Dept. 3 12 -

Dept. 4 - 16

Variable overheads 2 6
Fixed overheads per annum N50,000Nightingale operates a 40 hours week for 50 weeks each
year. Currently, the employees in each department are:

Dept. 1= 15

Dept. 2= 8

Dept. 3= 9

Dept. 4= 12

You are required to state if one product only were to be made.

a) Which product will give maximum profit and the problems that you envisage could
arise.

b) Which product should be made and the amount of profit per annum resulting
assuming that products K and L use the same direct materials and that there is a
shortage of material with supply limited at current price to a maximum of N200,000
per annum.

c) Which product should be made and the amount of profit per annum resulting,
assuming that there is a shortage of persons possessing the skills required in
Department 2 with the result that the number of employees there cannot be increased.

SOLUTION TO ILLUSTRATION 3

Notes:

(i) Number of Hours Required: K L

Hrs Hrs
Dept. 1 2 3
Dept. 2 1 2
Dept. 3 3 -
Dept. 4 - 4
(ii) Determination of Contribution
N N
Selling Price 48 72
 Less: Variable Costs
Direct materials (10) (12)
Direct Wages (24) (36)
Variable Overheads (2) (6)
Contribution 12 18

a) Product L gives the highest contribution and thus the product L alone should be
produced.
Problems:
i) If K is not produced, the workers who produce K will be laid-off/jobless
which will bring about problems with the union.
ii) Possible loss of goodwill due to the non-production of production K.
iii) If the products are jointly demanded, sales of product L will be affected.

K L
N N
b) Contribution 12 18
Limiting Factor: 10 12
Material is the key limiting factor

Contribution/Limiting Factor 1.2 1.5

Ranking 2nd 1st

Decision: Produce Product L alone. N
Total Contribution/Material= 200,000 x 1.5 300,000
Less: Fixed Costs 50,000
Profit 250,000

c) Product K Product L
N N
Contribution 12 18
Limiting Factor (Labour Hrs) 1 2
C/LF 12 9
Ranking 1st 2nd
 Produce Product K alone. N
Contribution 40hrs x 50 = 2,000hrs x 12 x 8 192,000
Less: Fixed Costs 50,000
Profit 142,000

ACCEPTANCE OR REJECTION OF SPECIAL ORDERS

This type of problem occurs when management wants to determine the minimum amount that
should be charged on an activity or order which is not part of the normal activity of its
business and in view of the fact that the company is presently working below the installed
capacity.

ILLUSTRATION 1

WAZOBIA (NIG.) LTD. manufactures and sells condensed milk which sells for N20 per can.
Currently output is 400,000 tins per month which represents 80% of installed capacity.

The company has the opportunity to utilize its surplus capacity by selling its products at
N13/tin to a supermarket who will sell it as an “own label” product.

Variable costs per can are N10

Period Fixed Cost N1,600,000

Required:

a) Based on the above data, should Wazobia accept the supermarket offer/order?

b) What other factors should be considered?

SOLUTION TO ILLUSTRATION 1

Evaluation of the Present Situation

Sales (400,000 x N20) 8,000,000

Less: Variable Cost (400,000 x N10) 4,000,000

Contribution 4,000,000

Less: Fixed Cost 1,600,000

Profit 2,400,000

Evaluation of the Special Order

Sales (100,000 x N13) 1,300,000

Variable Cost (100,000 x N10) 1,000,000

Contribution 300,000

Decision: Accept the Special Order.

Qualitative Factor

i) Will the acceptance of an order at a lower price lead other customers to demand
lower prices as well?
ii) Is the special order the most profitable way of using the spare capacity?
iii) Will the special order lock up capacity which could be used for future price
business?

Note:

i) Although the price of N13 is less than the current selling price of N20/can; it can
still provide some contribution and so, may be worthwhile.
ii) The process of Marginal Cost Pricing to utilize spare capacity is widely used.
E.g. Hotels provide cheap weekend rates, railways and airlines have cheap rates
for off peak period, etc.
ILLUSTRATION 2

Nzeribe Nig. Plc. has been offered a contract which, if accepted would significantly increase
next year’s activity level. The contract requires the production of 20,000kg of Product X and
specifies a contract price of N100/kg. The resources used in the production of each kg of X
include:

Resource per kg of X

Labor - Grade 1 2hrs

 Grade 2 6hrs

Materials - A 2 units

B 1 liter

Grade 1 Labor is highly skilled although it is currently unutilized in the firm, it is Nzeribe’s
policy to continue to pay Grade 1 Labor in full. Acceptance of the contract would reduce the
idle time of Grade 1 Labor.

Grade 2 is unskilled labor with a high turnover and may be considered a variable cost. The
cost to Nzeribe of each type of labor are:

Grade 1 N4 per hour

Grade 2 N2 per hour

The material required to fulfil the contract will be drawn from those materials already in
stock. Material A is widely used within the firm and any usage for this contract will
necessitate replacement. Material B was purchased to fulfill an expected order which was not
received. If Material B is not used for this contract, it will now be sold.

For accounting purpose, FIFO is used. The values and costs for A and B are:

A B

Per Unit Per Unit

N N

Book value 8 30

Replacement cost 10 32

Net Realizable Value 9 25

A single recovery rate for fixed factory overheads is used throughout for the firm even
though some fixed production overheads could be attributed to single products/departments.
The overheads is recovered per productive labor hour and initial estimate for next year’s
activity which exclude the current contract, shows fixed production overhead as N600,000
and productive labor hours as 300,000.

Acceptance of the contract will increase fixed production overheads by N228,000. Variable
production overheads are accurately estimated at N3 per productive labor hour.

Acceptance of the contract will be expected to encroach on the sales of another Product Y
which is also made by Nzeribe. It is estimated that sales of Y will then decrease by 5,000
units in the next year only. However, this forecast reduction in sales of Y would enable
attributable fixed factory overhead of N58,000 to be avoided.

Information on Y is as follows:

Per Unit

Sales Price N70

Labor – Grade 2 4 hours

Materials (relevant variable cost) N12

You are required to advise Nzeribe Nig. Plc on the desirability of the contract.

SOLUTION TO ILLUSTRATION 2

NZERIBE NIG. PLC

N N

Incremental Revenue (20,000 x N100) 2,000,000

Less: Incremental Outlay:

Material A (2 x 20,000 x N10) 400,000

Material B (1 x 20,000 x N25) 500,000

Labor 1: -

Labor 2 (6 x 20,000 x N2) 240,000

Variable overheads

* (2 x 20,000 x N3) 120,000

* (6 x 20,000 x N3) 360,000 1,620,000

380,000
Opportunity Cost:

N N
Sales (Y) (N70 x 5,000) 350,000

Less: Variable Cost

Labor Grade 2 (4 x N2 x 5,000) (40,000)

Variable Overhead (3 x N4 x 5,000) (60,000)

Materials (N12 x 5,000) (60,000)

(160,000)

190,000

Attributable Fixed Cost 228,000

418,000

Less: Fixed costs avoided (58,000) 360,000

20,000

Decision: Accept the special contract.

LEARNING CURVE THEORY.

This theory is a quantitative technique seeks to reduce the cost of production through labour.
This was developed in 1925 by Wright Peterson focusing on the time taken by an employee
in getting the job done. This theory stipulates that the time taken by an employee on the same
job repeatedly has a significant impact on the overall time spent on the same job in
subsequent times. This was tested in Ohio with the results showing an 80% learning curve in
a job performed repeatedly. However, if the job fails to follow the following conditions, the
average time spent might not fall.
In other words, when a worker works repeatedly on the same job, the average time spent will
fall. This can be summarised as follows:

a. The first time a worker is working on a job, the anxiety is high this could be joy or
fear. So, the time taken to produce is high.
b. In the subsequent times, the initial bottle neck/problems associated with the job is
resolved.
c. The worker gets familiar with the problems or challenges associated with the job,
finding possible solutions while learning curve sets in.

Sloppy learning curve.

100

80

60
Level of activity.
40

Q1 Q2 Q3 Q4

Conditions Under Which Learning Curve Operates.

1. The job must be repetitive
2. The job must be labour intensive
3. Management must be ready and able to motivate workers
4. There must be little or no labour turnover

Where Can We Apply Learning Curve?

1. Cost estimation
2. Price tenders
3. Project evaluations
4. Deciding wage incentive.

Procedure to the Computation of the Learning Curve

1. To ascertain the learning curve rate

2. Calculate the time expected in producing the unit
3. Determine the average time taken on the first batch
4. Calculate the average time taken on the second batch
5. Calculate the cumulative time taken
 6. Repeat the same steps for subsequent batches.

Algebraic Approach:

Y = axb

Where:

Y= expected average time per unit, based on expected output.

a= average time per unit spent on first batch.

x= Index/percentage of the learning curve ÷ by number of units in the first batch

b= the log of the learning curve which is log2

Illustration

A customer has asked a firm to produce a bill for the supply of 1,600 units of Ebola drugs.
Production will be in batches of 100 units. The first batch of 100 units will average 50 hours
per unit. The firm also expects that 80% learning curve will apply to the cumulative labour
hours on this job.

Required:

a. Prepare an estimate of labour hours of fulfilling this contract

b. Estimate the incremental hours of exceeding the production run of producing
additional 1,600 units
c. Estimate the incremental hours of exceeding the production run from 1,600-2,000
units in this contract.

Solutions (A and B computed using the statistical approach)

-learning curve rate is 80%

-time (average per unit) is 50 hours

-time taken on batches:

Units Cumulative Time spent Cumulative Average Workings

produced units time spent time
(hours)

100 100 5,000 5,000 50 -

100 200 3,000 8,000 40 80% of 50

200 400 4,800 12,800 32 80% of 40

400 800 7,680 20,480 25.6 80% of 32

800 1,600 12,288 32,768 20.48 80% of 25.6

1,600 B. 3,200 19,642.8 52,428.8 16.384 80% of 20.48

a. The cumulative labour hours spent on fulfilling the contract is 32,768 hours.
b. Producing additional 1,600 units will take an incremental hour of 19,642.8 hours and
a cumulative of 52,428.8 hours.
c. Using the algebraic approach,
Y = axb
a = 50 hours
x = 2,000/100
b = -0.3219
Therefore, Y = 50 X (20)-0.3219; Y = 50 X 0.38
Y = 19.06 which is the average time expected.
The cumulative time spent is 19.06 X 2,000 = 38,120 hours.

The Learning Curve Effect

Femgork Automobile Ltd has designed a new type of Motor Security, for which the cost and
sales price of the first motor to be produced has been estimated as follow:

N’000

Materials 5,000

Labor (800 hours x N5/hr) 4,000

Overhead (150% of labor cost) 6,000

15,000

Profit mark-up (20%) 3,000

Sales Price 18,000

It is planned to sell all the motor at full cost plus 20%. An 80% learning curve is expected to
apply to the production work. Only one customer has expressed interest in buying the motor
so far, but he thinks N18m is too high a price to pay. He might want to buy two, or even four
of the motor during the next six months.

Required:

He has asked the following questions and you should provide answers.
 a) If he paid N18m for the motor what price would he have to pay later for a second
motor?
b) Could Femgork Automobiles. Ltd quote the same unit price for two motors, if the
customer ordered two at the same time?
c) If the customer buys two motors now at one price, what would be the price per unit
for a third and fourth motor, if he ordered them both together later on?
d) Could Femgork Auto Ltd quote a single – unit price for
i) 4 motors
ii) 8 motor if they were all ordered now?
Solution: Workings

Cum.
Total Incremental
Average Workings for
No. of Cumulative for all Time for
Workings Time Incremental
Motor Motor motor to additional
per Time
date motor/hr
motor

1 1 Given 800 800 - -

1 2 (80%x800 640 1280 1280-800 480

)
2 4 512 2048 2048-1280 768
(80%x640
4 8 ) 409.6 3276.8 3276.8-2048 1228.8

(80%x512
)

a) Separate price for a second motor N’000

Materials 5,000
Labor (480 hrs x N50) 2,400
Overhead (150% x Lab Cost of 2,400) 3,600
Total Cost 11,000
Profit (20% x 11,000) 2,200
Sales Price 13,200

b) A single price for the first two motors

N’000

Materials cost for two motors (N5000x2) 10,000

Labor (1280 hours x N5) 6,400

 Overhead (150% of lab cost of N6400) 9,600

Total cost for two motors 26,000

Profit (20% x N26,000) 5,200

Total sales price for two motors 31,200

Price per motor (N31,200/2) 15,600

c) A price for the third and fourth motors N’000

Materials cost for two motor (N5000x2) 10,000
Labor (768 hours x N5) 3,840
Overhead (150% of labor cost of N3840) 5,760
Total cost 19,600
Profit 20% x 19,600 3,920
Total sale price for motors 23,520
Price per motor (N23,520 / 2) 11,760

d) A price for the first 4 motors together and 8 motors together

First 4 motors First 8 motors

N’000 N’000

Material (N5000x4) 20,000 (45,000x8) 40,000

Labor (N5x2048hr) 10,240 (N5 x 3276.8 hrs) 16,384

Overhead (150% x 10240) 15,360 (150% x 16,384) 24,576

Total Cost 45,600 80,960

Profit (20% x 45,600) 9,120 (20% x 80,960) 16,192

Total sales price 54,720 97,152

Price Per Motor (54,720/4) 13,680 (97,152/8) 12,144

MARGINAL AND ABSORPTION COSTING.

Illustration

Odunnayo ltd produces a product for which the following estimates have been made:

Direct materials 12

Direct labour (2 hours) @ 5

Variable prod. O/H for machine (1/2hrs) 6 per hour.

The product fixed O/H are budgeted based on 12,000 machine hours @ 144,000 per month.
The company targets 20% profit as max-up. Determine the cost of the product using marginal
and absorption costing.

Solution.

Marginal Costing: N

Material 12

Labour (2X5) 10

Variable O/H 3

Cost 25

Profit (20% of 25) 5

Selling price 30

Absorption Costing: N

Material 12

Labour (2X5) 10

Variable O/H 3

Fixed O/H (144/12) 12

Cost 37
Profit (20% of 37) 7.4

Selling price N 44.40k