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FOUNDATION EXAM

MANAGEMENT ACCOUNTING

STUDY MANUAL

Foundation exam

Management Accounting

ii |

Fifth edition 2015


First edition 2010
ISBN 9781472714565
Previous ISBN 9781 4453 6875 7
British Library Cataloguing-in-Publication Data
A catalogue record for this book
is available from the British Library.
Published by BPP Learning Media Ltd
All rights reserved. No part of this publication may be
reproduced or transmitted in any form or by any means or
stored in any retrieval system, electronic, mechanical,
photocopying, recording or otherwise without the prior
permission of the publisher.
The contents of this book are intended as a guide and not
professional advice. Although every effort has been made to
ensure that the contents of this book are correct at the time of
going to press, BPP Learning Media, the Editor and the Author
make no warranty that the information in this book is accurate
or complete and accept no liability for any loss or damage
suffered by any person acting or refraining from acting as a
result of the material in this book.
Every effort has been made to contact the copyright holders of
any material reproduced within this publication. If any have
been inadvertently overlooked, BPP Learning Media will be
pleased to make the appropriate credits in any subsequent
reprints or editions.
We are grateful to CPA Australia for permission to reproduce
the Learning Objectives, the copyright of which is owned by
CPA Australia.
Printed in Australia
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BPP Learning Media Ltd 2015

INTRODUCTION | iii

FOUNDATION EXAMS
International Education Standards
CPA Australia is a member of the International Federation of Accountants (IFAC). All foundation exam
education materials are developed in line with IFACs International Education Standards. These
standards provide guidance in establishing the content of professional accounting education
programs together with the associated assessment. The standards also assist in developing the
required passing standard for accounting education and competence of a professional accountant.
The foundation exams provide you with the opportunity to demonstrate your competence in areas
required for Associate membership of CPA Australia. By demonstrating this entry level knowledge you
will be well positioned to succeed at the CPA Program and ultimately attaining the CPA designation.

YOU AND YOUR STUDY PLAN


This study manual is designed to give you an understanding of what to expect in your exam as a well
as covering the fundamentals that you need to know. Exams will be based on the contents of this
study manual.
There are no specifically recommended hours of study. Each candidate brings their own level of
experience and knowledge to the foundation exams. The number of study hours required is entirely
dependent on your prior knowledge of the subject. You will need to develop your own study plan.
Refer to Preparing for foundation exams on page viii.

ADDITIONAL LEARNING SUPPORT


If you feel you have gaps in your knowledge after reviewing the study manual, there is a range of
optional additional support to assist in your exam preparation. Additional learning support caters for
different learning styles and budgets.
Please check the CPA Australia website for more information www.cpaustralia.com.au/learningsupport

STANDARDS AND LEGISLATION


The material in this study manual has been prepared based upon standards and legislation in effect as
at 1 September 2013. Candidates are advised that they should confirm effective dates of standards
and legislation when using additional study resources. Exams are based on the learning objectives
outlined within this study manual.

iv | MANAGEMENT ACCOUNTING

INTRODUCTION | v

CONTENTS
Page

INTRODUCTION
Foundation exams

iii

Chapter features

vi

Preparing for your foundation exam


Chapter summary
Learning objectives

viii
x
xii

CHAPTER
1

The nature and purpose of management accounting

Decision making and relevant costing

39

Budgeting

63

Cost behaviour and CVP analysis

99

Overheads, absorption and marginal costing

135

Overhead costing activity-based costing

171

Process and job costing

191

Standard costing

233

Variance analysis

247

10

Capital expenditure

273

11

Inventory and pricing decisions

297

12

Performance measurement and evaluation

323

Revision questions

353

Answers to revision questions

377

Before you begin questions: answers and commentary

395

Glossary of terms

415

Index

423

vi | MANAGEMENT ACCOUNTING

CHAPTER FEATURES
Each chapter contains a number of helpful features to guide you through each topic.
Learning
objectives

Show the referenced CPA Australia learning objectives.

Topic list

Tells you what you will be studying in this chapter.

Introduction

Presents a general idea of what is covered in this chapter.

Chapter summary
diagram

Summarises the content of the chapter, helping to set the scene so that you
can gain the bigger picture.

Before you begin

This is a small bank of questions to test any pre-existing knowledge that you
may have of the chapter content. If you get them all correct then you may
be able to reduce the time you need to spend on the particular chapter.
There is a commentary section at the end of the Study Manual called Before
you begin: answers and commentary.

Section overview

This summarises the key content of the particular section that you are about
to start.

Learning objective
reference

This box indicates the learning objective covered by the section or


paragraph to which it relates.

LO
1.2

Definition

Definitions of important concepts. You really need to know and understand


these before the exam.

Exam comments

These highlight points that are likely to be particularly important or relevant


to the exam. (Please note that this feature does not apply in every
foundation exam study manual.)

exam

Worked example

This is an illustration of a particular technique or concept with a solution or


explanation provided.

Question

This is a question that enables you to practise a technique or test your


understanding. You will find the solution at the end of the chapter.

Key chapter points

Review the key areas covered in the chapter.

Quick revision
questions

A quick test of your knowledge of the main topics in this chapter.


The quick revision questions are not a representation of the difficulty or
style of questions which will be in the exam. They provide you with an
opportunity to revise and assess your knowledge of the key concepts
covered in the materials so far. They are not a practice exam, but rather a
means to reflect on key concepts and not as the sole revision for the exam.

INTRODUCTION | vii

Revision questions

The revision questions are not a representation of the difficulty or style of


questions which will be in the exam. They provide you with an opportunity
to revise and assess your knowledge of the key concepts covered in the
materials so far. They are not a practice exam but rather a means to reflect
on key concepts and not as the sole revision for the exam.

Case study

This is a practical example or illustration, usually involving a real world


scenario.

Formula to learn

These are formulae or equations that you need to learn as you may need to
apply them in the exam.

Bold text

Throughout the Study Manual you will see that some of the text is in bold
type. This is to add emphasis and to help you to grasp the key elements
within a sentence and paragraph.

viii | MANAGEMENT ACCOUNTING

PREPARING FOR YOUR FOUNDATION EXAM


STUDY PLAN
Review all the learning objectives thoroughly. Use the topic exam weightings listed at the end of
the learning objectives to develop a study plan to ensure you provide yourself with enough time to
revise each learning objective.
Dont leave your study to the last minute. You may need more time to explore learning objectives
in greater detail than initially expected.
Be confident that you understand each learning objective. If you find that you are still unsure after
reading the study manual, seek additional information from other resources such as text books,
supplementary learning materials or tuition providers.

STUDY TECHNIQUES
In addition to being able to complete the revision and self-assessment questions in the study
manual, ensure you can apply the concepts of the learning objectives rather than just memorising
responses.
Some exams have formulae and discount tables available to candidates throughout the exams. My
Online Learning lists the tools available for each exam under "Useful Resources".
Check My Online Learning on a weekly basis to keep track of announcements or updates to the
study manual.

TIPS FOR EXAMS


Plan to arrive at the exam centre at least 15 minutes before your exam. Allow for possible delays
with public transport or traffic.
You have three hours and fifteen minutes to complete the exam. As soon as you commence the
exam your exam clock in the top right hand corner of the screen begins to count down. Watch your
time carefully.

ANSWERING MULTIPLE CHOICE QUESTIONS


Foundation exams are a series of 100 multiple choice questions. Each question will contain four
possible options.

Step 1

Attempt every question. Read the question thoroughly. You may prefer to work out the
answer before looking at the options, or you may prefer to look at the options at the
beginning. Adopt the method that works best for you.

Step 2

Read the four options and see if one matches your own answer. Be careful with
numerical questions, as some options are designed to match answers that incorporate
common errors. Check that your calculation is correct. Have you followed the
requirement exactly? Have you included every step of the calculation?

Step 3

You may find that none of the options matches your answer.
Re-read the question to ensure that you understand it and are answering the
requirement
Eliminate any obviously wrong answers
Consider which of the remaining answers is the most likely to be correct and select the
option

INTRODUCTION | ix

Step 4

If you are still unsure, you can flag the question and continue to the next question. Some
questions will take you longer to answer than others. Try to reduce the average time per
question, to allow yourself to revisit problem questions at the end of the exam.
Revisit unanswered questions. A review tool is available at the end of the exam, which
allows you to Review Incomplete or Review Flagged questions. When you come back to a
question after a break you often find you are able to answer it correctly straight away. You
are not penalised for incorrect answers, so never leave a question unanswered!

COMPUTER-BASED EXAM NAVIGATION


Your computer-based exam has the following functions:
Navigation
You can select your answer by: clicking on the circle to the left of the option, or typing the letter
corresponding to the option.
To move through the exam, you use the 'Next' or 'Previous' buttons on the bottom of the
screen. The function of each button is selected by your mouse, or with a combination of
keyboard keys. For example, you can select the 'Next' button by clicking it with the mouse, or
by typing ALT + N.
The 'Next' button moves you from one screen to the next screen. If you wish to go back and
view the screen you just viewed, click the 'Previous' button or type ALT + P.
Select for review
There is a flag in the upper right corner of your exam screen labelled 'Fag for Review'. You mark
an exam question to review at a later time by clicking on this flag. The flag will appear filled-in
once it is selected. You may mark any exam question for later review, whether you select an
answer or not.
Review Screen
After finishing the last exam question, you will see a review screen. This lists every exam
question. If you clicked the 'Flag for Review' flag on a question screen, that question appears on
the Review Screen marked with the flag filled in.
If you skipped any exam questions, these will be labelled as 'Incomplete' even if you did not
select them for review.
From the Review Screen you can choose to:
1. review all of the questions in the exam by clicking 'Review All';
2. individually select more questions for review (click on the flags corresponding to the
questions);
3. review all questions marked as incomplete by clicking 'Review Incomplete';
4. begin reviewing the selected questions by clicking 'Review Flagged'; or
5. exit by clicking 'End Review' this will also end your exam.

x | MANAGEMENT ACCOUNTING

CHAPTER SUMMARY
This summary provides a snapshot of each of the chapters, to help you to put the Study Manual into
perspective.

CHAPTER 1 THE NATURE AND PURPOSE OF MANAGEMENT


ACCOUNTING
This introductory chapter sets the scene for your forthcoming studies of Management Accounting. It
explains the differences between financial, cost and management accounting and explains the role of
the management accountant.
It also introduces two key activities of the management accountant: decision making and performance
measurement and evaluation.

CHAPTER 2 DECISION MAKING AND RELEVANT COSTING


One of the most important things that a management accountant does is to provide the information
that enables a business to make decisions about its activities. This involves ascertaining the relevant
costs of the business, which are its future costs and cash flows. The chapter goes on to consider
choice of product (product mix) decisions, make or buy decisions and outsourcing.

CHAPTER 3 BUDGETING
A budget is a quantitative statement, for a defined period of time (often a year) which usually includes
planned revenues, expenses, assets, liabilities and cash flows. When organisations draw up budgets
they have stated objectives and intentions, and the actual results can then be compared with the
budget and differences identified and analysed. This chapter explains the background of budgeting
and then teaches you how to prepare and operations budget and a cash budget.

CHAPTER 4 COST BEHAVIOUR AND CVP ANALYSIS


This chapter introduces the different types of cost and also discusses cost behaviour. It then moves on
to cost-volume-profit analysis, which is based on cost behaviour principles; this is necessary so that the
appropriate decision-making information can be provided to management.

CHAPTER 5 OVERHEADS, ABSORPTION AND MARGINAL COSTING


There are some costs incurred by organisations that have to be allocated out to the various units
produced, so that a cost per unit can be produced. This chapter examines the different types of
overheads and introduces two methods of accounting for them: absorption and marginal costing. It
ends with a comparison between the two.

CHAPTER 6 OVERHEAD COSTING ACTIVITY-BASED COSTING


Activity-based costing (ABC) has been developed relatively recently to suit modern business and
accounting practices. It provides a modern alternative to traditional methods such as absorption
costing, which tend to allocate too great a proportion of overheads to high volume products. ABC
involves the identification of those factors, known as cost drivers, which cause the costs of an
organisations major activities.

CHAPTER 7 PROCESS AND JOB COSTING


Costing systems are used to cost goods or services, and the method used depends on the way in
which the goods or services are produced. Within the context of your syllabus, the two most important
are process costing, used when it is not possible to identify separate units of production, and job
costing, where work is undertaken to a particular customers specific requirements.

INTRODUCTION | xi

CHAPTER 8 STANDARD COSTING


In business, standards are applied to the costs of products and services. An organisation will expect
the standards that it sets (for example for the amount of materials to be used in production, or for the
amount of workforce time involved) to be met. If they are not, a variance analysis will be carried out,
which identifies where they have not been met.

CHAPTER 9 VARIANCE ANALYSIS


The actual results achieved by an organisation during the reporting period are frequently different
from those expected. Variance analysis identifies where these differences from the expected occur. It
is important to realise that in some situations a favourable (ie positive) variance on one aspect of
production will be cancelled out by an adverse (ie negative) variance on another aspect. Hence
businesses produce operating statements, which reconcile the expected and the actual results, by
means of all the variances, so management can see the complete picture.

CHAPTER 10 CAPITAL EXPENDITURE


Decisions about capital expenditure require different thought processes from those about revenue
expenditure. Capital expenditure often involves the expenditure of larger sums of money, and this
usually happens over a longer period of time. Because of this, there are sometimes elements of
uncertainty, such as interest rates or the revenue to be gained from a project, and this chapter
introduces the different means of assessing the value of capital expenditure.

CHAPTER 11 INVENTORY AND PRICING DECISIONS


Manufacturing businesses in particular are very concerned to retain the right amount of stock, or
inventory. They do not want to tie too much cash up in the purchase and holding of stocks of goods or
components, but nor do they want to run the risk of not being able to fulfil an order from a customer
because they do not have the stock or cannot get it quickly enough. This chapter examines systems
for maintaining inventory and controlling its levels, and also looks at different approaches to pricing.

CHAPTER 12 PERFORMANCE MEASUREMENT AND EVALUATION


This chapter is concerned with performance indicators, i.e. the ways of assessing how a business, or a
division, or a particular product within a catalogue, is performing. The central theme here is
responsibility accounting, the system of accounting that divides revenue and costs into area of
personal responsibility in order to monitor and assess the performance of each part of an
organisation.

xii | MANAGEMENT ACCOUNTING

LEARNING OBJECTIVES
MANAGEMENT ACCOUNTING
CPA Australia's learning objectives for this Study Manual are set out below. They are cross-referenced
to the chapter in the Study Manual where they are covered.
This exam covers an understanding of developments in management accounting and the tools
management accountants use to cost products and services, and to develop and manage budgets. It
also covers performance management and control; planning and assessment of project alternatives;
and an understanding of the nature, functions, structures and operations of management.
CHAPTER(S)
WHERE
COVERED

Topics
LO1. Conceptual issues and behavioural implications
LO1.1

Explain the historical development of management accounting

LO1.2

Analyse the key differences between financial, cost and management


accounting

LO1.3

Describe how management accounting creates value

LO1.4

Analyse the current influences on management accounting

LO1.5

Explain the range of theories that underpin management accounting


and how they have an influence on practice

LO1.6

Outline the core parts of management accounting systems and how


they enable strategic management

LO1.7

Analyse the roles of management accountants in cross-functional


teams

LO1.8

Identify and explain appropriate internal controls for management


and accounting systems in a range of situations

12

LO1.9

Explain how organisational behaviour can impact the creation of


organisational value

LO1.10

Describe the increasing awareness of sustainability and its relationship


to management accounting

LO2. Decision making


LO2.1

Apply the steps in the decision making process

2.1.1 define the problem


2.1.2 identify the decision making criteria
2.1.3 develop alternatives
2.1.4 analyse alternatives
2.1.5 select an alternative
LO2.2

Apply relevant information guidelines for short-term alternative choice


operating decisions

LO2.3

Identify the quantitative and qualitative criteria involved in accepting a


project

10

LO2.4

Analyse the challenges posed by differences between a project and


an organisations risk profiles

10

LO2.5

Explain the impact of cash flows and risks on project decision making

2, 10

INTRODUCTION | xiii

CHAPTER(S)
WHERE
COVERED

Topics
LO3. Budgeting
LO3.1

Identify and analyse the human behavioural challenges to the


budgeting process in organisations

LO3.2

Explain the nature of budgets and the reasons that organisations use
budgets

LO3.3

Prepare an operations budget

LO3.4

Prepare a cash budget

LO4. Cost behaviour


LO4.1

Describe the nature of costs and their behaviour

2, 4

LO4.2

Apply relevant techniques to separate costs into their fixed and


variable components

3, 4

LO4.3

Apply the principles of cost-volume-profit analysis in organisations

LO5. Overhead costing product and service costing


LO5.1

Explain key methods of departmental overhead allocation

LO5.2

Explain the concepts underpinning product costing in organisations

LO5.3

Develop different product costing statements involving production


resource costs

LO5.4

Evaluate the difference between direct production costs and indirect


overhead costs

LO5.5

Apply the principles of absorption and variable costing to product


costing analysis

LO6. Overhead costing activity based costing


LO6.1

Identify and apply the principles of activity based costing to allocate


overheads in organisations

LO7. Process and job costing


LO7.1

Explain the differences between job and process costing techniques

LO7.2

Apply costing principles to job costing and process costing


organisations

LO8. Standard costing


LO8.1

Explain how standard costing can be used to assist in cost control and
efficient resource allocation

LO9. Variance analysis


LO9.1

Define and describe a variance

LO9.2

Explain the causes of variances and associated corrective actions

LO9.3

Calculate a variance

xiv | MANAGEMENT ACCOUNTING

CHAPTER(S)
WHERE
COVERED

Topics
LO10. Capital expenditure
Analyse capital expenditure decisions in organisations using relevant
tools and techniques
Apply capital expenditure analysis to project planning and managing
LO10.2
uncertain scenarios through scenario analysis
LO11. Inventory and pricing decisions
LO10.1

LO11.1

Evaluate the principles of just-in-time

Apply the economic order quantity formula to determine order


quantities for inventory management
Establish and apply the appropriate approach for long-term pricing
LO11.3
decisions
LO12. Performance measurement and evaluation
LO11.2

10
10

11
11
11

LO12.1

Explain the characteristics and purpose of performance measurement


systems

12

LO12.2

Analyse the different types of financial performance measures and


their limitations

12

LO12.3

Describe the key characteristics of the Balanced Scorecard and its


advantages over traditional performance measurement systems

12

LO12.4

Outline the characteristics of reward systems and the circumstances in


which they can be tied to performance measures

12

Exam topic weightings


1

Conceptual issues and behavioural implications

7%

Decision making

13%

Budgeting

10%

Cost behaviour

15%

Overhead costing product and service costing

13%

Overhead costing activity-based costing

5%

Process and job costing

5%

Standard costing

5%

Variance analysis

5%

10

Capital expenditure

5%

11

Inventory and pricing decisions

5%

12

Performance measurement and evaluation

12%

TOTAL

100%

CHAPTER 1
THE NATURE AND PURPOSE
OF MANAGEMENT
ACCOUNTING
Learning objectives

Reference

Conceptual issues and behavioural implications

LO1

Explain the historical development of management accounting

LO1.1

Analyse the key differences between financial, cost and management accounting

LO1.2

Describe how management accounting creates value

LO1.3

Analyse the current influences on management accounting

LO1.4

Explain the range of theories that underpin management accounting and how they
have an influence on practice

LO1.5

Outline the core parts of management accounting systems and how they enable
strategic management

LO1.6

Analyse the roles of management accountants in cross-functional teams

LO1.7

Explain how organisational behaviour can impact the creation of organisational value

LO1.9

Describe the increasing awareness of sustainability and its relationship to management


accounting

LO1.10

Decision making

LO2

Apply the steps in the decision making process

LO2.1

define the problem

LO2.1.1

identify the decision making criteria

LO2.1.2

develop alternatives

LO2.1.3

analyse alternatives

LO2.1.4

select an alternative

LO2.1.5

Topic list

1
2
3
4
5
6
7
8

The management accounting function


Financial accounting and management and cost accounting
Planning, control and decision-making
Information
Management accounting systems
Design of management accounting systems
Developments in management accounting
Sustainability and management accounting

2 | MANAGEMENT ACCOUNTING

INTRODUCTION
This chapter provides an introduction to Management Accounting.
We begin this first chapter by looking at the role of the management accounting function.
We then examine the differences between management accounting and financial accounting and
introduce cost accounting.
The chapter goes on to look at the importance of information provided by the management
accountant in planning, control and decision making. It also briefly looks at the design and
development of management accounting systems.
This chapter discusses the limitations of some of the traditional methods of management accounting,
and considers how recent developments in management accounting attempt to overcome these
limitations.
Finally we examine the management accountant's role in the creation of organisational value and the
relationship between sustainability and management accounting.
The chapter content is summarised in the diagram below.

The nature and


purpose of
management accounting

Information

Presentation of
information to
management

Planning, control
and decision
making

Management
accounting
systems

Financial accounting and cost


and management accounting

Design of management
accounting systems

Developments in management
accounting

The management
accounting function

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 3

If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What are the differences between financial accounts and management accounts?

(Section 2.2)

2 What are the differences between cost accounting and management accounting?

(Section 2.3)

3 Explain the link between an organisation's objectives and its strategy.


4 Identify steps involved in the decision making process.

(Section 3.2)
(Section 3.6.1)

5 What are the three types of management activity identified by Anthony


(Management Control Systems, 1972)?

(Section 3.7)

6 What are the basic elements of a management control system?

(Section 3.8)

7 What is the difference between data and information?

(Section 4.1)

8 List the qualities of good information.

(Section 4.2)

9 What are the main features of a report?

(Section 4.5)

10 What are the risks of using traditional management accounting methods?

(Section 5.4)

11 What are the components of a management accounting system?

(Section 5.2)

12 Define and explain Just-In-Time (JIT).

(Section 7.1)

13 Define and explain Total Quality Management (TQM).

(Section 7.2)

14 Define and explain Kaizen.

(Section 7.3)

CHAPTER 1

BEFORE YOU BEGIN

4 | MANAGEMENT ACCOUNTING

1 THE MANAGEMENT ACCOUNTING FUNCTION


Section overview
The role of the management accounting function as an information provider has developed
with advances in technology. To assess the effectiveness of the management accounting
function, a clear understanding is needed of its objectives and activities, so that
appropriate measures of performance can be determined.
We will now look at the role and objectives of the management accounting function and how its
performance should be measured.

1.1 ROLE OF THE MANAGEMENT ACCOUNTING FUNCTION


The role of the management accountant is to provide information to decision makers, and to provide
advice based on that information. The information provided by management accounting covers all
areas of strategy and operations, and includes information to assist with planning, control and
decision-making by management.
The role of the management accountant today is more concerned with providing complex analysis
and information to support business management than with providing routine reports, since much
routine work is now computerised. At the same time the areas covered by management accounting
have extended to include strategic information and non-financial information, and information to
support risk management. Developments in technology have also made it easier to provide
accounting information to non-financial managers.

1.1.1 THE DEVELOPMENT OF MANAGEMENT ACCOUNTING INFORMATION


LO
1.1

In the 1950s Simons identified three attributes of what could by now be called management
accounting information:
It should be useful for scorekeeping to see how well the organisation is doing overall and to
monitor performance.
It should be attention-directing to indicate problem areas that need to be investigated.
It should be useful for problem-solving to provide a means of evaluating alternative responses
to the situations in which the organisation finds itself.
Management accounting information is therefore used by managers for a number of purposes:
To make decisions.
To plan for the future. Managers have to plan and they need information to do this. Much of this is
provided by management accounting systems.
To monitor the performance of the business. Managers need to understand how they are
performing against goals and targets.
To measure profits and put a value on inventory.
To implement processes and practices that focus on effective and efficient use of organisational
resources to support managers to enhance customer and stakeholder value (IFAC 2002)

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 5

LO
1.7

In some organisations, the cost and management accounting function may be organised as a
functional section or department within the organisation. However, because management accountants
provide information to other managers, it has become fairly common to include management
accountants within cross-functional teams, or to assign them to work with non-accounting functions. A
cross-functional team is a small group of individuals, with different expertise, taken from many
different parts and levels of an organisation, which comes together to work towards a common
purpose or goal. The size of each team will vary according to the scale and complexity of the project.
Cross-functional teams are typically formed on the assumption that a small group is better for a
particular task than either individuals acting alone or in a large, permanently structured group.
Benefits of cross-functional teams include:
improved coordination and integration of systems or activities
problem-solving across traditional functional or organisational boundaries
facilitate innovation and product/service development
In addition to contributing their technical expertise as accounting and finance experts and their
functional expertise as information providers, management accountants have a key role to play in
helping maximise the potential of a cross-functional team by:
providing, collecting and assessing critical team information;
helping establish goals and set priorities;
assisting with problem-solving and decision-making, through the application of decision-making
models and other techniques
ensuring the team maintains an organisation-wide perspective.

1.3 DEFINING OBJECTIVES OF THE MANAGEMENT ACCOUNTING


FUNCTION
The objectives of the management accounting function should depend on the information needs of
the 'internal customers' the managers within an organisation who need information to help them to
run the business. The overall objective should be the provision of quality service and decision making
information. This broad objective can be analysed into a number of sub-objectives.
SUB-OBJECTIVE

DETAIL

The provision of good


information

This requires supplying information that fulfils the following criteria.


Information must be relevant to the needs of users. This involves identifying
the users of information and the reasons why they need it. Information can
only ever be relevant if it has a purpose and a use.
Information should be reliable. It should be sufficiently accurate for its
purpose. For example it should be free from material error and should not be
taken from an unreliable source. Unless information is reliable, management
will not have sufficient confidence to use it.
Information should be timely, which means that it should be provided in time
for the purpose for which it is intended. Information has no value if it is
provided too late. Some information, such as information provided for control
purposes, may lose value with time.
Information should be clear, comprehensible and appropriately
communicated, since it will lose its value if it is not clearly communicated to
the user in a suitable format and medium. A large amount of management
accounting information should be accessible immediately and on-line to
authorised managers.

The provision of a value-formoney service

The costs of management accounting should be justified by the benefits that


the function provides to the organisation, and the level of service and the
quality of information provided.

The availability of informed


personnel

Users will expect management accounting staff to be available to answer


queries and resolve problems as and when required.

CHAPTER 1

1.2 ROLE OF THE MANAGEMENT ACCOUNTANT IN CROSSFUNCTIONAL TEAMS

6 | MANAGEMENT ACCOUNTING

1.4 MANAGEMENT ACCOUNTING FUNCTION ESTABLISHING


ACTIVITIES
Once the objectives have been defined, the activities that the function should carry out to achieve its
objectives must be established. This is why it is necessary to answer the question:
'What information do we want, or might we want?'
The specific information that a management accounting system needs to provide (and the timing or
accessibility of this information) will vary between organisations, according to factors such as the
nature of their business and their size. The management accounting function should be organised and
staffed so that it is able to provide the information expected from it.
A follow-up question is:
'What type and size of function do we need to provide this information, and what will it cost?'
Management, as users of information, should therefore understand what information they are getting,
and what it is costing to get it.

1.5 MANAGEMENT ACCOUNTING FUNCTION IDENTIFYING


PERFORMANCE MEASURES
The performance of the management accounting function should be measured according to its
objectives and its specified activities. Suitable specific performance measures might be as follows:
a. Measures relating to the quality of the information provided. Quality measures may be based on
the judgement of users, such as opinions about whether the information provided is useful, timely
and reliable.
b. Measures relating to value for money. The cost of the function should be measurable. It may be
possible to compare the cost with other information provision services within the organisation or in
different organisations. The benefits are not so easy to assess, but management need to be
satisfied that they are getting value for money.
c. Measures relating to the availability of accounting staff to assist management, such as the
amount of time the accounting staff spend with managers in other functions, and the speed of
their response to requests for information, advice or assistance.
d. Measures relating to flexibility, such as delivery in accordance with the service levels agreed with
business units to meet needs for ad-hoc reporting.
e. Ratings provided from user satisfaction surveys would provide extremely useful measures of
performance. 'Users' are the 'internal customers' for the management information.
f. Measure of management accounting service:
i. Timeliness of reports
ii. Attendance/contribution at management meetings/forums
iii. Management accounting involvement in strategic projects

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 7

Section overview
Financial accounting systems ensure that the assets and liabilities of a business are properly
accounted for, and provide information about profits and historical financial performance to
shareholders and to external stakeholders such as ATO and ASIC; and other interested
parties including interest groups, potential shareholders, unions and NGOs.
Management accounting systems provide information specifically for the use of managers
within an organisation. Corporate Performance Management (CPM) software and Business
Intelligence (BI) software are management accounting tools used by management
accountants.
Cost accounting is part of management accounting. The purpose of cost accounting is to
determine the cost of products and services.

2.1 FINANCIAL ACCOUNTS AND MANAGEMENT ACCOUNTS


LO
1.2

Financial accounting systems ensure that the assets and liabilities of a business are properly
accounted for. They are used to provide information to shareholders and other interested parties in
the form of (published) financial statements. Management accounting systems provide information
specifically for the use of managers within an organisation.
Management information provides a common source from which information for two groups of
people is drawn.
a. Financial accounts are prepared for individuals external to an organisation: for example
shareholders, customers, suppliers, regulatory authorities, employees.
b. Management accounts are prepared for internal use by managers of the organisation.
Much of the data used to prepare financial accounts and management accounts are the same but
differences between the financial accounts and the management accounts arise because the data are
analysed differently. In addition, management accounting systems draw on a wider range of data,
including non-financial data, data from external sources, and data relating to the future.

2.2 FINANCIAL ACCOUNTS VERSUS MANAGEMENT ACCOUNTS


Management accountants and financial accountants perform different parts of the accounting
function. The table below shows the differences between the two areas of accounting.
FINANCIAL ACCOUNTS

MANAGEMENT ACCOUNTS

Financial accounts detail the performance of an


organisation over a defined period and the state of
affairs at the end of that period. Financial accounts
provide information to third parties.

Management accounts are used to aid management


record, plan and control the organisation's activities and
to help the decision-making process. The information in
management accounts can measure the organisation's
activities against its strategic objectives.

Limited liability companies must, by law, prepare


financial accounts.

There is no legal requirement to prepare management


accounts.

The format of published financial accounts is


determined by local law, by International Accounting
Standards and International Financial Reporting
Standards. In principle the accounts of different
organisations can therefore be easily compared.

The format of management accounts is entirely at


management discretion: no strict rules govern the way
they are prepared or presented. Each organisation can
devise its own management accounting system and
format of reports.

Financial accounts concentrate on the business as a


whole, aggregating revenues and costs from different
operations, and are an end in themselves.

Management accounts can focus on specific areas of an


organisation's activities. Information may be produced
to aid a decision rather than as the end product of a
decision.

CHAPTER 1

2 FINANCIAL ACCOUNTING AND MANAGEMENT


AND COST ACCOUNTING

8 | MANAGEMENT ACCOUNTING

FINANCIAL ACCOUNTS

MANAGEMENT ACCOUNTS

Most financial accounting information is of a


monetary nature.

Management accounts incorporate non-monetary


measures. Management may need to know, for example,
tons of aluminium produced, monthly machine hours, or
miles travelled by sales staff.

Financial accounts present an essentially historic


picture of past operations.

Management accounts are both an historical record and


a future planning tool.

Question 1: Management accounts


Which of the following statements about management accounts is/are true?
I There is a legal requirement to prepare management accounts
II The format of management accounts is largely determined by law
III They serve as a future planning tool and are not used as a historical record
A III only
B I and II only
C II and III only
D none of the statements are correct
(The answer is at the end of the chapter)

2.3 COST ACCOUNTS


The terms 'cost accounting' and 'management accounting' are often used interchangeably. It is not
correct to do so. Cost accounting is part of management accounting. Cost accounting provides
source data for the management accountant to use.
Cost accounting is concerned with:
Preparing cost estimates of new and current products
Cost data collection
Measuring inventory costs including raw materials, work-in-progress and finished goods, and the
costs and profitability of products and services.
Management accounting on the other hand is concerned with:
Interpretation and assessment of financial, accounting and operational data, and communicating
it as information to users, for example as financial targets or performance measurements.

2.3.1 USES OF COST ACCOUNTS


Cost accounting is used to measure:
a. The cost of goods produced or services provided.
b. The cost of a department or business unit.
c. The revenues earned from a product, service, department or business unit, or the organisation in
total.
d. The profitability of a product, a service, a department, or the organisation in total.
e. Selling prices with some regard for the costs of sale.
f. The value of inventories of goods (raw materials, work in progress, finished goods) that are still
held in store at the end of a period, thereby aiding the preparation of a statement of financial
position of the company's assets and liabilities.
g. Future costs of goods and services, based on given assumptions about what will happen in the
future. Costing is an integral part of budgeting, because budgets are detailed financial plans.
h. How actual costs compare with budgeted costs. If an organisation plans for its revenues and
costs to be a certain amount, but they actually turn out differently, the differences (variances) can
be measured and reported. Management can use these reports as a guide to whether corrective
action, or 'control' action, is needed to sort out a problem. This system of control is often referred
to as budgetary control or variance analysis.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 9

3 PLANNING, CONTROL AND DECISION-MAKING


Section overview
Management information is used for planning, control and decision making.
Long-term planning, also known as corporate or strategic planning, involves selecting
appropriate strategies to prepare a long-term plan to attain the organisation's objectives.
Robert N Anthony (Management Control Systems, 1972) has categorised management
activities and decision-making into strategic planning, management control and
operational control.
A management control system is a system which measures and corrects the performance of
activities of subordinates.
Information within an organisation can be analysed into the three levels of Anthony's
hierarchy: strategic; tactical; and operational information.

3.1 PLANNING
LO
1.9

Planning forces management to think ahead systematically in both the short term and the long term.
Planning involves the following:
Establishing overall objectives.
Selecting appropriate strategies to achieve those objectives.
Setting targets for each strategy.
Formulating detailed plans for achieving those targets.
When expected changes are gradual, planning occurs in a fairly stable environment, and routine
budget planning procedures may be used.

3.2 OBJECTIVES OF ORGANISATIONS


Definitions
A vision is a succinct statement of an organisation's future aspirations.
A mission statement sets out an organisation's fundamental purpose.
An objective is the aim or goal of an organisation.
A strategy is a possible course of action that might enable an organisation to achieve its objectives.

Organisations often start by setting out their vision. This is a succinct statement of the organisation's
future aspirations e.g. Microsoft's vision is 'to help people and businesses throughout the world
realise their full potential'.
A mission statement is then created, setting out the organisation's fundamental purpose and
including references to its strategy, standards of behaviour and values.
The mission sets the overall direction of the organisation and the organisation's goals and more
detailed objectives then follow from this. The strategies identified as a result of the planning process
are designed to achieve these objectives.

CHAPTER 1

Cost accounting systems are not restricted to manufacturing operations, although they are probably
more fully developed in this area. Service industries, government departments and non-profit making
organisations all make use of cost accounting information. Within a manufacturing organisation, the
cost accounting system should be applied not only to manufacturing but also to administration, selling
and distribution, research and development and all other departments and functions.

10 | MANAGEMENT ACCOUNTING

Note that in practice, the terms objective, goal and aim are often used interchangeably.
The two main types of organisation that you are likely to come across in practice are as follows:
Profit making
Non-profit making
It is often assumed that the main objective of profit making organisations is to maximise profits. A
secondary objective of profit making organisations might be growth, for example by increasing the
output and sales of its goods/services. Instead of maximising profit, an organisation may seek to
maximise the wealth of its shareholders. Unfortunately, the aim of profit maximisation may encourage
decisions that compromise the long term viability of the business in the attempt to maximise
immediate profit outcomes.
The main objective of non-profit making organisations is usually to provide goods and services. A
secondary objective of these organisations might be to minimise the costs involved in providing the
goods/services.
The stated objectives of an organisation might include one or more of the following:
Maximise profits
Maximise revenue
Maximise shareholder value
Increase market share
Minimise costs
Management accounting techniques often assume one of these objectives when recommending a
course of action to management. Remember however that decisions have consequences for the
longer term as well as the short term, and decisions to maximise profit may have high associated risks.

3.3 LONG-TERM STRATEGIC PLANNING


Management accounting contributes to long-term strategic planning. Long-term planning, also known
as corporate planning, involves selecting appropriate strategies to attain the organisational
objective, and integrating these strategies into an overall long-term corporate or strategic business
plan.
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 for a strategic business plan are 2,
5, 7 or 10 years although longer planning periods may be used.
Long-term strategic planning consists of four basic elements:
assess the organisation and its environment
determine the corporate objectives
devise strategies for achieving these objectives
create a corporate plan
The diagram below provides an overview of the process and shows the link between short-term and
long-term planning.

3.4 SHORT-TERM TACTICAL PLANNING


The corporate or strategic plan serves as the long-term framework for the organisation as a whole.
For operational purposes it is necessary to convert the corporate (strategic) plan into a series of shortterm plans, usually covering one year, which relate to business units, functions or departments. The
annual process of short-term planning should be seen as stages in the progressive fulfilment of the
corporate plan. Each short-term plan steers the organisation towards its long-term objectives. It is
therefore vital that, to obtain the maximum advantage from short-term planning, some form of longterm plan exists.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 11

The management accounting function supports the short-term planning process, for example by
providing information for setting targets and standards, and helping to establish the assumptions on
which the short-term plan is based, such as growth rates, costs, efficiency savings and cost inflation.

The planning process


Assess the
external
environment

Assess the
organisation

Assess the
future

Assess
expectations

CHAPTER 1

THE
ASSESSMENT
STAGE

Evaluate
corporate
objectives

THE
OBJECTIVE
STAGE

THE
EVALUATION
STAGE

Consider
alternative
ways of achieving
objectives

THE
CORPORATE
PLAN

Agree a
corporate
plan

Production
planning

Resource
planning

Product
planning

LONGTERM
STRATEGY
PLANNING

Research and
development
planning

SHORTTERM
PLANNING

Detailed operation plans which implement the corporate plan on a monthly,


quarterly or annual basis. Operational plans include short-term budgets,
standards and objectives.

3.5 CONTROL
As well as providing information for planning, management accounting also provides information to
assist with monitoring and control. There are two stages in the control process.
a. The planned performance of the organisation (set out as targets or expectations in the detailed
operational plans) is compared with the actual performance of the organisation on a regular and
continuous basis. Significant deviations from the plans can then be identified and appropriate
corrective action can be taken where possible.
b. The corporate (strategic) 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 instructions
and so on), to assess whether the objectives of the plan can be achieved. The plan is modified to
ensure the organisation's future success.
Effective control is not practical without planning, and planning and control are interrelated. Targets
and objectives will not be achieved without monitoring and control measures when needed.
An established organisation should have a system of management reporting that produces control
information in a specified format at regular intervals.
Smaller organisations may rely on informal information flows or ad-hoc reports being produced as
required.

12 | MANAGEMENT ACCOUNTING

3.6 DECISION-MAKING
LO
2.1

A function of management is decision-making. Managers at all levels within an organisation make


decisions, both long term and short term, and routine and occasional. It is the role of the
management accountant to provide information so that management can reach an informed decision.
Decision making always involves a choice between alternative courses of action. For example, when
comparing actual results against a target, if actual results are poor, management needs to decide
whether corrective action should be taken. This may involve considering the different ways in which
control may be applied, and choosing the preferred course of action from the available alternatives.
Budgeting decisions involve a choice between different ways of using the organisation's scarce
resources (such as cash, equipment and manpower).
It is vital that management accountants understand the decision-making process so that they can
supply the appropriate type of information.

3.6.1 DECISION-MAKING PROCESS


It is possible to analyse the decision-making process into a sequence of steps. These apply whether
the decision is taken immediately, or whether the matter is carefully considered before a decision is
reached. These steps are shown below:
LOs
2.1.1
2.1.2
2.1.3
2.1.4
2.1.5

Define the problem

Identify decision-making criteria


(goals & objectives)

Develop alternative solutions/


opportunities which might
contribute towards achieving
them.

PLANNING

Collective and analyse relevant


data about each alternative.

Select an alternative
State the expected outcome
and check that the expected
outcome is in keeping with
the overall goals or objectives.

Implement the decision.

The sequence of steps can be applied to form decision making. Note the role of relevant and reliable
information is critical to the decision making process.
Define the problem. A decision is made only when a problem is recognised. If a manager is
unaware that a problem exists, they will not feel the need to make any decision. A workflow for
decision making has been set out above.
Identify the decision-making criteria. Having recognised that there is a problem for which a
decision must be made, the next step is to recognise the decision-making criteria. What are we
trying to achieve? In the planning process, the criteria may be to maximise profits over the next 12
months, given the available resources and subject to limitations on the risks that should be taken.
The criterion for control decisions may be to reduce excessive spending. In management
accounting, the decision-making criterion is often to maximise profitability, but as explained
earlier, consideration must be given to the longer term and risk.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 13

Analyse the alternatives. Each of the alternatives should be analysed and evaluated. If the
decision-making criterion is to maximise short-term profit, each alternative should be evaluated
financially, to estimate the profit that would result from choosing that alternative. Although a
management decision is often based on financial considerations, other non-financial factors may
also be considered if they are a part of the decision-making criteria.
Select an alternative. A decision involves selecting one alternative from the two or more that have
been analysed. The recommended choice should satisfy the goals of the organisation.
These steps in the decision-making process should be apparent in later chapters, when specific
management accounting techniques for analysis are described.

3.7 ANTHONY'S (1972) VIEW OF MANAGEMENT ACTIVITY


LO
1.5

Author Robert N Anthony (Management Control Systems, 1972) divided management activities into
three levels: strategic planning, management control and operational control. This is sometimes
known as the Anthony hierarchy.
a. Strategic planning is 'the process of deciding on the objectives of the organisation, on changes in
these objectives, on the resources required to attain these objectives, and on the policies that are
to govern the acquisition, use and disposition of these resources'.
b. Management control is 'the process by which managers assure that resources are obtained and
used effectively and efficiently in the accomplishment of the organisation's objectives'.
c. Operational control is 'the process of assuring that specific tasks are carried out effectively and
efficiently'.
A management accounting system provides information to management for strategic planning and
management control, and for some aspects of operational control.

3.7.1 STRATEGIC PLANNING


Strategic plans are those which set or change the objectives, or strategic targets, of an
organisation. They would include such matters as the selection of products and markets, the required
levels of company profitability and the purchase and disposal of subsidiary companies or major noncurrent assets.

3.7.2 MANAGEMENT CONTROL


While strategic planning is concerned with setting objectives and strategic targets, management
control is concerned with decisions about the efficient and effective use of an organisation's
resources to achieve these objectives or targets.
(a) Efficiency in the use of resources to achieve optimum output from the input resources used. It
relates to the combinations of labour, land and capital (for example, how much production work
should be automated) and to the productivity of labour, or material usage.
(b) Effectiveness in the use of resources to create the outputs that are in line with the intended
objectives or targets.

CHAPTER 1

Develop alternatives. The next step is to recognise different ways in which the problem might be
resolved in a way that is consistent with the decision-making criteria. For a simple decision, there
may be just two alternatives 'Do it', or 'Don't do it.' However there may be a number of different
alternatives, and the process of developing alternatives involves:
recognising the range of possible options and
from these, selecting a small number of alternatives for evaluation.

14 | MANAGEMENT ACCOUNTING

3.7.3 OPERATIONAL CONTROL


The third, and lowest tier, in Anthony's hierarchy of decision making, consists of operational control
decisions. Operational control is about ensuring that specific tasks are carried out effectively and
efficiently. Just as 'management control' plans are set within the guidelines of strategic plans,
'operational control' plans are set within the guidelines of both strategic planning and management
control. Consider the following:
a. Senior management may decide that the company should increase sales by five per cent per
annum for at least five years a strategic plan.
b. The sales director and senior sales managers will make plans to increase sales by five per cent in
the next year, with some provisional planning for future years. This involves planning direct sales
resources, advertising, sales promotion and so on. Sales quotas are assigned to each sales territory
a tactical plan (management control).
c. The manager of a sales territory specifies the weekly sales targets for each sales representative.
This is operational planning. Individuals are given tasks which they are expected to achieve.
Although we have used an example of selling to describe operational control, it is important to
remember that this level of planning occurs in all aspects of an organisation's activities, even nonstandard activities, such as repair work or answering customer complaints.
The scheduling of unexpected or ad-hoc work must be done at short notice, which is a feature of
much operational planning. In the repairs department, for example, routine preventive maintenance
can be scheduled, but breakdowns occur unexpectedly and unplanned repair work must be done 'on
the spot' by a repairs department supervisor.

3.8 MANAGEMENT CONTROL SYSTEMS


A management control system is a system which measures and corrects the performance of activities
of subordinates in order to make sure that the objectives of the organisation are being met and the
plans devised to attain them are being carried out.
The basic elements of a management control system are as follows:
Planning what to do and identifying the desired results.
Recording the plan which should incorporate standards of efficiency or targets.
Carrying out the plan and measuring actual results achieved.
Comparing actual results against the plans.
Evaluating the comparison, and deciding whether further action is necessary.
Where corrective action is necessary, this should be implemented.
Information to assist with this process is needed for recording the plan, comparing actual results
against the plan and evaluating the comparison. The information is often financial or partially financial
in nature, although it will include non-financial information too. This is why management accounting,
by providing information of both a financial and non-financial nature, should be an integral part of a
management control system.

3.9 TYPES OF INFORMATION


Information within an organisation can be analysed into the three levels assumed in Anthony's
hierarchy: strategic; tactical; and operational information.

3.9.1 STRATEGIC INFORMATION


Strategic information is used by senior managers to plan the objectives of their organisation, and to
assess whether the objectives are being met in practice. Examples of such information include overall
profitability, the profitability of different segments of the business, capital equipment needs and so
on.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 15

Strategic information therefore has the following features:


It is derived from both internal and external sources.
It is summarised at a high level, and is directed at senior management.
It is relevant to the long term.
It is often prepared on an ad-hoc basis.
It is both quantitative and qualitative.
It cannot provide complete certainty, given that the future cannot be predicted.

3.9.2 TACTICAL INFORMATION


Tactical information is 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 direct labour hour or per machine hour), budgetary
control or variance analysis reports, and cash flow forecasts.
Tactical information has the following features:
It is primarily generated internally.
It is summarised at a lower level and is directed at middle management as well as more senior
management.
It is relevant to the short and medium term.
It describes or analyses activities or departments.
It is prepared routinely and regularly.
It is based largely on quantitative measures.
It allows the monitoring of business performance against goals.

3.9.3 OPERATIONAL INFORMATION


Operational information is used by 'front-line' managers, such as foremen and supervisors, to ensure
that specific tasks are planned and carried out properly. 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, the rate of pay per hour, details of deductions, and for the purpose of wages analysis,
details of the time each person 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 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:
It is derived almost entirely from internal sources.
It is highly detailed, being the processing of raw data.
It relates to the immediate term, and is prepared constantly, or very frequently.
It is task-specific and largely quantitative.

4 INFORMATION
Section overview
Data is the raw material for data processing. Data relates to facts, events and transactions.
Information is data that has been processed so as to be meaningful.
Good information is relevant, complete, accurate and clear. It inspires confidence, is
appropriately communicated, its volume is manageable, it is timely to produce and it costs
less to produce than the benefits it provides.

CHAPTER 1

It deals with the whole organisation.

16 | MANAGEMENT ACCOUNTING

4.1 DATA AND INFORMATION


Definitions
Data is the raw material for data processing. Data relates to facts, events and transactions.
Information is data that has been processed so as to be meaningful to the person who receives it.
Information is knowledge communicated or received concerning facts or circumstances.

Information is sometimes referred to as processed data. The terms 'information' and 'data' are often
used interchangeably. It is important to understand the difference between these two terms.
For example, researchers who conduct market research surveys might ask members of the public to
complete questionnaires about a product or a service. These completed questionnaires are data; they
are processed and analysed in order to prepare a report on the survey. This resulting report is
information and may be used by management for decision-making purposes.
Management accounting systems provide information, and the quality of the management accounting
system depends on the quality of the information that it provides.

4.2 QUALITIES OF GOOD INFORMATION


Good information is relevant, complete, accurate and clear. It inspires confidence, is appropriately
communicated and its volume is manageable. It is timely and its cost to produce is less than the
benefits it provides.
Let us look at those qualities in more detail.
a. Relevance. Information should have a purpose; otherwise there is unlikely to be sufficient benefit
from processing data to justify the cost of providing it. Information must be relevant to the purpose
for which a manager wants to use it.
b. Completeness. Information users should have all the information they need to do the job properly.
If they do not have a complete picture of the situation, they might well make bad decisions.
c. Reliability. Information should be reliable. This means that it should be sufficiently accurate for its
purpose. Using incorrect information could have serious and damaging consequences. However,
there is no need to go into unnecessary detail. Where there is some uncertainty about the accuracy
or reliability, for example when making forecasts about the future, the nature of the uncertainty
should be fully understood, so that the information is used and treated with caution.
d. Clarity. Information must be clear to the user. If the user does not understand it properly they will
not be able to 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.
e. 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. Having confidence in information
depends on other qualities of the information reliability, relevance and clarity.
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. For example, an office manager
might be made responsible for controlling expenditure in the office, and given a budget
expenditure limit for the year. As the year progresses, they might try to keep expenditure in check
but unless they are told throughout the year what current total expenditure is to date, they will find
it difficult to judge whether they are 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 inappropriate amount of information, even if it is all
relevant, cannot be handled. Reports to management must therefore be clear and concise and in

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 17

h. Timing. Information should be timely. If it is not available until after a decision is made, it will be
useful only for comparisons and longer-term control. 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 operations, information to make the decision is only required once a month,
and weekly reports would be a time-consuming waste of effort.
i. Channel of communication. Information should be communicated or should be accessible
through appropriate channels of communication. There are occasions when using one particular
method of communication will be better than others. Some internal memoranda may be better
sent by 'electronic mail'. Some information is best communicated informally by telephone or
word-of-mouth, whereas other information ought to be formally communicated in writing or
figures. Electronic methods of data transmission, data storage and data access are integral parts of
most management accounting systems.
j. Cost. Information should have some value, otherwise it would not be worth the cost of collecting
and filing it. The benefits obtainable from the information must also exceed the costs of acquiring
it. Whenever management is trying to decide whether or not to produce information for a
particular purpose, for example, whether to computerise an operation or to build a financial
planning model, a cost/benefit analysis ought to be undertaken.
k. Comparability. Information needs to be measured and reported in a similar manner so that
meaningful comparisons can be made over time.
Question 2: Value of information
Managers receive a monthly performance report indicating that costs in the previous month were 15%
more than expected. Which one of the following would be the most appropriate response by
management to this information?
A Control action should be taken to deal with the problem and reduce costs by 15%.
B The overspend indicates that planning targets will not be met, and forecasts should be revised.
C The reasons for the overspend may be controllable; therefore they should be investigated with a
view to reducing the overspend as much as possible.
D The reasons for the overspend may be controllable or uncontrollable; therefore they should be
investigated with a view either to reducing the overspend as much as possible or revising forecasts
or targets.
(The answer is at the end of the chapter)

4.3 WHY IS INFORMATION IMPORTANT?


Information is important for management because it provides awareness and understanding of an
issue. By helping management to make better-informed decisions, information should contribute
significantly to better-quality decision-making. Consider the following problems and what
management needs to solve these problems.
a. A company wishes to launch a new product. The company's pricing policy is to charge cost plus
20%. What should the price of the product be?
b. An organisation's widget-making machine has a fault. The organisation has to decide whether to
repair the machine, buy a new machine or hire a machine. What does the organisation do if its aim
is to control costs?
c. A company is considering offering a discount of 2% to those customers who pay an invoice within
seven days of the invoice date and a discount of 1% to those customers who pay an invoice within
eight to fourteen days of the invoice date. How much will this discount offer cost the company?

CHAPTER 1

many systems, control action works basically on the 'exception' principle, with reports only being
produced if there is an issue that needs to be brought to management attention or investigated
further .

18 | MANAGEMENT ACCOUNTING

In solving these and a wide variety of other problems, management needs information.
a. In problem (a) above, management would need information about the cost of the new product.
b. Faced with problem (b), management would need information on the cost of repairing, buying and
hiring the machine.
c. To calculate the cost of the discount offer described in (c), information would be required about
current sales settlement patterns and expected changes to the pattern if discounts were offered.
The successful management of any organisation depends on information: organisations in the public
sector, such as hospitals and local authorities and other non-profit making organisations such as
charities and clubs need information for decision making and for reporting the results of their activities
just as multi-nationals do. For example, a local government authority needs to know what resources
are being used to deliver services to residents. A tennis club needs to know the cost of undertaking its
various activities so that it can determine the amount of annual subscription it should charge its
members.

4.4 WHAT TYPE OF INFORMATION IS NEEDED?


Managers require a mixture of financial and non-financial information.
Worked Example: Financial and non-financial information
Assume that the management of ABC Co have decided to provide a cafeteria for their employees.
a. The financial information required by management might include cafeteria staff costs, costs of
subsidising meals, capital costs, costs of heat and light and so on.
b. The non-financial information might include comment on the effect on employee morale of the
provision of cafeteria facilities, details of the number of meals served each day, meter readings for
gas and electricity and attendance records for cafeteria employees.
ABC Co could now combine financial and non-financial information to calculate the average cost to
the company of each meal served, thereby enabling them to predict total costs depending on the
number of employees in the work force.

4.4.1 NON-FINANCIAL INFORMATION


Management accounting is mainly concerned with the provision of financial information to aid
planning, control and decision making. However, the management accountant cannot ignore nonfinancial influences and should qualify the information provided with non-financial matters as
appropriate.
Non-financial information may relate to matters such as quality, speed, flexibility, creativity, motivation,
customer satisfaction and competitive advantage.

4.5 PRESENTATION OF INFORMATION TO MANAGEMENT


Reports
Information may be communicated by word of mouth, but in many organisations, especially larger
organisations, formal reports are an important method of communication. Financial information in
particular is often presented in the form of reports, because managers cannot always easily and
quickly understand financial details, and need to have the information presented to them in a
structured way. Management accountants need to be skilled in writing and presenting formal reports.

Main features of a report


TITLE
Most reports are usually given a heading to show that it is a report.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 19

WHO IS THE REPORT INTENDED FOR?


It is vital that the intended recipients of a report are clearly identified. For example, if you are
writing a report for Joe Rafter, it should be clearly stated at the head of the report.

If the recipients of the report have any comments or queries, it is important that they know who to
contact.
DATE
We have already mentioned that information should be communicated at the most appropriate
time. It is also important to show this timeliness by giving your report a date.
SUBJECT: REPORT HEADING
What is the report about? Managers are likely to receive a great number of reports that they need
to review. It is useful to know what a report is about before you read it! A report should therefore
have a clear heading or title.
SUB-HEADINGS
Unless they are very brief, reports should be divided into sections, each with a clear sub-heading.
The first heading may be an introduction (explaining the purpose of the report), followed by an
executive summary (setting out both the purpose and the findings of the report). The final subheading may be for a summary, conclusion or recommendation.
APPENDIX
In general, information is summarised in a report and the more detailed calculations and data are
included in an appendix at the end of the report.

5 MANAGEMENT ACCOUNTING SYSTEMS


Section overview
Management accounting systems developed from cost accounting systems. They are used
for scorekeeping, directing management attention and problem solving.
LO
1.1

We start this section by briefly looking at how management accounting systems have developed, and
we consider the implications of systems not developing quickly enough to keep pace with changes in
the business world.

5.1 THE DEVELOPMENT OF MANAGEMENT ACCOUNTING


Management accounting has developed gradually over time, and has changed in nature. Originally,
cost accounting systems were used to record costs and report costs to management in manufacturing
industries, so that product costs and profitability could be better managed. Historically manufacturing
costs were a larger proportion of total costs, and a larger proportion of total manufacturing costs
consisted of direct materials and direct labour costs, than is found in many modern manufacturing
industries. Manufacturing costs were 'driven' by direct labour hours worked or machine hours
operated.
Cost and management accounting information was also used for planning, particularly for annual
budgeting. Budgetary control reports were produced regularly, typically every month, to inform
management about actual performance and how this compared against the budget targets.
Some industries produced standard products in large quantities, so that standard costing systems
could be operated for budgeting and also for control reporting (standard costing variance reports).

CHAPTER 1

WHO IS THE REPORT FROM?

20 | MANAGEMENT ACCOUNTING

A significant development in management accounting was the use of marginal costing, and the
separation of costs into fixed and variable costs. Marginal costing concepts were applied to planning
and other aspects of decision-making. Management accounting systems became more relevant and
reliable in providing information to management for decision-making, through the application of
concepts and techniques such as relevant costs and discounted cash flow analysis.
More recently, management accounting systems have developed quite rapidly, in a variety of different
ways. Service industries and non-manufacturing activities became more important for many
companies, and management accounting systems were developed within service industries, and also
for activities such as marketing and distribution.
Management accounting techniques have also been developed to analyse costs in different ways,
particularly overhead costs, and techniques such as activity based costing and customer profitability
analysis have emerged.
The importance of information for strategic planning has also been recognised, and management
accounting has expanded from the provision of information at the management control level to
information provision for strategic planning and control. Management accounting systems must now
gather non-financial as well as financial information, and information from external as well as internal
sources. Corporate Performance Management (CPM) and Business Intelligence (BI) software are
examples of such systems.
There have also been changes in manufacturing techniques, such as Total Quality Management and
Just-in-Time (JIT) production. As manufacturing management has changed, the information to
support management management accounting has also had to change so that it remains relevant
and useful.
The expansion and increased sophistication of many management accounting systems would not have
been possible without technological change, and enormous improvements in the capabilities of IT
systems.

5.2 WHAT IS A MANAGEMENT ACCOUNTING SYSTEM (MAS)?


LO
1.6

A management accounting system (MAS) can be defined by its tangible components:


a. People with accounting knowledge (management accountants).
b. The technology they use.
c. Paper or computer records of financial transactions.
d. The cost accounting system on which it is based.
e. The management accounting techniques that are used to provide information: there are a wide
variety of simple and complex mathematical techniques for analysing data.
f. The reports that are produced by the system, or the nature of the information that is accessible online.
g. The users of the information the managers for whom the reports are prepared.
In summary, a management accounting system is an information system that produces information
required by managers to manage resources and create value for customers and shareholders.

5.3 RISKS IN USING MANAGEMENT ACCOUNTING SYSTEMS


In practice, management accounting systems may not provide information of sufficient quality, and
this will affect the quality of decision-making within the organisation. Typical weaknesses in some
management accounting systems are explained briefly below.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 21

Management information may be unduly focused on financial costs and short-term profits that can
easily be measured. Non-financial information may be overlooked. At a strategic level, for example,
the objective of a company may be to increase profitability, but in order to grow the business and its
profits, it may be necessary to consider factors such as quality, flexibility, customer satisfaction and
employee skills.

5.3.2 INTERNAL ORIENTATION


Management accounting systems may use data and information from internal sources, and fail to
make use of external sources. A business needs an external orientation. It operates in a competitive
and regulated environment, and management cannot ignore what is happening in the business
environment. There should be some focus on customers and competitors, suppliers and perhaps
other stakeholders.

5.3.3 LACK OF GOAL CONGRUENCE


Management accounting systems may encourage a lack of goal congruence within the organisation,
i.e. managers may be encouraged to concentrate on their own part of the company operations,
without regard for other aspects of the business. Managers may pursue targets that are in their
departmental interests but not in the best interests of the organisation as a whole. Often this may
reflect poor overall design of the system, with potential conflicts between short and long-term
objectives being ignored and incompatible targets being set for different parts of the organisation.

5.3.4 LACK OF FUTURE PERSPECTIVE


The management accounting systems may highlight historical financial costs and report on past
performance. There is a requirement to provide information for management to make decisions about
the future. Financial information for decision-making should consist of relevant costs (which we will
discuss below). However, management accounting systems may fail to provide relevant cost
information for management.

5.3.5 FAILURE TO ADAPT PERFORMANCE MEASURES TO CHANGING CIRCUMSTANCES


A particular problem with management accounting systems is that they may remain 'stuck' in
traditional methods of reporting and analysis, when new approaches may be much more appropriate
and valuable for management.

5.4 RISKS OF TRADITIONAL MANAGEMENT ACCOUNTING METHODS


A serious risk with using traditional management accounting methods and reports is that the
information they provide may be inappropriate for management's changing needs. Changes in the
business environment call for changes in information systems for management. Changes in the
business environment have included:
Globalisation and increased competition.
Information technology changes resulting in changes in production methods and information
flows.
Changes in organisation structures, such as internal reorganisations and external mergers.
Increasing awareness of sustainability and environmental issues.
Traditional management accounting systems may be inadequate for advanced manufacturing
technology and a modern business environment that focuses on marketing, customer satisfaction,
employee involvement and total quality ('getting things right first time').

CHAPTER 1

5.3.1 EXCESSIVE EMPHASIS ON FINANCIAL MEASURES

22 | MANAGEMENT ACCOUNTING

5.4.1 TIMING
In trying to improve profitability, management will often look for ways of reducing costs. However, as
we will see later, the cost of a new product is substantially determined when it is being designed, not
at the time it goes into production. The materials that will be used, the machines and labour required,
are largely determined at the design stage. In the car industry, 85 per cent of all future product costs
are determined during the design stage and by the end of the testing stage. Target costing is a
management accounting technique that draws attention to control of product costs at the design
stage. Traditional management accounting, however, continues to direct its attention to the
production stage.

5.4.2 CONTROLLABILITY
Traditionally, management accounting systems have provided more information about direct costs of
operations (material and labour) than about indirect costs (overheads), for example, by the
preparation of cost cards. This may result in an organisation focussing on controlling direct labour and
direct material costs and directing insufficient attention to overheads. However for many modern
organisations the controllable element of overhead costs, such as power, may be more significant and
offer more scope for savings than the direct costs of material or labour. There are techniques for
analysing overhead costs more closely, such as activity based costing and customer profitability
analysis, but traditional management accounting systems do not provide information of this quality.

5.4.3 NON-FINANCIAL ASSETS


Traditional management accounting measures do not deal with intangible assets, such as knowledgebased assets. Management information systems need to be able to provide information about the
resources that drive value, how knowledge-based assets help the organisation to improve its strategic
value and develop performance indicators that will help determine resource allocation and strategic
development.

5.4.4 CUSTOMER COSTS AND PROFITABILITY


Many costs are driven by customers such as delivery costs, discounts and after-sales service but
traditional cost and management accounting systems do not recognise this. Companies may be
trading with certain customers at a loss but not realise it because costs are not analysed in a way that
would reveal it.

6 DESIGN OF MANAGEMENT ACCOUNTING


SYSTEMS
Section overview
A management accounting system comprises people with accounting knowledge,
technology, records, processes, mathematical techniques, reports and the users for whom
those reports are prepared. The key components of the system are: inputs, processes and
outputs. It is used for strategic decision making, performance measurement, operational
control and costing.
LO
1.6

In this section we focus on the factors determining the design of management accounting systems,
and assessing the adequacy of existing management accounting systems. The most important factor
is for the output to meet the needs of management, for various decision making purposes.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 23

6.1 DESIGNING A MANAGEMENT ACCOUNTING SYSTEM


FACTOR

DETAIL

Information and timing

A starting point for design or assessment should be the output from the
management accounting system. For what purposes do management need
the information? The management accountant must identify the information
needs of managers making planning and control decisions, and monitoring
progress. Levels of detail and accuracy of output must be determined in each
case, and also the speed or frequency with which the information should be
provided or made available.

Sources of input data

A management accounting system should be capable of gathering the data


that is needed to provide the information. This involves obtaining data from
both internal and external sources. It also involves specifying the methods
that should be used to obtain and store the data.

Processing involved

Decisions should be made about how the data will be processed to provide
the information, and how frequently it should be provided (for example, in
monthly routine reports, continuously accessible online, or prepared in
response to specific requests from management). Decisions should also be
made about which methods or techniques of management accounting should
be used to process the data.

Response required

An important issue is how managers should be expected to respond to the


information provided. This will depend to some extent on how the
information is presented to them. Ultimately the information is meant to result
in decision making.

Question 3: Information
Management accounting information should be relevant to the user's needs, and should be reliable. It
should also be timely, appropriately communicated and cost-effective.
Which one of the following best describes the consequences if management accounting information
does not have these qualities?
A
B
C
D

The quality of decision making will be poor.


None of the information will be used by management.
Management will be forced to rely more on external information.
Management will be forced to rely more on financial accounting statements.

(The answer is at the end of the chapter)

6.2 STRATEGIC, TACTICAL AND OPERATIONAL INFORMATION


LO
1.6

A management accounting system should be capable of providing information at a strategic, tactical


(management control) and operational level for management.

6.2.1 STRATEGIC INFORMATION


Definition
Strategic Management Accounting is a form of management accounting in which emphasis is
placed on information which relates to factors external to the entity, as well as to non-financial
information and internally-generated information.

CHAPTER 1

The following factors should be considered when designing a management accounting system:

24 | MANAGEMENT ACCOUNTING

Some examples of strategic information that may be provided by a management accounting system
are found in the table below.
ITEM

COMMENT

Competitors' costs

What are they? How do they compare with ours? Can we beat them?
Are competitors vulnerable because of their cost structure?

Financial effect of competitor response

Have sales fallen?

Product profitability

A company should want to know not just what profits or losses are
being made by each of its products, but why one product is making
good profits whereas another equally good product might be
making a loss.

Customer profitability

Some customers or groups of customers are worth more than others.

Pricing decisions

Accounting information can help to analyse how profits and cash


flows will vary according to price and prospective demand.

Value of market share

A company ought to be aware of what it is worth to increase the


market share of one of its products.

Capacity expansion

Should the company expand its capacity, and if so by how much?


Should it diversify into a new area of operations, or a new market?

Brand values

How much is it worth investing in a 'brand' which customers will


choose over competitors' brands?

Shareholder wealth

Future profitability determines the value of a business.

Cash flow

A loss-making company can survive if it has adequate cash resources,


but a profitable company cannot survive unless it has sufficient
liquidity.

6.2.2 MANAGEMENT CONTROL INFORMATION


The information required for management control embraces the entire organisation. It is provided
for budgeting and planning, monitoring and other decision-making purposes at a management
control level within the organisation. The information is often quantitative, such as labour hours,
quantities of materials consumed, volumes of sales and production, and is commonly expressed in
money terms, but (as indicated previously) tactical information as well as strategic information may
include non-financial elements.
Examples of management control information might include profit forecasts, variance analysis reports,
and productivity statistics.
Some tactical information is prepared regularly, perhaps weekly, or monthly, in the form of regular
reports.

6.2.3 OPERATIONAL CONTROL INFORMATION


Operational information is information which is needed for the conduct of day-to-day
implementation of plans. It will include much 'transaction data' such as data about customer orders,
purchase orders, cash receipts and payments.
The amount of detail provided in information is likely to vary with the purpose for which it is needed.
Operational information is likely to go into much more detail than management control information,
which in turn will be more detailed than strategic information. Operational information, although
quantitative, is more often expressed in terms of units, hours and quantities of material. The extent
to which management accountants are involved in providing information at the operational level will
depend on the nature of the information and the responsibility structure within the organisation.

6.3 PERFORMANCE MEASUREMENT IN DIFFERENT SECTORS


An important aspect of management accounting systems is the provision of information about
performance. The nature of the performance measures used will depend largely on the nature of the
organisation's business and the type of industry in which it operates. The information will be both
financial and non-financial in nature.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 25

Management accounting information is provided for management in service industries, not just
manufacturing industries. The management accountant must take into account the characteristics of
the service businesses, including the fact that (unlike manufacturing) production and consumption of
services occur at the same time and there are no finished goods inventories. Customer satisfaction
may be difficult to measure in service businesses, and there may also be problems with identifying
which parts of the service the customer values most, and providing relevant information about
meeting customer needs.
In the service sector, performance evaluation (and information about performance) may have several
dimensions:
Flexibility
Excellence
Innovation
Financial performance
Resource utilisation
Competitiveness

6.3.2 PERFORMANCE MEASUREMENT IN THE NOT-FOR-PROFIT SECTOR


In the public sector/government, performance may be judged in terms of inputs and outputs, which
tie into the idea of 'value for money', based on:
Economy obtaining suitable inputs at the lowest cost.
Efficiency the process working as expected.
Effectiveness achieving goals.
Management accounting information in the not-for-profit sector may therefore focus on all three of
these aspects of performance.

7 DEVELOPMENTS IN MANAGEMENT
ACCOUNTING
Section overview
Management accountants have responded to developments such as JIT, TQM and lean
management accounting by using techniques such as target costing, life cycle costing and
Kaizen.
LOs
1.4
1.5

In this section we look at changes in the business environment and manufacturing methods, and how
management accounting techniques have been developed in response to them. Many of the
'modern' manufacturing methods are grouped around the concept of World-Class Manufacturing
(WCM), which sets as its objective achieving and sustaining competitive advantage in an environment
of strategic cost reduction. We shall revisit these concepts of manufacturing management, and the
associated management accounting techniques, in more detail later in the Study Manual.

7.1 JUST-IN-TIME (JIT)


JIT encompasses a commitment to continuous improvement and the search for excellence in the
design and operation of the production management system. Just-in-time manufacturing systems
seek to eliminate waste and 'get things right first time' in production operations. Waste is anything
that incurs costs without adding value holding inventories is one example of waste and JIT systems
seek to minimise inventory holding. To do this, materials must be supplied at exactly the time they are
needed to meet production requirements, and production must be completed exactly at the time that
output is needed to meet customer demand.

CHAPTER 1

6.3.1 PERFORMANCE MEASUREMENT IN THE SERVICE SECTOR

26 | MANAGEMENT ACCOUNTING

Definition
Just-in-time (JIT) is a system whose objective is to produce or to procure products or components
as they are required by a customer or for use, rather than for inventory. A JIT system is a 'pull'
system, which responds to demand, in contrast to a 'push' system, in which stocks act as buffers
between the different elements of the system, such as purchasing, production and sales.
Just-in-time production is a system which is driven by demand for finished products whereby each
component on a production line is produced only when needed for the next stage.
Just-in-time purchasing is a system in which material purchases are contracted so that the receipt
and usage of material, to the maximum extent possible, coincide.
The implications of JIT for the management accounting systems is that they have to be reorganised to
include or highlight items that are seen as costs under JIT but are not included in traditional systems.
Systems must highlight excessive inventory levels, machinery set ups and long lead times. The
changes in organisation resulting from JIT, such as the regroupings of workings, will also result in
changes in accounting systems to adjust to new demands and changed sources of information.
JIT is considered in more detail in chapter 11.

7.2 TOTAL QUALITY MANAGEMENT


Definition
Total Quality Management (TQM) is a culture of management and operations, rather than a specific
technique. The culture is one of achieving continuous improvements, no matter how small each
individual improvement may be, so that customer needs and expectations are met with increasing
success. The approach (like JIT) has a zero defects philosophy.
Total Quality Management (TQM) originated in Japanese manufacturing companies, notably Toyota,
from the end of the 1940s. The following 'requirements of quality' could be seen as the characteristics
of TQM programs and the TQM philosophy:
a. Organisation wide there must be acceptance that the only thing that matters is the customer.
b. There should be recognition of the all-pervasive nature of the customer-supplier relationship,
including internal customers; passing sub-standard material to another division is not acceptable.
c. Instead of relying on inspection to a predefined level of quality, the cause of the defect should be
prevented. (Defects should be eliminated and operations should be 'right first time'.)
d. Each employee or group of employees must be personally responsible for defect-free production
or service in their domain.
e. There should be a move away from 'acceptable' quality levels. Any level of defects is
unacceptable.
f. All departments should strive for perfection; this applies to misdirected phone calls and typing
errors as much as to production.
g. Quality certification programs should be introduced.
h. The cost of poor quality should be emphasised; good quality generates savings.
Key costs in a TQM system include:
a. Conformance costs, those costs incurred to prevent problems and to appraise quality.
b. Non-conformance costs, internal failures such as waste, and external failures selling faulty
goods to customers and as a result suffering claims from customers because products or services
supplied have been faulty. The emphasis will be on minimising or, preferably, eliminating nonconformance costs as these tend to be much larger than conformance costs.
Total quality management and continuous improvement tie in with risk management. Constant
review of processes to identify what went wrong, systems to input feedback from within the
organisation and from the customer, and procedures to ensure the organisation responds successfully
may reduce exposure to certain types of risk.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 27

7.3 KAIZEN
Definition

The Kaizen method is applied during the production process when it is difficult to make really big
changes. Kaizen focuses on the key elements of operations: production, purchasing and distribution.
Kaizen aims to achieve a specified cost reduction, but to do so through continuous improvements
rather than one-off changes.
Though managers may set the targets, employees working in the production process will ensure that
those targets are met. The logic of this approach is that those involved in production will be best able
to see how to achieve the necessary economies effectively but with minimum disruption. Often these
targets will be achieved in collaboration with suppliers.

7.4 LEAN MANAGEMENT ACCOUNTING


Lean management accounting has a lot in common with the other techniques outlined above. Its
emphasis is on the elimination of waste and continuous improvement. Customer demand
determines the flow of products or services, and emphasis is on processes and value streams rather
than departments.
In a lean system, management accounting systems need to be refocused to provide the information
necessary to drive improvement, and highlight waste. Distortions such as reduced unit costs arising
from producing large batches at a time need to be removed.

7.5 LIFE CYCLE COSTING


Life cycle costing is based on the view that the costs and profitability of products should be planned
and monitored over the entire life cycle of the products, from the design stage to the end of its
commercial life. Life cycle costing tracks and accumulates actual costs and revenues attributable to
each product or project over the entire product/project life cycle. The total profitability of any given
product / project can therefore be determined.
Traditional management accounting systems usually total all non-production costs and record them as
a period expense. Under life cycle costing such costs are traced to individual products over complete
life cycles.
Some organisations find that approximately 90% of a product's life cycle cost is determined by
decisions made early within the cycle at the design stage. Life cycle costing is therefore particularly
suited to innovative organisations and products, incurring high spending and commitments to spend
during the early stages of a product's life cycle.
In order to compete effectively in today's competitive market, many organisations need to continually
redesign their products with the result that product life cycles have become much shorter. The
planning, design and development stages of a product's cycle are therefore critical to an
organisation's cost management process. Cost reduction at this stage of a product's life cycle,
rather than during the production process, is one of the most important ways of reducing product
cost.

7.5.1 ADVANTAGES OF LIFE CYCLE COSTING


The life cycle costing approach emphasises the importance of development and design costs by
placing them in the context of the product's whole history. This may sway organisations away from
under-expenditure initially on design and development that results in problems later. The approach
deals well with other costs that may vary over a product's life cycle, for instance advertising. The life
cycle approach also highlights the importance of time to market; the success of a product may
depend on whether it gets to market quicker than its rivals.

CHAPTER 1

Kaizen is a Japanese term for continuous improvement in all aspects of an entity's performance at
every level. Kaizen is a feature of Total Quality Management.

28 | MANAGEMENT ACCOUNTING

7.5.2 PROBLEMS OF LIFE CYCLE COSTING


The biggest challenge is estimating product life costs over a number of years and how realistic they
will be in the light of the information available at the start of its life. When circumstances change, life
cycle costs have to change and management accounting systems may not be flexible enough to be
able to cope. Customer information may be important as customers may be prepared to pay a higher
price for a product that has lower lifetime costs.

7.6 TARGET COSTING


Target costing requires managers to change the way they think about the relationship between cost, price
and profit.
a. The traditional approach is to develop a product, determine the expected standard production
cost of that product and then set a selling price with a resulting profit or loss. Costs are controlled
through variance analysis at monthly intervals.
b. The target costing approach is to develop a product concept and the primary specifications for
performance and design and then to determine the price customers would be willing to pay for
that concept. The desired profit margin is deducted from the price leaving a figure that
represents total cost. This is the target cost and the product must be capable of being produced
for this amount otherwise the product will not be manufactured.

7.6.1 ADVANTAGES OF TARGET COSTING


The biggest advantage of target costing is that it brings market information into the management
accounting system rather than the accounting system being internally focused. It also encourages
continual product and production improvements and provides a structured approach for dealing
with those improvements.

7.6.2 PROBLEMS OF TARGET COSTING


The most significant challenge is setting a target, as it will be very difficult to forecast the market
price. It will partly depend on assumptions made about the future market situation including
behaviour of competitors, and technological and customer preferences.
A number of other problems may undermine the use of target costing as a means of control. These
include whether to use one target cost or several target costs, what costs to include and on what level
of production to base the target.

7.7 ORGANISATIONAL BEHAVIOUR


LO
1.9

Organisational behaviour is about the impact that individuals, groups and organisational structure
have on behaviour within an organisation and on that organisation's effectiveness or ability to create
value.
It is possible to identify three components that have an impact on organisational behaviour:
People
Structure
Technology and systems
To realise its full potential, an organisation needs to exploit the potential of its individual employees
and ensure that their goals are aligned with those of the organisation. The way that an organisation is
structured and its systems for planning, control and decision-making will affect the motivation of its
staff and hence the achievement of its results.
In today's fast-changing environment, a successful company is often one that is outward looking and
always looking to the future towards new markets, innovative products or services, better designs, new
processes, improved quality and increased productivity.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 29

To create and improve value, organisations need to:


Recruit and retain the best talent.

Create a culture that supports individual and team abilities and promotes and rewards the drivers
of organisational success.
Recognise the power and value of knowledge and ensure that this is captured and then shared to
improve competitive advantage, eg through the use of knowledge management systems.
Implement a management style and organisational structure that is consistent with all of the above.
Develop and maintain an information system to support management.
The management accountant plays a vital role in organisational behaviour.

7.8 ROLE OF THE MANAGEMENT ACCOUNTANT IN CREATING VALUE


LO
1.3

Earlier in this chapter we examined the role of the management accounting function and the
contribution of management accounting to strategic management.
Management accounting is a value added process. This value added process:
Guides management action
Motivates behaviour
Supports and creates the cultural values required to achieve the organisation's objectives
The management accountant plays a key role in providing relevant and timely information to the
management of the organisation, explaining the impact of that information and participating in the
managerial decision-making process.
The information provided by management accountants and the management accounting system:
supports the strategic planning process which ensures the organisation adapts to its competitive
environment (planning)
helps senior management to evaluate performance (control) and
provides timely and accurate information about activities required for success (decision making)
and
helps maximise the effective use of resources over time
Thus the management accountant helps create organisational value by:
providing relevant information for planning and decision making
assisting management in direction and control activities
motivating managers and other employees towards organisational objectives
measuring the performance of the activities of managers and other employees
assessing the organisation's competitive position

8 SUSTAINABILITY AND MANAGEMENT


ACCOUNTING
Section overview
Sustainability is about considering the future as well as the present. Management
accountants have a role in ensuring that this aim is recognised, relevant objectives are set,
performance measured and corrective action taken.

CHAPTER 1

Get the best from their employees.

30 | MANAGEMENT ACCOUNTING

LO
1.10

In this section we examine one of the newer concepts in management accounting, that of
sustainability and sustainability accounting. In recent years there has been an increasing awareness of
sustainability. The section begins by looking at what is meant by sustainability both on a global scale
and at an organisational level. The objectives of sustainability are then considered and its relationship
to management accounting.
Definition
In relation to the development of the world's resources, sustainability has been defined as
ensuring that development meets the needs of the present without compromising the ability of
future generations to meet their own needs.
For organisations, sustainability involves developing strategies so that the organisation only uses
resources at a rate that allows them to be replenished (in order to ensure that they will continue to
be available). At the same time emissions of waste are confined to levels that do not exceed the
capacity of the environment to absorb them.
(Brundtland report)
The concept of sustainability should not be confused with environmental protection and the scarcity of
natural resources, although for many industries there is a direct connection between these. The
concept of sustainable business applies to all types of business banks and retail businesses as well as
mining and oil companies.

8.1 THE OBJECTIVES OF SUSTAINABILITY


Sustainability is about ensuring that an industry will be able to continue into the foreseeable future.
To do this, it needs to identify any risks that may exist to its continued existence, and develop
strategic objectives to protect itself against those risks. For many companies, sustainability involves
considering how to achieve a sustainable business that does not deplete natural resources below a
sustainable level, and does not create excessive pollution that endangers the future well-being of
society. It may be argued that sustainability is concerned with ensuring a better quality of life for
everyone, now and for generations to come, whilst meeting the following four objectives:

Social progress that recognises the needs of everyone


Effective protection of the environment
Prudent use of natural resources
Maintenance of high and stable levels of economic growth or employment

However it is important to recognise that business organisations do not exist primarily to benefit
society as a whole. It is all too easy to become nave and unrealistic when thinking about sustainability!

8.2 SUSTAINABILITY AND MANAGEMENT ACCOUNTING


There is clearly a growing interest in providing information to management that will help to support
decision-making within the context of setting and achieving sustainability objectives. Many
organisations now produce social and environmental reports or sustainability reports. There is also a
growing understanding that accountants have an important role to play, demonstrated by the work
that is being done by the leading accountancy bodies to engage the profession in sustainability
issues.
Definition
The term 'sustainability accounting' encompasses a range of new accounting and reporting tools
and approaches which are part of a transition towards a different kind of organisational decisionmaking, focused not just on economic rationality, but consistent with ecological and social
sustainability.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 31

The role of the management accountant in sustainability accounting includes:


producing public reports of an organisation's carbon emissions, energy use, and impact on the
local economy (sometimes called physical, environmental or social accounting);
According to the International federation of Accountants (IFAC), 'a sustainability or (environmental)
management system can help an organisation:
Define its sustainability objectives, and ensure their alignment to business objectives;
Identify sustainability challenges, risks, and opportunities; and
Ensure that management and operational practices respond to these challenges, risks, and
opportunities.'
the reporting of initiatives which demonstrate that an organisation is taking its social and
environmental impacts into account in its decisions (such as in Corporate Social Responsibility
reporting);
the reporting of such initiatives together with an organisation's financial accounts; and
the reporting of information within key performance indicator criteria, reflecting progress towards
the sustainability of an organisation.
the reporting of costs organisations incur to prevent, monitor and report environmental impacts.

8.3 SUSTAINABILITY REPORTING


The term 'sustainability reporting' refers to the concept of organisations reporting to stakeholders not
only on their economic performance, but also on their performance in relation to the environment and
society. This has led to the emergence of frameworks to encompass reporting on social and
environmental performance.

8.3.1 GLOBAL REPORTING INITIATIVE (GRI)


The Global Reporting Initiative (GRI), founded in 1997, is an international not-for-profit organization. It
is the world-wide standard setter in sustainability reporting and its reporting guidelines are a global
voluntary code which provide a framework for organisations to measure their economic,
environmental and social performance. Reporting on these three aspects of performance is
sometimes called 'triple bottom line reporting'.
Economic: concerns the organisation's impacts on the economic conditions of its stakeholders and on
economic systems at local, national, and global levels.
Environmental: concerns an organisation's impacts on living and non-living natural systems, including
ecosystems, land, air, and water.
Social: concerns the impacts an organisation has on the social systems within which it operates.
Examples of GRI core performance indicators include:
ECONOMIC

ENVIRONMENTAL

SOCIAL

Revenues and costs

Materials used

Employee turnover and


absenteeism

Wages, pensions, other


employee benefits

Energy consumption

Diversity of workforce, incidents


of discrimination

Retained earnings and payments


to providers of capital

Water use

Employee health and safety

Taxes paid, subsidies and


grants received

Greenhouse gas emissions

Child labour

Geographic analysis of key


markets

Effluents and waste produced

Training undertaken

CHAPTER 1

the use of such reports as part of an environmental or sustainability management system;

32 | MANAGEMENT ACCOUNTING

ECONOMIC

ENVIRONMENTAL

SOCIAL

Return on capital employed

Significant spillages

Bribery and corruption

Fines and penalties

Community relations

Impact of activities on
biodiversity

Complaints re breaches of
customer privacy
Standard of Product labelling
(Source: GRI 2006)

The GRI Reporting Framework sets out the principles and Performance Indicators that organisations
can use to measure and report their economic, environmental, and social performance. There are
Sustainability Reporting Guidelines for different industries. The third version of the Guidelines known
as the G3 Guidelines - was published in 2006.
Many organisations around the world have declared their use of the GRI Guidelines as the basis for
sustainability reporting, including companies such as Coca Cola, Bayer, British American Tobacco,
Dell, and MTR Corporation. There are GRI guides for different industries, because the nature of
sustainability information differs according to the nature of the industry.

8.3.2 SUSTAINABILITY REPORTING IN AUSTRALIA


In October 2008 GRI Focal Point Australia was set up as a collaborative initiative by GRI and the St
James Ethics Centre. It is funded by the Federal Government's Treasury, CPA Australia and GRI. Its
goal is to increase the uptake of responsible business practice and make reporting on economic,
environmental and social performance by all organizations as routine and comparable as financial
reporting.
According to GRI Focal Point Australia, sustainability reporting in Australia is gaining momentum with
GRI reports almost doubling between 2007 and 2009. The establishment of the Focal Point has led to
an increased number of organisations considering GRI in their reporting and Australia is now the
fourth largest reporter against GRI, after Spain, USA and Brazil.
By 2010, 70 organisations in Australia, including Corporate Express Australia, Australia and New
Zealand Banking Group Ltd, Australia Post, and Telstra, had registered their use of GRI's reporting
guidelines and sustainability framework.
(http://www.globalreporting.org)
Case study
People, Productivity and Planet - Attitudes to Sustainability Reporting in Australia
The Nossal Institute for Global Health at the University of Melbourne, in partnership with Beaton and
Wellmark Perspexa undertook an Australia - wide survey on business sustainability, capturing the
attitudes of over 5000 business leaders.
The following is an extract of their key finding, published in 2011:
The strongest message emerging from the study is the huge latent potential in sustainability reporting
in Australia the will is there, but a substantial proportion of organisations are yet to find the way.
Snapshot of sustainability reporting in Australian organisations:
35% of leaders say their organisation currently produces sustainability reports
54% of those have been producing reports for less than three years
Huge business community support for sustainability reporting:
Reputation management, minimised environmental impacts, employee satisfaction and more
healthy workplaces are considered the major benefits of committing formally to sustainability
reporting

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 33

44% believe the benefits of sustainability reporting outweigh the costs


47% believe that in five years' time the majority of businesses will be producing sustainability
reports

Supply chain pressures will be a critical driver in the near future:


57% of leaders from reporting organisations would give preference to suppliers who can
demonstrate their commitment to sustainability
80% of leaders in reporting organisations agree it is likely that their organisation will require
suppliers to meet certain sustainability standards in the future
20% of leaders in non-reporting organisations in manufacturing, utilities, engineering and
architecture have been asked by clients about their sustainability reporting
If relevance can be demonstrated, most organisations have the will:
42% of leaders say they are not doing sustainability reporting because they don't feel it is relevant
to their organisation
20% of leaders say it is only a matter time before they start they are already talking about it
73% of leaders would personally like to see their organisation start sustainability reporting
Despite this, 25% of employees blame a lack of leadership commitment and interest for their
organisation not producing sustainability reports
53% of employees haven't done anything to encourage their organisation to start sustainability
reporting but have thought about it.
The employee attraction, satisfaction and retention case for sustainability reporting is strong:
54% of employees say that as a result of their organisation tackling sustainability issues, they feel
more proud of their organisation
70% of employees in non-reporting organisations say they would feel they were promoting a
healthier and more productive workplace if their organisation made a commitment to sustainability
41% of employees in reporting organisations said if they changed jobs they wouldn't want to work
somewhere that doesn't tackle sustainability issues
(http://www.sustainabilityatwork.com.au/2011/05/16/a-snapshot-of-sustainability-in-australia/)

8.3.3 SOCIALLY RESPONSIBLE INVESTMENT INDEXES


The two leading global Socially Responsible Investment (SRI) indexes are the Dow Jones Sustainability
Index World (DJSI World) and the FTSE4Good Global.
These indexes are designed to measure the performance of companies that meet globally recognised
corporate responsibility standards, and to facilitate investment in those companies. They include
companies that meet the selection criteria, but exclude those in certain sectors such as tobacco,
weapons and nuclear power.
Launched in February 2005, the Australian SAM Sustainability Index (AuSSI) tracks the performance
of Australian companies that lead their industry in terms of corporate sustainability. It comprises
companies from a range of industry sectors, including National Australia Bank Ltd, David Jones Ltd,
Foster's Group Ltd, Macquarie Group Ltd, and Energy Resources of Australia Ltd.

CHAPTER 1

47% of leaders in reporting organisations say there was no pressure to commence sustainability
reporting it was deemed to be the right thing to do

34 | MANAGEMENT ACCOUNTING

KEY CHAPTER POINTS


The role of management accounting as an information provider has developed with advances in
technology. To measure an organisation's performance effectively, clear understanding is needed
of its objectives and activities, and appropriate measures developed based on these.
Financial accounting systems ensure that the assets and liabilities of a business are properly
accounted for, and provide information about profits and so on to shareholders and to other
interested parties. Management accounting systems provide information specifically for the use of
managers within the organisation.
Cost accounting and management accounting are terms which are often incorrectly used
interchangeably. Cost accounting is part of management accounting. Cost accounting provides a
bank of data for the management accountant to use.
Information provided by management accountants is likely to be used for planning, control and
decision making.
Anthony (1972) divided management activities into strategic planning, management control and
operational control.
A management control system is a system which measures performance against a target or
benchmark, and indicates where control action may be required to make sure that the objectives of
an organisation are being met and the plans devised to attain them are being carried out.
Management accounting systems are management information systems. Information is data that
has been processed in such a way as to be meaningful to the person who receives it. Information is
anything that is communicated.
Good information should be relevant, complete, accurate and clear. It should inspire confidence, it
should be appropriately communicated and its volume should be manageable. It should be timely
and its cost should be less than the benefits it provides.
Information within an organisation can be analysed into the three levels assumed in Anthony's
hierarchy: strategic; tactical; and operational.
Management accounting developed from cost accounting. It is used for scorekeeping, directing
management attention and problem solving. It has since branched out into behavioural aspects.
A management accounting system comprises people with accounting knowledge, technology,
records, processes, mathematical techniques, reports and the users for whom those reports are
prepared. The key components of the system are: inputs, processes and outputs. It is used for
strategic decision making, performance measurement, operational control and costing.
Management accountants have responded to developments such as JIT, TQM and lean
management accounting by using techniques such as target costing, life cycle costing and Kaizen.
Organisational behaviour is about the impact that individuals, groups and organisational structure
have on behaviour within an organisation and on that organisation's effectiveness or ability to
create value.
Management accounting is a value added process which guides management action, motivates
behaviour and supports the cultural values required to achieve an organisation's objectives
For companies in many industries, sustainability involves developing strategies so that the
organisation only uses resources at a rate that allows them to be replenished. At the same time
emissions of waste are confined to levels that do not exceed the capacity of the environment to
absorb them.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 35

CHAPTER 1

The term 'sustainability accounting' encompasses a range of new accounting and reporting tools
and approaches which are part of a transition towards a different kind of organisational decisionmaking focused not just on economic rationality, but consistent with ecological and social
sustainability.

36 | MANAGEMENT ACCOUNTING

QUICK REVISION QUESTIONS


1 Which of the following is not an essential quality of good information?
A
B
C
D

It should be timely
It should be completely accurate
It should be relevant for its purposes
It should be communicated to the right person

2 The sales manager has prepared a direct labour plan to ensure that sales targets for the year are
achieved. This is an example of
A tactical planning.
B strategic planning.
C corporate planning.
D operational planning.
3 Which of the following statements is/are correct?
I Information is data that has been processed into a form meaningful to the recipient.
II An objective is a course of action that an organisation might pursue in order to achieve its strategy.
III A management control system is a term used to describe the hardware and software used to drive a
database system which produces information outputs that are easily assimilated by management.
A
B
C
D

I only
I, II and III
I and II only
I and III only

4 Monthly variance reports are an example of which of the following types of management
information?
A Tactical only
B Strategic only
C Operational only
D Tactical, strategic and operational
5 The three main types of accounting are management accounting, financial accounting and cost
accounting. Which of the following sequences is correct?
A Management accounting: immediate; financial accounting: quick; cost accounting: delayed
B Financial accounting: immediate; cost accounting: quick; management accounting: delayed
C Management accounting: immediate; cost accounting: quick; financial accounting: delayed
D Cost accounting: immediate; management accounting: quick; financial accounting: delayed
6 Which of the following describes a Just-in-time system?
A Sustaining a culture of continuous improvement
B Aiming to produce goods when required by customers or for use
C Using resources to create outputs that are in line with the intended objectives or targets
D Developing a product concept and determining the price customers would be willing to pay for
that concept
7 Which one of the following statements is not correct?
A Financial accounting information can be used for internal reporting purposes.
B Cost accounting can only be used to provide inventory valuations for internal reporting.
C Routine information can be used to make decisions regarding both the long term and the short term.
D Management accounting provides information relevant to decision making, planning, control
and evaluation of performances.

THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 37

1 B The reliability of information depends on its accuracy. Information should be sufficiently


accurate for its purpose. Relevance and clarity are different qualities of good information, and
information that is not provided in a timely way loses relevance.
2 A Tactical planning is used by middle management to decide how the resources of the business
should be employed to achieve specific objectives in the most efficient and effective way.
Strategic planning (option B) is planning for the achievement of long-term objectives, and
corporate planning (option C) is another name for this.
Operational planning (option D) is concerned with the very short term, day to day planning that
is carried out by 'front line' managers such as supervisors and head clerks.
3 D An objective is a target for achievement, not a course of action.
4 A Variance reports are an example of tactical management information. They have the key
features outlined in section 3.9.2.
5 C Management accounting information is generally needed and provided immediately and
responsively; cost accounting information is provided quickly and responsively, but not
necessarily immediately. The provision of financial accounting information is usually delayed.
6 B Just-in-time is a system whose objective is to produce or to procure products or components as
they are required by a customer or for use.
Option A (sustaining a culture of continuous improvement) is a general principle and not
specific to Just-in-time.
Option C (using resources to create outputs that are in line with the intended objectives or
targets) describes effectiveness in the context of management control.
Option D (developing a product concept and determining the price customers would be willing
to pay for that concept) describes target costing.
7 B Cost accounting has a variety of uses.

CHAPTER 1

ANSWERS TO QUICK REVISION QUESTIONS

38 | MANAGEMENT ACCOUNTING

ANSWERS TO CHAPTER QUESTIONS


1 D Statement I is incorrect. Limited liability companies must, by law, prepare financial accounts.
The format of published financial accounts is determined by law, but not the format of
management accounts. Statement II is therefore incorrect.
Management accounting information is sometimes used as a planning tool, for example in
budgeting. Therefore management accounts do serve as a future planning tool, but they are
also useful as a historical record of performance for example in monthly performance reports.
Management accounting information is used for control and one-off decision-making purposes,
as well as for planning purposes. Therefore, all three statements are incorrect and D is the
correct answer.
2 D Management accounting information has identified that costs were 15% more than expected.
Where actual performance is compared against a target, the problem could be with the actual
performance or the target may have been inappropriate Control information should lead to
investigation of the reasons for differences or variances. In this case the variance could suggest
that there has been unnecessary overspending or that there are reasons for the overspending
that is outside management's control. Where appropriate, control action should be taken to
reduce excess spending. Alternatively, if the overspend is caused by factors outside
management control it may be necessary to revise forecasts about what will happen in the
future.
3 A Management accounting information is used, even when its quality is poor. For example,
organisations prepare budgets, even when there is a lack of confidence in the quality of the
forecasts and other assumptions in the budget. Using external information is not a substitute for
internal information. Financial statements are for external publication and are not produced
frequently enough for management purposes. This suggests that the correct answer must be
answer A. The information will be used, even if there is a lack of confidence in it, but the quality
of decision-making will be adversely affected.

39

CHAPTER 2
DECISION MAKING AND
RELEVANT COSTING
Learning objectives

Reference

Decision making

LO2

Apply relevant information guidelines for short-term alternative choice operating


decisions

LO2.2

Explain the impact of cash flows and risks on project decision making

LO2.5

Cost behaviour

LO4

Describe the nature of costs and their behaviour

LO4.1

Topic list

1
2
3
4

Relevant costs
Choice of product (product mix) decisions
Make or buy decisions
Outsourcing

40 | MANAGEMENT ACCOUNTING

INTRODUCTION
Management at all levels within an organisation take decisions. The overriding requirement of the
information that should be supplied by the cost/management accountant to aid decision making is
that of relevance. This chapter therefore begins by looking at the concept of relevant costing, and
explains how to decide which costs need taking into account when a decision is being made.
We then go on to see how to apply relevant costing to product mix decisions, and make or buy
decisions.
Finally, the important area of outsourcing is considered.
The chapter content is summarised in the diagram below.

Decision making
and
relevant costing

Relevant
costs

Choice of product
(product mix) decisions

Outsourcing

Make or buy
decisions

DECISION MAKING AND RELEVANT COSTING | 41

BEFORE YOU BEGIN


If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.

1 What is a relevant cost?

(Section 1.1)

2 What are avoidable costs?

(Section 1.2)

3 Define differential and opportunity costs.

(Section 1.3)

4 What is a sunk cost?

(Section 1.5)

5 What is deprival value?

(Section 1.9)

6 A limiting factor is anything which limits the activity of an entity. What are the
possible limiting factors for an organisation?

(Section 2.1)

CHAPTER 2

There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.

42 | MANAGEMENT ACCOUNTING

1 RELEVANT COSTS
Section overview
Relevant costs are future cash flows arising as a direct consequence of a decision.
Decisions should be based on future incremental cash flows.

1.1 RELEVANT COSTS


Definition
LO
4.1

Relevant costs are future cash flows arising as a direct consequence of a decision and which are
therefore pertinent to the decision making process.

Decision making should be based on relevant costs. Relevant costs are:


a. Future costs. A decision is about the future and it cannot alter what has been done already. Costs
that have been incurred in the past are totally irrelevant to any decision that is being made 'now'.
Such costs are past costs or sunk costs.
Costs that have been incurred include not only costs that have already been paid, but also costs
that have been committed. A committed cost is a future cash outflow that will be incurred
regardless of future decisions.
LO
2.5

b. Cash flows. Only cash flow information is required. This means that costs or charges which do not
reflect additional cash spending, such as depreciation or arbitrarily apportioned costs, should be
ignored for the purpose of decision-making.
c. Incremental costs. Incremental costs are additional costs incurred due to particular decision or
alternative course of action. For example, an employee is expected to have no work to do next
week, but will continue to be paid the basic wage, of $100 per week for attending. A manager
wants to decide whether to give the employee a job which earns the organisation $40 revenue. The
$100 is irrelevant to the decision because although it is a future cash flow, it will be incurred anyway
whether the employee is given work or not. Therefore the job would generate a net gain of $40
and should be given to the employee.

1.2 AVOIDABLE COSTS


Definition
Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist.

One situation in which it is necessary to identify avoidable costs, is in deciding whether to discontinue
a product. The only costs which would be saved are the avoidable costs which are usually the
variable costs and some specific costs. Costs which would be incurred whether or not the product is
discontinued are known as unavoidable costs.

1.3 DIFFERENTIAL COSTS AND OPPORTUNITY COSTS


Relevant costs also include differential costs and opportunity costs:
Differential cost is the difference in total cost between alternatives.
An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in
preference to an alternative.
For example, if decision option A costs $300 and decision option B costs $360, the differential cost is
$60.

DECISION MAKING AND RELEVANT COSTING | 43

Worked Example: Differential costs and opportunity costs


Assume for example, that there are three options, A, B and C, only one of which can be chosen. The
net profit from each would be $80, $100 and $70 respectively.
Since only one option can be selected, option B would be chosen because it offers the biggest
benefit.
Profit from option B
Less opportunity cost (i.e. the benefit from the next most profitable alternative, A)
Differential benefit of option B

$
100
80
20

The decision to choose option B would not be taken simply because it offers a profit of $100, but
because it offers a differential profit of $20 in excess of the next best alternative.

Controllable costs are items of expenditure which can be directly influenced by a given manager
within a given time span.
As a general rule, committed fixed costs such as rental costs arising from the possession of plant,
equipment and building, are largely uncontrollable in the short term because they have been
committed by long term decisions.
Discretionary fixed costs, for example, advertising and research and development costs can be
thought of as being controllable because they are incurred as a result of decisions made by
management and can be increased or decreased at fairly short notice.

1.5 SUNK COSTS


Definition
A sunk cost is a past cost which is not directly relevant in decision making.

The principle underlying decision making is that management decisions can only affect the future. In
decision making, managers therefore require information about future costs and revenues which
would be affected by the decision under review. Managers must consider decisions in light of future
costs and avoid incorporating sunk costs when comparing alternatives.
Sunk costs are irrelevant to decision-making because the expenditure has already been incurred.
Worked Example: Sunk costs
An example of a sunk cost is development costs which have already been incurred. Suppose that a
company has spent $250 000 in developing a new service for customers, but the marketing
department's most recent findings are that the service might not gain customer acceptance and could
be a commercial failure. The company needs to decide whether to abandon the development of the
new service, but the $250 000 spent so far should be ignored by the decision makers because it is a
sunk cost.

1.6 FIXED AND VARIABLE COSTS


Unless you are given an indication to the contrary, in general you should assume the following:
Variable costs, which are costs that are constant per unit but can change as production or service
volume changes, will be relevant costs.
Existing Fixed costs, which are costs that are constant but decrease per unit output as activity
increases, will be incurred in any event, regardless of the decision, so are non-relevant.

CHAPTER 2

1.4 CONTROLLABLE AND UNCONTROLLABLE COSTS

44 | MANAGEMENT ACCOUNTING

This is not always the case, however, and you should analyse variable and fixed cost data carefully. Do
not forget that 'fixed' costs may only be fixed in the short term.

1.6.1 NON-RELEVANT VARIABLE COSTS


There might be occasions when a variable cost is in fact a sunk cost and therefore a non-relevant
variable cost. For example, suppose that a company has some units of raw material in inventory. They
have been paid for already, and originally cost $2 000. They are now obsolete and are no longer used
in regular production, and they have no scrap value. However, they could be used in a special job
which the company is trying to decide whether to undertake. The special job is a 'one-off' customer
order, and would use up all these materials in inventory.
a. In deciding whether the job should be undertaken, the relevant cost of the materials to the special
job is nil. Their original cost of $2 000 is a sunk cost, and should be ignored in the decision.
b. However, if the materials did have a scrap value of, say, $300, then their relevant cost to the job
would be the opportunity cost of being unable to sell them for scrap, i.e. $300.

1.6.2 ATTRIBUTABLE FIXED COSTS


There might be occasions when a fixed cost is a relevant cost, and you must be aware of the
distinction between specific or directly attributable fixed costs, and general fixed overheads.
Directly attributable fixed costs are those costs which, although fixed within a relevant range of
activity levels are relevant to a decision for either of the following reasons:
a. They could increase if certain extra activities were undertaken. For example, it may be necessary to
employ an extra supervisor if a particular order is accepted. The extra salary would be an
attributable fixed cost.
b. They would decrease or be eliminated entirely if a decision were taken either to reduce the scale of
operations or shut down entirely.
General fixed overheads are those fixed overheads which will be unaffected by decisions to increase
or decrease the scale of operations. Unless there is an incremental element, general fixed overheads
are not a relevant cost.

1.6.3 ABSORBED OVERHEAD


Absorbed overhead is a notional accounting cost and hence should be ignored for decision-making
purposes. Only incremental overheads arising as a result of the decision are relevant.

1.7 THE RELEVANT COST OF MATERIALS


If additional materials need to be acquired for a job/contract, the relevant cost of the materials is their
current purchase price.
If the raw materials required are already in inventory then the relevant cost is generally their current
replacement cost, unless the materials would not be replaced once used. In this case the relevant
cost of using them is the higher of the following:
Their current resale value and
The value they would obtain if they were put to an alternative use.
If the materials have no resale value and no other possible use, then the relevant cost of using them
for the opportunity under consideration would be nil.

DECISION MAKING AND RELEVANT COSTING | 45

Question 1: Relevant cost of materials I


O'Reilly has been approached by a customer who would like a special job to be done for him, and
who is willing to pay $22 000 for it. The job would require the following materials:
Material

Total units
required

A
B
C
D

1 000
1 000
1 000
200

Units already
in inventory
0
600
700
200

Book value of
units in inventory
$/unit

2
3
4

Realisable
value
$/unit

2.50
2.50
6.00

Replacement
cost
$/unit
6
5
4
9

Materials C and D are in inventory as the result of previous excessive-buying, and they have a
restricted use.
No other use could be found for material C. The units of material D could be used in another job as
substitute for 300 units of material E, which currently costs $5 per unit (of which the company has no
units in inventory at the moment).
Calculate the relevant costs of material for deciding whether or not to accept the contract.
(The answer is at the end of the chapter)

Question 2: Relevant cost of materials II


A company regularly uses a material. It currently has 100kg in inventory for which it paid $200. If it were
sold it could be sold for $3 per kg. The market price is now $4 per kg. A customer has placed an order
that will use 200kg of the material. The relevant cost of the 200 kgs is
A $500.
B $600.
C $700.
D $800.
(The answer is at the end of the chapter)

1.8 THE RELEVANT COST OF LABOUR


The relevant cost of labour, in different situations, is best explained by means of an example.
Worked Example: Relevant cost of labour
LW is currently deciding whether to undertake a new contract. 15 hours of labour will be required for
the contract. LW currently produces product L, the standard cost details of which are shown below:
STANDARD COST
PRODUCT L
Direct materials (10kg @ $2)
Direct labour (5 hrs @ $6)
Selling price
Contribution

$/unit
20
30
50
72
22

a. What is the relevant cost of labour if the labour must be hired from outside the organisation?
b. What is the relevant cost of labour if LW expects to have five hours' spare capacity?
c. What is the relevant cost of labour if labour is in short supply?

CHAPTER 2

Material B is used regularly by O'Reilly, and if units of B are required for this job, they would need to
be replaced to meet other production demand.

46 | MANAGEMENT ACCOUNTING

Solution
a. Where labour must be hired from outside the organisation, the relevant cost of labour will be the
variable costs incurred.
Relevant cost of labour on new contract = 15 hours @ $6 = $90
b. It is assumed that the five hours spare capacity will be paid anyway, and so if these five hours are
used on another contract, there is no additional cost to LW.
Relevant cost of labour on new contract
$
60
0
60

Direct labour (10 hours @ $6)


Spare capacity (5 hours @ $0)

c. Contribution earned per unit of product L produced = $22


If it requires five hours of labour to make one unit of product L, the contribution earned per labour
hour = $22/5 = $4.40
Relevant cost of labour on new contract
Direct labour (15 hours @ $6)
Contribution lost by not making product L ($4.40 15 hours)

$
90
66
156

It is important that you are able to identify the relevant costs which are appropriate to a decision.
Check your understanding by attempting the following question.
Question 3: Customer order
A company has been making a machine to order for a customer, but the customer has since gone into
liquidation, and there is no prospect that any money will be obtained from the winding up of the
company.
Costs incurred to date in manufacturing the machine are $50 000 and progress payments of $15 000
had been received from the customer prior to the liquidation.
The sales department has found another company willing to buy the machine for $34 000 once it has
been completed.
To complete the work, the following costs would be incurred:
a. Materials: these have been bought at a cost of $6 000. They have no other use, and if the machine
is not finished, they would be sold for scrap for $2 000.
b. Further labour costs would be $8 000. Labour is in short supply, and if the machine is not finished,
the work force would be switched to another job, which would earn $30 000 in revenue, and incur
direct costs of $12 000 and absorbed (fixed) overhead of $8 000.
c. Consultancy fees $4 000. If the work is not completed, the consultant's contract would be cancelled
at a cost of $1 500.
d. General overheads of $8 000 would be added to the cost of the additional work.
Assess whether the new customer's offer should be accepted.
(The answer is at the end of the chapter)

1.9 THE RELEVANT COST OF AN ASSET


The relevant cost of an asset represents the amount of money that a company would have to receive if
it were deprived of the asset in order to be no worse off than it already is. We can call this the deprival
value.
The deprival value of an asset is best demonstrated by means of an example.

DECISION MAKING AND RELEVANT COSTING | 47

Worked Example: Deprival value of an asset


A machine cost $14 000 ten years ago. The machine is expected to generate future revenues of $10
000. Alternatively, the machine could be scrapped for $8 000. An equivalent machine in the same
condition would cost $9 000 to buy now.
What is the deprival value of the machine?
Solution
First, let us think about the relevance of the costs given to us in the question.
Cost of machine = $14 000 = past/sunk cost
Future revenues = $10 000 = revenue expected to be generated
Net realisable value (NRV) = $8 000 = scrap proceeds
Replacement cost = $9 000
When calculating the deprival value of an asset, use the following diagram.

REPLACEMENT
COST
($9 000)

CHAPTER 2

LOWER OF

HIGHER OF
($10 000)

NRV
($8 000)

REVENUES
EXPECTED
($10 000)

Therefore, the deprival value of the machine is the lower of the $9 000 replacement cost and the $10
000 future revenues. The deprival value is therefore $9 000.

2 CHOICE OF PRODUCT (PRODUCT MIX)


DECISIONS

LO
2.2

Section overview
A limiting factor is any factor which limits the organisation's activities. In a limiting factor
situation, contribution will be maximised by earning the biggest possible contribution per
unit of limiting factor.

2.1 THE LIMITING FACTOR


A limiting factor is anything which limits the activity of the entity. This could be the level of demand for
its product or it could be one or more scarce resources which limit production to below the level of
demand.
Possible limiting factors are:
a. Sales. There may be a limit to sales demand.
b. Labour. There may be a limit to total quantity of labour available or to labour having particular
skills.
c. Materials. There may be insufficient available materials to produce enough units to satisfy sales
demand.
d. Manufacturing capacity. There may not be sufficient machine capacity for the production required
to meet sales demand.

48 | MANAGEMENT ACCOUNTING

One of the more common decision-making problems is a situation where there are not enough
resources to meet the potential sales demand. A decision has to be made about what mix of products
to produce, to ensure the available resources are used as efficiently as possible.
It is assumed in limiting factor decision making that management wishes to maximise profit and that
profit will be maximised when total contribution is maximised and that there is no change in fixed cost
expenditure incurred. Contribution is equal to sales revenue less variable costs.
Contribution will be maximised by earning the biggest possible contribution from each unit of
limiting factor. For example, if grade A labour is the limiting factor, contribution will be maximised by
earning the biggest contribution from each hour of grade A labour worked.
The limiting factor decision therefore involves the determination of the contribution earned by
each different product from each unit of the limiting factor.
Worked Example: Profit-maximising production mix
Colour makes two products, the Red and the Blue. Unit variable costs are as follows:
Red
$
1
6
1
8

Direct materials
Direct labour ($3 per hour)
Variable overhead

Blue
$
3
3
1
7

The sales price per unit is $14 per Red and $11 per Blue. During July 20X2 the available direct labour is
limited to 8 000 hours. Sales demand in July is expected to be 3 000 units for Reds and 5 000 units for
Blues.
Determine the profit-maximising production mix, assuming that monthly fixed costs are $20 000, and
that opening inventories of finished goods and work in progress are nil.
Solution

Step 1

Confirm that the limiting factor is something other than sales demand.
Labour hours per unit
Sales demand
Labour hours needed
Labour hours available
Shortfall

Reds
2 hrs
3 000 units
6 000 hrs

Blues
1 hr
5 000 units
5 000 hrs

Total

11 000 hrs
8 000 hrs
3 000 hrs

Labour is the limiting factor on production.

Step 2

Identify the contribution earned by each product per unit of limiting factor, that is per
labour hour worked.

Sales price
Variable cost
Unit contribution
Labour hours per unit
Contribution per labour hour (= unit of limiting factor)

Reds
$
14
8
6
2 hrs
$3

Blues
$
11
7
4
1 hr
$4

Although Reds have a higher unit contribution than Blues ($8 versus $7), two Blues can be
made in the time it takes to make one Red. Because labour is in short supply it is more
profitable to make Blues than Reds.

DECISION MAKING AND RELEVANT COSTING | 49

Determine the optimum production plan. Sufficient Blues will be made to meet the full
sales demand, and the remaining labour hours available will then be used to make Reds.
(a)

Hours
required
5 000
6 000
11 000

Sales
Demand
5 000
3 000

Product
Blues
Reds

Hours
available
5 000
3 000(bal)
8 000

Hours
Needed

(b)
Product

Units

Blues
Reds

5 000
1 500

Contribution
per unit
$
4
6

5 000
3 000
8 000

Less fixed costs


Profit

Priority of
manufacture
1st
2nd

Total
$
20 000
9 000
29 000
20 000
9 000

In conclusion:
a. Unit contribution is not the correct way to decide priorities.
b. Labour hours are the scarce resource, and therefore contribution per labour hour is the correct
way to decide priorities.
c. The Blue earns $4 contribution per labour hour, and the Red earns $3 contribution per labour hour.
Blues therefore make more profitable use of the scarce resource, and should be manufactured first.

Question 4: Limiting factor 1


The following details relate to three products made by DSF Co:
V
$ per unit
120
30
20
10
20
80

Selling price
Direct materials
Direct labour
Variable overhead
Fixed overhead
Profit

40

A
$ per unit
170
40
30
16
32
118
52

L
$ per unit
176
60
20
20
40
140
36

All three products use the same direct labour and direct materials, but in different quantities.
In a period when the direct labour used on these products is in short supply, the most profitable and
least profitable use of the direct labour is:
A
B
C
D

Most profitable
L
L
V
A

Least profitable
V
A
A
L

(The answer is at the end of the chapter)

CHAPTER 2

Step 3

50 | MANAGEMENT ACCOUNTING

Question 5: Limiting factor 2


Jam Co makes two products, the K and the L. The K sells for $50 per unit, the L for $70 per unit. The
variable cost per unit of the K is $35, that of the L $40. Each unit of K uses 2 kg of raw material. Each
unit of L uses 3 kg of raw material.
In the forthcoming period the availability of raw material is limited to 2,000 kg. Jam Co is contracted to
supply 500 units of K. Maximum demand for the L is 250 units. Demand for the K is unlimited.
What is the profit-maximising product mix?
A
B
C
D

K
250 units
625 units
750 units
1 250 units

L
625 units
250 units
1 250 units
750 units

(The answer is at the end of the chapter)

3 MAKE OR BUY DECISIONS

LO
2.2

3.1 INTRODUCTION
Section overview

A make or buy problem involves a decision by an organisation about whether to make a


product with its own internal resources, or to pay another organisation to make the
product.

In deciding whether to make internally or buy externally, and assuming no scarce resources,
the relevant costs for the decision will be the differential costs between the two options.
One example of a make or buy decision is whether a company should manufacture its own
components, or buy the components in from an outside supplier.
The 'make' option should give management more direct control over the work, but the 'buy' option
often has the benefit that the external organisation has a specialist skill and expertise in the work.
Make or buy decisions should not be based exclusively on cost considerations. The following should
also be considered:
a. How can spare capacity freed up by the 'buy' option be used most profitably?
b. Could the decision to use an outside supplier cause an industrial dispute?
c. Would the subcontractor be reliable with delivery times and product quality?
d. Does the company wish to be flexible and maintain better control over operations by making
everything itself?
Where the organisation has a choice about whether to make internally or buy externally, and scarce
resources are not a factor, the relevant cost is the differential cost between sourcing internally and
sourcing externally.
The organisation will need to consider differences in both variable and fixed costs. For example the
variable cost per unit of buying externally may be higher than the variable cost of making in-house,
but the use of an outside supplier may give rise to savings in directly attributable fixed costs. As a
result, if only a small number of units are required, it may be cheaper overall for an organisation to buy
externally, because the saving in fixed costs may outweigh the additional variable costs incurred.

DECISION MAKING AND RELEVANT COSTING | 51

Worked Example: Make or buy


An organisation makes four components, W, X, Y and Z, for which costs in the forthcoming year are
expected to be as follows:
Production (units)
Unit marginal costs
Direct materials
Direct labour
Variable production overheads

W
1 000
$
4
8
2
14

X
2 000
$
5
9
3
17

Y
4 000
$
2
4
1
7

Z
3 000
$
4
6
2
12

Directly attributable fixed costs per annum and committed fixed costs are as follows:

CHAPTER 2

$
1 000
5 000
6 000
8 000
30 000
50 000

Incurred as a direct consequence of making W


Incurred as a direct consequence of making X
Incurred as a direct consequence of making Y
Incurred as a direct consequence of making Z
Other fixed costs (committed)

A subcontractor can supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively.
Decide whether the organisation should make or buy the components.
Solution
a. The relevant costs are the differential costs between making and buying. They consist of
differences in unit variable costs plus differences in directly attributable fixed costs. Buying will
result in some fixed cost savings.

Unit variable cost of making


Unit variable cost of buying
Annual requirements (units)
Extra variable cost of buying (per annum)
Fixed costs saved by buying
Extra total cost of buying

W
$
14
12
$(2)

X
$
17
21
$4

Y
$
7
10
$3

1 000
(2 000)
1 000
(3 000)

2 000
8 000
5 000
3 000

4 000
12 000
6 000
6 000

Z
$
12
14
$2
3 000
6 000
8 000
(2 000)

b. The company would save $3 000 pa by buying component W, where the purchase cost would be
less than the marginal cost per unit to make internally. It would save $2 000 pa by subcontracting
component Z. This is because of the saving in fixed costs of $8 000.
c. Important further considerations would be as follows:
i. If components W and Z are subcontracted, the company will have spare capacity. How should
that spare capacity be profitably used? Are there hidden benefits to be obtained from
buying? Would the company's workforce resent the loss of work to an outside supplier, and
might such a decision cause an industrial dispute?
ii. Would the supplier be reliable with delivery times, and would they supply components of the
same quality as those manufactured internally?
iii. Does the company wish to be flexible and maintain better control over operations by making
everything itself?
iv. Are the estimates of fixed cost savings reliable? In the case of product W, buying is clearly
cheaper than making in-house. In the case of product Z, the decision to buy rather than make
would only be financially beneficial if the fixed cost savings of $8,000 could really be 'delivered'
by management.

52 | MANAGEMENT ACCOUNTING

4 OUTSOURCING
LO
2.2

Section overview
An organisation's value chain refers to the sequence of activities by which inputs are
converted into outputs and includes its supply chain and distribution network.

An organisation should concentrate on retaining those core activities that enhance its
competitive advantage and should consider outsourcing all other activities where it cannot
achieve benchmarked levels of performance.

To minimise the risks associated with outsourcing, organisations generally build close longterm partnerships or alliances with a few key suppliers.

4.1 INTRODUCTION
A significant trend in recent years has been for organisations and government bodies to concentrate
on their core competences, what they are really good at, and turn other activities over to specialist
contractors. Facilities management companies have grown in response to this. An organisation that
earns its profits from manufacturing bicycles does not also need to have expertise in mass catering or
office cleaning.
Definition
Outsourcing is the use of external suppliers as a source of finished products, components or services.
This is also known as contract manufacturing or sub-contracting.

4.2 REASONS FOR THIS TREND


a. Frequently an outsourcing decision is made on the grounds that specialist contractors can offer
superior quality and efficiency. If a contractor's main business is making a specific component, it
can invest in the specialist machinery and labour and knowledge skills needed to make that
component. However, this component may be only one of many needed by the contractor's
customer, and the complexity of components is now such that attempting to keep internal facilities
up to the standard of specialists detracts from the main business of the customer. For example,
Dell Computers buys the Pentium chip for its personal computers from Intel because it does not
have the know-how and technology to make the chip itself.
b. Contracting out manufacturing frees capital and management time that can then be invested in
core activities such as market research, product definition, product planning, marketing and sales.
c. Contractors generally have the capacity and flexibility to start production very quickly to meet
sudden variations in demand. In-house facilities may not be able to respond as quickly, because
of the need to redirect resources from elsewhere.

4.3 INTERNAL AND EXTERNAL SERVICES


In administrative and support functions, too, organisations are increasingly likely to use specialist
companies. Decisions such as the following are now common.
a. Whether the design and development of a new computer system should be entrusted to inhouse data processing staff or whether an external software house should be hired to do the work.
b. Whether maintenance and repairs of certain items of equipment should be dealt with by in-house
engineers, or whether a maintenance contract should be entered into with a specialist
organisation.
A familiar example is office cleaning being done by contractors.

DECISION MAKING AND RELEVANT COSTING | 53

4.4 CHOOSING THE ACTIVITIES TO OUTSOURCE


In deciding whether to outsource an activity, an organisation must consider whether:

Within the value chain, both primary activities and support activities are candidates for outsourcing,
although many can be eliminated from the list immediately either because the activity cannot be
contracted out or because the organisation must control it to maintain its competitive position. For
instance, Coca Cola does not outsource the manufacture of its concentrate to safeguard its formula
and retain control of the product.
Of the remaining activities, an organisation should carry out only those that it can deliver on a
level comparable with the best organisations in the world. If the organisation cannot achieve
benchmarked levels of performance, the activity should be outsourced so that the organisation is only
concentrating on those core activities that enhance its competitive advantage.

4.5 ADVANTAGES AND DISADVANTAGES


The advantages of outsourcing are as follows:
a. It frees up time of existing staff on the contracted-out activities. It also frees up time spent
supporting the contracted-out services by staff not directly involved, for example, supervisory staff,
personnel staff.
b. It allows the company to take advantage of specialist expertise and equipment rather than
investing in these facilities itself and underutilising them.
c. It may be cheaper, once time savings and opportunity costs are taken into account.
d. It is particularly appropriate when an organisation is attempting to expand in a time of uncertainty
as it is a way of gaining all the benefits of extra capacity without having to fund the full cost.
However there are also a number of disadvantages:
a. Without monitoring there is no guarantee that the service will be performed to the organisation's
satisfaction.
b. There is a chance that contracting out will be more expensive than providing the service in-house.
c. By performing services itself the organisation retains or develops skills that may be needed in the
future and will otherwise be lost.
d. Contracting out any aspect of information-handling carries with it the risk that commercially
sensitive data will get into the wrong hands.
e. There may be some ethical considerations, such as exploitation of staff and inadequate pay and
working conditions.
f. There will almost certainly be opposition from employees and their representatives if contracting
out involves redundancies.
To minimise the risks associated with outsourcing, organisations generally enter into long-run
contracts with their suppliers that specify costs, quality and delivery schedules. They build close
partnerships or alliances with a few key suppliers, collaborating with suppliers on design and
manufacturing decisions, and building a culture and commitment for quality and timely delivery.

CHAPTER 2

retaining control of the activity is vital to maintain its competitive position and
the activity can be delivered internally on a level comparable with the best organisations in the
world.
An organisation's value chain refers to the sequence of activities by which inputs are converted into
outputs and includes its supply chain and distribution network. The concept of a value chain was
suggested by Michael Porter (1985) to demonstrate how value for the customer is added to the
products or services produced by an organisation. The chain consists of primary activities (such as
inbound logistics, operations, outbound logistics, marketing and service) and secondary activities
(such as infrastructure, human resources, technology and procurement).

54 | MANAGEMENT ACCOUNTING

Case study
Albright and Davis ('The Elements of Supply Chain Management') describe the extreme outsourcing
approach adopted by Mercedes.
Instead of contracting with suppliers for parts, Mercedes outsourced the modules making up a
completed M-class to suppliers who purchase the subcomponents and assemble the modules for
Mercedes.
This has led to a reduction in plant and warehouse space needed, and a dramatic reduction in the
number of suppliers used (from 35 to one for the cockpit, for example).
At the beginning of the production process Mercedes maintained strict control in terms of quality and
cost on both the first tier suppliers, who provide finished modules, and the second tier suppliers, from
whom the first tier suppliers purchase parts. As the level of trust grew between Mercedes and the first
tier suppliers, Mercedes allowed them to make their own arrangements with second tier suppliers.
Benefits of this approach for Mercedes
i. Reduction in purchasing overhead.
ii. Reduction in labour and employee-related costs.
iii. Higher level of service from suppliers.
iv. Supplier expertise in seeking ways to improve current operations.
v. Suppliers working together to continuously improve both their own module and the integrated
product.

DECISION MAKING AND RELEVANT COSTING | 55

KEY CHAPTER POINTS


Relevant costs are future cash flows arising as a direct consequence of a decision.
Decisions should be based on future, incremental cashflows.
Relevant costs also include differential costs and opportunity costs:
Differential cost is the difference in total cost between alternatives.
An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in
preference to an alternative.
A sunk cost is a past cost which is not directly relevant in decision making.
In general, variable costs will be relevant costs and fixed costs will be irrelevant to a decision.

A limiting factor is any factor which limits the organisation's activities. In a limiting factor situation,
contribution will be maximised by earning the biggest possible contribution per unit of limiting
factor.
In deciding whether to make internally or buy externally, and assuming no scarce resources, the
relevant costs for the decision will be the differential costs between the two options.
An organisation's value chain refers to the sequence of activities by which inputs are converted into
outputs and includes its supply chain and distribution network.
An organisation should concentrate on retaining those core activities that enhance its competitive
advantage and should consider outsourcing all other activities where it cannot achieve
benchmarked levels of performance.
To minimise the risks associated with outsourcing, organisations generally build close long-term
partnerships or alliances with a few key suppliers.

CHAPTER 2

The relevant cost of an asset represents the amount of money that a company would have to
receive if it were deprived of an asset in order to be no worse off than it already is. We can call this
the deprival value.

56 | MANAGEMENT ACCOUNTING

QUICK REVISION QUESTIONS


1 You are currently employed as a management accountant in an insurance company, but you are
contemplating starting your own business. In considering whether or not to take this action your
current salary level would be
A a sunk cost.
B an irrelevant cost.
C an incremental cost.
D an opportunity cost.
2 Your company regularly uses material X and currently has in inventory 500 kgs for which it paid
$1 500 two weeks ago. If this were to be sold as raw material, it could be sold today for $2.00 per
kg. You are aware that the material can be bought on the open market for $3.25 per kg, but it must
be purchased in quantities of 1,000 kgs.
You have been asked to determine the relevant cost of 600 kgs of material X to be used in a job for
a customer. The relevant cost of the 600 kgs is
A
B
C
D

$1 325
$1 825
$1 950
$3 250

3 A company is considering its option with regard to a machine which cost $60 000 four years ago.
If sold, the machine would generate scrap proceeds of $75 000. If kept, this machine would
generate net income of $90 000.
The current replacement cost for this machine is $105 000.
What is the relevant cost of the machine?
A
B
C
D

$60 000
$75 000
$90 000
$105 000

4 A company manufactures and sells two products (X and Y) both of which utilise the same skilled
labour. For the coming period, the supply of skilled labour is limited to 2,000 hours. Data relating
to each product are as follows:
Product
Selling price per unit
Variable cost per unit
Skilled labour hours per unit
Maximum demand (units) per period

X
$20
$12
2
800

Y
$40
$30
4
400

In order to maximise profit in the coming period, how many units of each product should the
company manufacture and sell?
A
B
C
D

200 units of X and 400 units of Y


400 units of X and 300 units of Y
600 units of X and 200 units of Y
800 units of X and 100 units of Y

5 In the short-term decision-making context, which one of the following would be a relevant cost?
A Specific development costs already incurred
B The cost of special material which will be purchased
C The cost of a report that has been carried out but not yet paid for
D The original cost of raw materials currently in inventory which will be used on the project

DECISION MAKING AND RELEVANT COSTING | 57

6 A company manufactures and sells a single product. The variable cost of the product is $2.50 per
unit and all production each month is sold at a price of $3.70 per unit. A potential new customer
has offered to buy 6,000 units per month at a price of $2.95 per unit. The company has sufficient
spare capacity to produce this quantity. If the new business is accepted, sales to existing customers
are expected to fall by two units for every 15 units sold to the new customer.
What would be the overall increase in monthly profit which would result from accepting the new
business?
A
B
C
D

$1 740
$2 220
$2 340
$2 700

7 A company is evaluating a project that requires two types of material (T and V). Data relating to the
material requirements are as follows:

T
V

Quantity
needed for
project
kg
500
400

Quantity
currently in
inventory
kg
100
200

Original cost
of quantity in
inventory
$/kg
40
55

Current
purchase
price
$/kg
45
52

Current
resale price
$/kg
44
40

Material T is regularly used by the company in normal production. Material V is no longer in use by
the company and has no alternative use within the business.
What is the total relevant cost of materials for the project?
A
B
C
D

$40 400
$40 900
$43 400
$43 900

8 A machine owned by a company has been idle for some months but could now be used on a one
year contract which is under consideration. The net book value of the machine is $1 000. If not used
on this contract, the machine could be sold now for a net amount of $1 200. After use on the
contract, the machine would have no saleable value and the cost of disposing of it in one year's
time would be $800.
What is the total relevant cost of the machine to the contract?
A
B
C
D

$400
$800
$1 200
$2 000

9 A company has just secured a new contract which requires 500 hours of labour.
There are 400 hours of spare labour capacity. The remaining hours could be worked as overtime at
time and a half or labour could be diverted from the production of product X. Product X currently
earns a contribution of $4 in two labour hours and direct labour is currently paid at a rate of $12 per
normal hour.
What is the relevant cost of labour for the contract?
A
B
C
D

$200
$1 200
$1 400
$1 800

CHAPTER 2

Material type

58 | MANAGEMENT ACCOUNTING

10 A company uses limiting factor analysis to calculate an optimal production plan given a scarce
resource.
The following applies to the three products of the company:
Product
Direct materials (at $6/kg)
Direct labour (at $10/hour)
Variable overheads ($2/hour)
Maximum demand (units)
Optimal production plan

I
$
36
40
8
84

II
$
24
25
5
54

III
$
15
10
2
27

2 000
2 000

4 000
1 500

4 000
4 000

How many kg of material were available for use in production?


A
B
C
D

15 750 kg
28 000 kg
30 000 kg
38 000 kg

DECISION MAKING AND RELEVANT COSTING | 59

ANSWERS TO QUICK REVISION QUESTIONS


1 D An opportunity cost is the value of the benefit sacrificed when one course of action is chosen, in
preference to another.
A sunk cost (option A) is a past cost which is not relevant to the decision.
An incremental cost (option C) is an extra cost to be incurred in the future as the result of a
decision taken now.
The salary cost forgone is certainly relevant to the decision therefore option B is not correct.

Option B values the inventory items at their original purchase price, but this is a sunk or past
cost.
Option D is the cost of the 1 000 kgs that must be purchased, but since the material is in
regular use the excess can be kept in inventory until needed.
3 C When calculating the relevant cost of an asset, use the following diagram.
LOWER OF = $90 000

REPLACEMENT
COST
($105 000)

HIGHER OF
= ($90 000)

NRV
($75 000)

REVENUES
EXPECTED
($90 000)

4 D
Product

Selling price per unit


Variable cost per unit
Contribution per unit
Contribution per skilled labour hour required
Ranking

X
$
20
12
8
4
1st

Y
$
40
30
10
( 4)

2.5
2nd

Manufacture and sell: 800 units of Product X (using 800 2 hours = 1 600 hours); 100 units of
Product Y (using the remaining 400 hours* (2 000 1 600).
* 400 hours 4 hours skilled labour per unit = 100 units.
5 B The cost of special material which will be purchased is a relevant cost in a short-term decisionmaking context.

CHAPTER 2

2 C The material is in regular use and so 1,000 kgs will be purchased. 500 kgs of this will replace the
500 kg in inventory that is used, 100 kgs will be purchased and used and the remaining 400 kgs
will be kept in inventory until needed. The relevant cost is therefore 600 $3.25 = $1,950.
If you selected option A you valued the inventory items at their resale price. However, the items
are in regular use therefore they would not be resold.

60 | MANAGEMENT ACCOUNTING

6 A
$
1.20
0.45
$
2 700
(960)
1 740

Contribution per unit current $(3.70 2.50)


Contribution per unit revised $(2.95 2.50)
Total contribution new business (6 000 $0.45)
Lost contribution current business (6 000/15 2 $1.20)
Increase in monthly profit

7 B Total relevant cost of materials


$
Material T
500kg $45
Material V
200kg $40
200kg $52
Total relevant cost of materials

22 500
8 000
10 400
40 900

8 D
$
1 200
800
2 000

Opportunity cost (net realisable value)


Cost of disposal in one year's time
Total relevant cost of machine

9 C
500
400
100

Hours are required


Hours are available as spare labour capacity
Hours are required but not available as spare capacity

1 If the 100 hours are from worked overtime, then the cost
= 100 hours 1.5 $12 = $1 800
2 If labour is diverted from the production of Product X, then the cost
= 100 hours $12 + (100/2 $4)
= $1 200 + $200
= $1 400
Option 2 is cheaper and therefore the relevant cost of labour for the contract is $1 400.
10 B
Optimal production plan (units)
Kgs required per unit
Kgs material available

I
2 000
6
12 000

II
1 500
4
6 000

III
4 000
2.5
10 000

Total

28 000

DECISION MAKING AND RELEVANT COSTING | 61

ANSWERS TO CHAPTER QUESTIONS


1 Material A is not yet owned. It would have to be bought in full at the replacement cost of $6 per
unit.
Material B is used regularly by the company. There are existing inventories (600 units) but if these
are used on the contract under review a further 600 units would be bought to replace them.
Relevant costs are therefore 1 000 units at the replacement cost of $5 per unit.

The required units of material D are already in inventory and will not be replaced. There is an
opportunity cost of using D in the contract because there are alternative opportunities either to sell
the existing inventories for $6 per unit ($1 200 in total) or avoid other purchases (of material E),
which would cost 300 $5 = $1 500. Since substitution for E is more beneficial, $1 500 is the
opportunity cost.
Summary of relevant costs
Material A (1 000 $6)

$
6 000

Material B (1 000 $5)

5 000

Material C (300 $4) plus (700 $2.50)


Material D
Total

2 950
1 500
15 450

2 D The material is in regular use and so 200 kg will be purchased. The relevant cost is therefore
200 $4 = $800.
3 Costs incurred in the past, or revenue received in the past, are not relevant because they cannot
affect a decision about what is best for the future. Costs incurred to date of $50 000 and revenue
received of $15 000 are not relevant and should be ignored.
Similarly, the price paid in the past for the materials is irrelevant. The only relevant cost of
materials affecting the decision is the opportunity cost of the revenue from scrap which would be
forgone $2 000.
Labour costs
Labour costs required to complete work
Opportunity costs: contribution forgone by losing
other work $(30 000 12 000)
Relevant cost of labour

$
8 000
18 000
26 000

The incremental cost of consultancy from completing the work is $2,500.


Cost of completing work
Cost of cancelling contract
Incremental cost of completing work

$
4 000
1 500
2 500

Absorbed overhead is a notional accounting cost and should be ignored. Actual overhead
incurred is the only overhead cost to consider. General overhead costs and the absorbed overhead
of the alternative work for the labour force should be ignored.

CHAPTER 2

1 000 units of material C are needed and 700 are already in inventory. If used for the contract, a
further 300 units must be bought at $4 each. The existing inventories of 700 will not be replaced. If
they are used for the contract, they could not be sold at $2.50 each. The realisable value of these
700 units is an opportunity cost of sales revenue forgone.

62 | MANAGEMENT ACCOUNTING

Relevant costs may be summarised as follows.


$
Revenue from completing work
Relevant costs
Materials: opportunity cost
Labour:
basic pay
opportunity cost
Incremental cost of consultant

$
34 000

2 000
8 000
18 000
2 500
30 500
3 500

Extra profit to be earned by accepting the order

4 B As direct labour is in short supply the contribution per $ of direct labour is used to rank the
products:

Selling price per unit


Variable cost per unit (materials, labour and variable
overhead)
Contribution per unit
Labour cost per unit
Contribution per $ of labour
Ranking

V
$
120

A
$
170

L
$
176

60
60
20
3

86
84
30
2.80

100
76
20
3.80

5 B
Contribution per unit
Contribution per unit of limiting factor
Ranking
Production plan
Contracted supply of K (500 2 kg)
Meet demand for L (250 3 kg)
Remainder of resource for K (125 2 kg)

K
$15
$15/2 = $7.50

L
$30
$30/3 = $10

1
Raw material used
kg
1 000
750
250
2 000

63

CHAPTER 3
BUDGETING
Learning objectives

Reference

Budgeting

LO3

Identify and analyse the human behavioural challenges to the budgeting process in
organisations

LO3.1

Explain the nature of budgets and the reasons that organisations use budgets

LO3.2

Prepare an operations budget

LO3.3

Prepare a cash budget

LO3.4

Cost Behaviour

LO4

Apply relevant techniques to separate costs into their fixed and variable components

LO4.2

Topic list

1
2
3
4
5
6
7
8
9
10

The purposes and benefits of a budget


Steps in the preparation of a budget
Preparing functional operating budgets
Cash budgets
Budgeted financial statements
Flexible budgets
Cost estimation
Incremental and zero-based budgeting systems
Budgeting, performance and motivation
Budgeting and quality

64 | MANAGEMENT ACCOUNTING

INTRODUCTION
This chapter begins by explaining the reasons why an organisation might prepare a budget and goes
on to detail the steps in the preparation of a budget. The method of preparing, and the relationship
between the various functional budgets is then set out.
The chapter also considers the construction of cash budgets and the budgeted statement of
comprehensive income and statement of financial position, which make up what is known as a master
budget. Two different budgeting systems are described: the more traditional incremental approach,
and a more recent development zero-based budgeting (ZBB). The first builds on the previous year's
budgets, while ZBB begins from scratch each time the budget is prepared.
Finally, we will look at the way in which budgets can affect the behaviour and performance of
employees, for better and for worse.
The chapter content is summarised in the diagram below.

Budgeting

Purposes and
benefits

Preparation

Flexible
budgets

Performance
and motivation

Functional
budgets

Cost
estimation

Budgeting
and quality

Cash
budgets

Statement of
comprehensive
income

Statement of
financial position

Incremental budgeting
and ZBB

BUDGETING | 65

BEFORE YOU BEGIN


If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What is a budget?

(Section 1)

2 What are the functions of the budget committee?

(Section 2.1)

3 Why is the principal budget factor important?

(Section 2.5)

5 Explain the difference between a fixed and a flexible budget.

(Section 6)

6 Explain the difference between incremental and zero-based budgeting systems.

(Section 8)

7 What are four types of performance standard?

(Section 9.2)

8 What are the advantages of participative budgets?

(Section 9.5)

9 What are the disadvantages of participative budgets?

(Section 9.5)

10 What is the aim of Total Quality Management (TQM)?

(Section 10.1)

11 Explain the link between TQM and budgeting

(Section 10.2)

CHAPTER 3

4 What is an appropriate management action when an organisation has a short-term surplus?


(Section 4.1)

66 | MANAGEMENT ACCOUNTING

1 THE PURPOSES AND BENEFITS OF A BUDGET


Section overview
The main purpose and benefit of using a budget is to assist with the achievement of the
organisation's objectives.

Definition
LO
3.2

A budget is a quantitative statement, for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows.

1.1 PURPOSES AND BENEFITS


The main purpose and benefit of using a budget is:
To assist with the achievement of the organisation's objectives
The organisation's objectives are quantified and drawn up as targets to be achieved within the
timescale of the budget.
Using a budget has seven further purposes/benefits, all of which contribute to the main purpose,
listed above:
To compel planning
Planning forces management to look ahead, to set out detailed plans for achieving targets for each
department, operation and (ideally) each manager. It should also help to anticipate problems.
To communicate ideas and plans
A formal system is necessary to ensure that each person involved is aware of what he or she is to
do. Communication may be one-way, where managers give instructions to staff, or there might be
a two-way dialogue where the staffs feedback their suggestions to management which may be
incorporated into the formal plan.
To co-ordinate activities
The activities of different departments need to be co-ordinated to ensure maximum integration of
effort towards common organisation goals. For example, the purchasing department should base
its budget on production requirements and the production budget should be based on sales
expectations.
To provide a framework for responsibility accounting
Budgets require that managers are made responsible for the achievement of budget targets for
the operations under their control.
To establish a system of control
Control over actual performance is provided by the comparisons of actual results against the
budget. Departures from budget can then be investigated and the reasons for the departures can
be found and acted on.
Motivate employees to improve their performance
The interest and commitment of employees can be retained if there is a system which lets them
know how well or badly they are performing. The identification of controllable reasons for
departures from budget with managers responsible provides an incentive for improving future
performance.

BUDGETING | 67

Allocation of resources
Allocation of scarce resources among competing uses.
The remainder of the chapter explain further how budgets are used to achieve these benefits. We will
begin by looking at the planning and control aspects of budgeting.

1.2 BUDGETS IN THE CONTEXT OF PLANNING AND CONTROL


Planning involves making choices between alternatives and is primarily a decision-making activity. The
control process involves measuring and correcting actual performance to ensure that the strategies
that are chosen and the plans for implementing them are carried out. The link between these two is
the budget.
The diagram below represents the planning and control cycle:

Planning
process

Control
process

Step 1

Identify objectives

Step 1

Identify alternative courses of action


(strategies) which might contribute
towards achieving the objectives

Step 2

Evaluate each strategy

Step 3

Choose alternative
courses of action

Step 4

Implement the long-term


plan in the form of
the annual budget

Step 5

Measure actual results


and compare with the plan

Step 6

Respond to
divergences from plan

Step 7

Identify objectives
Objectives establish the direction in which the management of the organisation wish it to
be heading. Typical objectives include the following:
To maximise profits.
To increase market share.
To produce a better quality product than anyone else.
Objectives answer the question: 'where do we want to be?'.

Step 2

Identify alternative courses of action


Once an organisation has decided 'where it wants to be', the next step is to identify a
range of possible courses of action or strategies that might enable the organisation to
get there.
The organisation must therefore carry out an information-gathering exercise to ensure
that it has a full understanding of where it is now. This is known as a position audit or
strategic analysis. It involves looking both inwards and outwards.
The organisation must gather information from all of its internal parts to find out what
resources it possesses: what its manufacturing capability is, what is the state of its
technical know-how, how well it is able to market itself, how much cash it has in the
bank, how much it could borrow, and any other relevant data available from its own
records.

CHAPTER 3

The planning and control cycle

68 | MANAGEMENT ACCOUNTING

It must also gather external information so that it can assess its position in the
environment. Just as it has assessed its own strengths and weaknesses, it must do
likewise for its competitors (threats). Its current market must be analysed. It must also
analyse any other markets that it is intending to enter, to identify possible new
opportunities. This process is known as SWOT analysis: Strengths, Weaknesses,
Opportunities and Threats. The state of the world economy must be considered. Is it
in recession or is it booming? What is likely to happen in the future and over what
timescale? This is known as assessing the business cycle.
Having carried out a strategic analysis, alternative strategies can be identified.

Step 3

Evaluate strategies
The strategies must then be evaluated in terms of suitability, feasibility and
acceptability in the context of the strategic analysis. Management should select those
strategies that have the greatest potential for achieving the organisation's objectives.
One strategy may be chosen or several.

Step 4

Choose alternative courses of action


The next step in the process is to collect the chosen strategies together and coordinate them into a long-term plan, commonly expressed in financial terms.
Typically a long-term financial plan would show the following (not in any particular order):

Step 5

Projected cash flows


Projected long-term profits
Capital expenditure plans
Statements of financial position forecasts
A description of the long-term objectives and strategies in words

Implement the long-term plan


The long-term plan should then be broken down into smaller parts. It is unlikely that
the different parts will fall conveniently into successive time periods. For example
Strategy A may take two and a half years, while strategy B may take five months, but not
start until year three of the plan. It is usual, however, to break down the plan as a whole
into equal time periods (usually one year). The resulting short-term plan is the budget.

Steps 6

Measure actual results and compare with plan. Respond to divergences from plan

and 7

At the end of the year actual results should be compared with those expected under the
long-term plan. The long-term plan should be reviewed in the light of this comparison
and the progress that has been made towards achieving the organisation's objectives
should be assessed. Management can also consider the feasibility of achieving the
objectives in the light of circumstances which have arisen during the year. If the plans are
now no longer attainable then alternative strategies must be considered for achieving the
organisation's objectives, as indicated by the feedback loop (the arrowed line) linking
step 7 to step 2. This aspect of control is carried out by senior management, normally on
an annual basis.
The control of day-to-day operations is exercised by lower-level managers. At frequent
intervals they must be provided with performance reports which consist of detailed
comparisons of actual results and budgeted results. Performance reports provide
feedback information by comparing planned and actual outcomes. Such reports should
highlight those activities that do not conform to plan, so that managers can devote their
scarce time to focusing on these items. Effective control requires that corrective action is
taken so that actual outcomes conform to planned outcomes, as indicated by the
feedback loop linking steps 5 and 7. Isolating past inefficiencies and the reasons for them
will enable managers to take action that will avoid the same inefficiencies being repeated
in the future. The system that provides reports that compare actual performance with
budget figures and holds managers responsible is known as responsibility accounting.
We will return to this topic below.

BUDGETING | 69

2 STEPS IN THE PREPARATION OF A BUDGET


Section overview
Ideally budget preparation begins towards the end of the strategy planning stage once
objectives and strategies have been decided upon. While the mechanics of budget
preparation is the focus of your immediate study, it is important to appreciate how
important budgets are in co-ordination and control.
It is not uncommon for the responsibility of administration and coordination of the budget
to sit with a Budget committee.
You will see how the activities of all aspects of the business are brought together in the budget.

2.1 BUDGET COMMITTEE


The co-ordination and administration of budgets may be the responsibility of a budget committee,
consisting of senior executives. The budget committee is assisted by a budget officer who is usually
an accountant. Every part of the organisation should be represented on the committee, so there
should be a representative from sales, production, marketing and so on. Functions of the budget
committee include the following:
Co-ordination and allocation of responsibility for the preparation of budgets
Issuing of the budget manual
Timetabling
Provision of information to assist in the preparation of budgets
Monitoring the budgeting and planning process by comparing actual and budgeted results

2.2 RESPONSIBILITY FOR BUDGETS


The responsibility for preparing the budgets should, ideally, lie with the managers who are
responsible for implementing them. For example, the preparation of particular budgets might be
allocated as follows:
The sales manager should draft the sales budget and the selling overhead cost centre budgets.
The purchasing manager should draft the material purchases budget.
The production manager should draft the direct production cost budgets.

2.3 THE BUDGET MANUAL


Definition
The budget manual is a collection of instructions on how to use the tools, systems and software
related to the budgeting process.

A budget manual may contain the following:


a. An explanation of the objectives of the budgetary process including the following:
The purpose of budgetary planning and control.
The objectives of the various stages of the budgetary process.
The importance of budgets in the long-term planning and administration of the organisation.
b. Organisational structures, including the following:
An organisation chart
A list of individuals holding budget responsibilities

CHAPTER 3

Communication of final budgets to the appropriate managers

70 | MANAGEMENT ACCOUNTING

c. An outline of the principal budgets and the relationship between them.


d. Administrative details of budget preparation such as the following:
Membership, and terms of reference of the budget committee
The sequence in which budgets are to be prepared
A timetable
e. Procedural matters such as the following:
Sample forms and instructions for their completion. (Note: many budgets are now prepared in
budget models, such as spreadsheet models).
Sample reports.
Account codes or a chart of accounts.
The name of the budget officer to whom enquiries must be directed.

2.4 STEPS IN BUDGET PREPARATION


The procedures for preparing a budget will differ from organisation to organisation but the steps
described below will be indicative of the steps followed by many organisations. The preparation of a
budget may take weeks or months and the budget committee may meet several times before the
master budget (budgeted statement of comprehensive income and budgeted statement of financial
position) is finally agreed.
Functional budgets (such as sales budgets, production budgets and direct labour budgets), which
are amalgamated into the master budget, may need to be amended many times as a consequence of
discussions between departments and changes in market conditions during the course of budget
preparation.

2.5 IDENTIFYING THE PRINCIPAL BUDGET FACTOR


Definition
The principal budget factor is the factor which limits the activities of an organisation.

The first task in the budgetary process is to identify the principal budget factor. This is also known as
the key budget factor or limiting budget factor.
The principal budget factor is usually sales demand. A company is usually restricted from making
and selling more of its products because there would be no sales demand for the increased output at
a price which would be acceptable/profitable to the company. The principal budget factor may also
be machine capacity, distribution and selling resources, the availability of key raw materials or the
availability of cash.
Once the principal budget factor is defined then the remainder of the budgets can be prepared. For
example, if sales are the principal budget factor then the production manager can only prepare the
production budget after the sales budget is complete.
A useful assumption for preparing the first draft of the functional budgets is to assume that sales
demand is the principal budget factor. If it then becomes apparent that a scarce resource is the
principal budget factor, the functional budgets can be revised and new drafts prepared.
The stages involved in the preparation of a budget with sales as the limiting factor can be summarised
as follows.
a. The sales budget (revenue budget) is prepared by calculating units of product (volume) multiplied
by sales price. The finished goods inventory budget can be prepared at the same time. This
budget decides the planned increase or decrease in finished goods inventory levels.
b. With the information from the sales and inventory budgets, the production budget can be
prepared. This is, in effect, the sales budget in units plus (or minus) the increase (or decrease) in
finished goods inventory. The production budget will be stated in terms of units.
c. This leads on to budgeting the resources for production. This involves preparing a materials
usage budget, machine usage budget and a labour budget.

BUDGETING | 71

d. In addition to the materials usage budget, a materials inventory budget will be prepared, to
decide the planned increase or decrease in the level of inventories held. Once the raw materials
usage requirements and the raw materials inventory budget are known, the purchasing department
can prepare a raw materials purchases budget in quantities and value for each type of material
purchased.
e. During the preparation of the sales and production budgets, the managers of the cost centres of
the organisation will prepare their draft budgets for the department overhead costs. (A cost
centre is any division, department, or subsidiary of a company that has expenses but is not directly
producing revenues). Such overheads will include maintenance, stores, administration, selling and
research and development.
f. From the above information a budgeted statement of comprehensive income can be produced.
g. In addition several other budgets must be prepared in order to arrive at the budgeted statement
of financial position. These are the capital expenditure budget (for non-current assets), the
working capital budget (for budgeted increases or decreases in the level of receivables and
payables as well as inventories), and a cash budget.

3 PREPARING FUNCTIONAL OPERATING BUDGETS


Section overview
A functional (or departmental) budget is a budget forecasting income and expenditure for
a particular department or process. It could be a production budget, a sales budget or
purchasing budget depending on the function and the nature of its activities.

LO
3.3

ECO Ltd manufactures two products, S and T, which use the same raw materials, D and E. One unit of
S uses 3 litres of D and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of E. A litre of
D is expected to cost $3 and a kilogram of E $7.
The sales budget for 20X2 comprises 8,000 units of S and 6,000 units of T; finished goods in stock at 1
January 20X2 are 1 500 units of S and 300 units of T, and the company plans to hold inventories of 600
units of each product at 31 December 20X2.
Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company
plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for damages
and deterioration of items held in store, as follows:
Product S:
Product T:
Material D:
Material E:

loss of 50 units
loss of 100 units
loss of 500 litres
loss of 200 kilograms

Prepare a material purchases budget for the year 20X2.

CHAPTER 3

Worked Example: Preparing a materials purchases budget

72 | MANAGEMENT ACCOUNTING

Solution
To calculate material purchases requirements first it is necessary to calculate the material usage
requirements. That in turn depends on calculating the budgeted production volumes.
Product S
Units
Production required
To meet sales demand
To provide for inventory loss
For closing inventory

Product T
Units

8 000
50
600
8 650
1 500
7 150

Less inventory already in hand


Budgeted production volume

6 000
100
600
6 700
300
6 400

Material D
Litres
Usage requirements
To produce 7 150 units of S
To produce 6 400 units of T
To provide for inventory loss
For closing inventory
Less inventory already in hand
Budgeted material purchases
Unit cost
Cost of material purchases
Total cost of material purchases

Material E
Kgs

21 450
32 000
500
5 000
58 950
6 000
52 950

28 600
12 800
200
3 500
45 100
2 800
42 300

$3

$7

$158 850

$296 100
$454 950

The basics of the preparation of each functional budget are similar to the above.

4 CASH BUDGETS
Section overview
The cash budget is one of the most important planning tools that an organisation can use.
It shows the cash effect of all plans made within the budgetary process.
Definition
A cash budget is a statement in which estimated future cash receipts and payments are tabulated
in such a way as to show the forecast cash balance of a business at defined intervals.

Worked Example: Cash position


LO
3.4

In December 20X2 an accounts department might wish to estimate the cash position of the business
for the following months, January to March 20X3. A cash budget might be drawn up in the following
format:

Estimated cash receipts


From credit customers
From cash sales
Proceeds on disposal of non-current assets
Total cash receipts

Jan
$

Feb
$

Mar
$

14 000
3 000

16 500
4 000
2 200
22 700

17 000
4 500

17 000

21 500

BUDGETING | 73

Estimated cash payments


To suppliers of goods
To employees (wages)
Purchase of non-current assets
Rent and rates
Other overheads
Repayment of loan
Net surplus/(deficit) for month
Opening cash balance
Closing cash balance

Jan
$

Feb
$

Mar
$

8 000
3 000

7 800
3 500
16 000

10 500
3 500

1 200
2 500
14 700

1 200

1 000
1 200

28 500

16 200

2 300
1 200
3 500

(5 800)
3 500
(2 300)

5 300
(2 300)
3 000

In the example above, where the figures are purely for illustration, the accounts department has
calculated that the cash balance at the beginning of the budget period, 1 January, will be $1 200.
Estimates have been made of the cash which is likely to be received by the business (from cash and
credit sales, and from a planned disposal of non-current assets in February). Similar estimates have
been made of cash due to be paid out by the business - payments to suppliers and employees,
payments for rent, rates and other overheads, payment for a planned purchase of non-current assets in
February and a loan repayment due in January.

The last part of the cash budget above shows how the business's estimated cash balance can then be
rolled along from month to month. Starting with the opening balance of $1 200 at 1 January a cash
surplus of
$2 300 is generated in January. This leads to a closing January balance of $3 500 which becomes the
opening balance for February. The deficit of $5 800 in February puts the business's cash position into
overdraft and the overdrawn balance of $2 300 becomes the opening balance for March. Finally, the
healthy cash surplus of $5 300 in March leaves the business with a favourable cash position of $3 000 at
the end of the budget period.

4.1 THE USEFULNESS OF CASH BUDGETS


The cash budget is one of the most important planning tools that an organisation can use. It shows
the cash effect of all plans made within the budgetary process and hence its preparation can lead
to a modification of budgets if it shows that there are insufficient cash resources to finance the
planned operations.
It can also give management an indication of potential problems that could arise and allows them
the opportunity to take action to avoid such problems. A cash budget can show four positions.
Management will need to take appropriate action depending on the potential position. This is part of
the process of the management of working capital.
CASH POSITION

APPROPRIATE MANAGEMENT ACTION

Short-term surplus

Short-term deficit

Pay suppliers early to obtain discount


Attempt to increase sales by increasing receivables
and inventories
Make short-term investments

Increase payables
Reduce receivables
Arrange an overdraft

CHAPTER 3

From these estimates it is a simple step to calculate the excess of cash receipts over cash payments in
each month. In some months cash payments may exceed cash receipts and there will be a deficit for
the month; this occurs during February in the above example because of the large investment in noncurrent assets in that month.

74 | MANAGEMENT ACCOUNTING

CASH POSITION

APPROPRIATE MANAGEMENT ACTION

Long-term surplus

Make long-term investments


Expand
Diversify
Replace/update non-current assets
Pay dividends, repay debt capital, buy back and
cancel shares

Long-term deficit

Raise long-term finance: borrow or raise equity


finance through a new share issue
Consider shutdown/disinvestment opportunities

Worked Example: Petra Blair cash budget


Petra Blair has worked for some years as a sales representative, but has recently been made
redundant.
She intends to start up in business on her own account, using $15 000 which is currently invested with a
building society. Petra maintains a bank account showing a small credit balance, and plans to approach the
bank for the necessary additional finance. Petra asks you for advice and provides the following additional
information:
a. Arrangements have been made to purchase non-current assets costing $8 000. These will be paid
for at the end of September 20X3 and are expected to have a five-year life, at the end of which
they will possess a nil residual value.
b. Inventories costing $5 000 will be acquired on 28 September and subsequent monthly purchases
will be at a level sufficient to replace forecast sales for the month.
c. Forecast monthly sales are $3 000 for October, $6 000 for November and December, and $10 500
from January 20X4 onwards.
d. Selling price is fixed at the cost of inventory plus 50%.
e. Two months' credit will be allowed to customers but only one month's credit will be received from
suppliers of inventory.
f. Running expenses, including rent but excluding depreciation of non-current assets, are estimated
at $1 600 per month.
g. Petra intends to make monthly cash drawings of $1 000.
Prepare a cash budget for the six months to 31 March 20X4.
Solution
The opening cash balance at 1 October will consist of Petra's initial $15 000 less the $8 000 expended
on non-current assets purchased in September. In other words, the opening balance is $7 000. Cash
receipts from credit customers arise two months after the relevant sales.
Payments to suppliers are a little more tricky. We are told that cost of sales is 100/150 sales.
Therefore for October cost of sales is 100/150 $3 000 = $2 000. These goods will be purchased in
October but not paid for until November. Similar calculations can be made for later months. The initial
inventory of $5 000 is purchased in September and consequently paid for in October.
Depreciation is not a cash flow and so is not included in a cash budget.
The cash budget can now be constructed.

BUDGETING | 75

CASH BUDGET FOR THE SIX MONTHS ENDING 31 MARCH 20X4

Payments
Suppliers (W1)
Running expenses
Drawings
Receipts
Debtors (W1)
Surplus/(shortfall)
Opening balance
Closing balance
Workings
W1 Suppliers
Purchased
Paid for in
W2 Receipts
Sales made
Cash received

Oct
$

Nov
$

Dec
$

Jan
$

Feb
$

Mar
$

5 000
1 600
1 000
7 600

2 000
1 600
1 000
4 600

4 000
1 600
1 000
6 600

4 000
1 600
1 000
6 600

7 000
1 600
1 000
9 600

7 000
1 600
1 000
9 600

(7 600)
7 000
(600)

(4 600)
(600)
(5 200)

3 000
(3 600)
(5 200)
(8 800)

6 000
(600)
(8 800)
(9 400)

6 000
(3 600)
(9 400)
(13 000)

10 500
900
(13 000)
(12 100)

Sept

Oct

Nov

Dec

Jan

Feb

Mar

5000
0

2000
5000

4000
2000

4000
4000

7000
4000

7000
7000

7000
7000

0
0

3000
0

6000
0

6000
3000

10500
6000

10500
6000

10500
10500

Question 1: Your organisation


You are presented with the budgeted data shown in the table below (Annex A). This will be used to
prepare a budget for the period January to June 20X5. The data has been extracted from the other
functional budgets that have been prepared.
a. Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sale.
b. Payments for purchases are made in the month following purchase.
c. 75% of wages are paid in the current month and 25% the following month.
d. Depreciation charges were $2 000 in each month in November and December 20X4. Depreciation
increases by $500 in each month from January 20X5 and by another $500 per month from April
20X5 (when the new capital expenditure occurs). All other overheads are cash expenditure items.
e. Cash expenditure items of overhead are paid the month after they are incurred.
f. Dividends are paid three months after they are declared.
g. Capital expenditure is paid two months after it is incurred.
h. The opening cash balance on 1 January 20X5 is $15 000.
The managing director is pleased with these figures as they show sales will have increased by more
than 100% in the period under review. In order to achieve this the MD has arranged a bank overdraft
with a ceiling of $50,000 to accommodate the increased inventory levels and wage bill for overtime
worked.

Sales
Purchases
Wages
Overheads
Dividends
Capital
expenditure

Nov X4
$
80 000
40 000
10 000
10 000

Dec X4
$
100 000
60 000
12 000
10 000
20 000

Jan X5
$
110 000
80 000
16 000
15 500
30 000

Annex A
Feb X5
Mar X5
$
$
130 000
140 000
90 000
110 000
20 000
24 000
15 500
15 500

Apr X5
$
150 000
130 000
28 000
20 000
40 000

May X5
$
160 000
140 000
32 000
20 000

Jun X5
$
180 000
150 000
36 000
20 000

CHAPTER 3

You are also told the following.

76 | MANAGEMENT ACCOUNTING

Requirements:
a. How much cash will be received from sales in February 20X5?
A
B
C
D

$100 000
$112 000
$118 000
$130 000

b. What is the budgeted cash balance at the end of January 20X5?


A
B
C
D

($6 000) overdraft


$9 000
$19 000
$24 000

c. What is the total budgeted cash spending on overheads in the six month period January June
20X5?
A
B
C
D

$81 000
$87 000
$95 000
$99 000

d. What is the total budgeted receipts from sales in the six month period January to June 20X5?
A
B
C
D

$666 000
$742 000
$774 000
$822 000

e. What are the total budgeted payments for purchases in the six month period January to June
20X5?
A
B
C
D

$610 000
$690 000
$700 000
$790 000

f. If the cash budget indicates a large bank overdraft at the end of June, which one of the following
measures might be the most practical for reducing the budgeted cash deficit?
A Postpone the capital expenditure
B Increase the speed of debt collection
C Take on extra staff to reduce the amount of overtime working.
D Persuade staff to work at a lower rate in return for an annual bonus or a profit-sharing
agreement
(The answers are at the end of the chapter)

4.2 OTHER WORKING CAPITAL BUDGETS


It may also be useful for a business monitoring its cash situation to look at other components of
working capital: inventory, receivables and payables. Inventory usually gets detailed consideration
when the functional budgets are prepared. Receivables budgets and payables budgets depend on
patterns of payment to suppliers and from customers, which are considered for the purpose of
preparing the cash budget.

BUDGETING | 77

5 BUDGETED FINANCIAL STATEMENTS

LO
3.3

Section overview
As well as wishing to forecast its cash position, a business might want to estimate its
profitability and its financial position for a coming period. This would involve the
preparation of a budgeted statement of comprehensive income and statement of financial
position, both of which form the master budget.
Worked Example: Budgeted financial statements
Using the information in the previous example involving Petra Blair (section 4.1) you are required to
prepare Petra's budgeted statement of comprehensive income for the six months ending on 31 March
20X4 and a budgeted statement of financial position as at that date.
Solution
The statement of comprehensive income is straightforward. The first figure is sales, which can be
computed very easily from the information in paragraph (c) in the original question. It is sufficient to
add up the monthly sales figures given there; for this statement there is no need to worry about any
closing receivables. Similarly, cost of sales is calculated directly from the information on gross margin
contained in the example above.

$
46 500

Sales (3 000 + (2 6 000) + (3 10 500))

31 000

Cost of sales (100/150 $46 500)


Gross profit
Expenses
Running expenses (6 $1 600)
Depreciation ($8 000 20% 6/12)
Net profit

15 500
9 600
800
10 400
5 100

a. Inventory will comprise the initial purchases of $5 000.


b. Receivables at the end of March will comprise sales made in February and March, not paid until
April and May respectively.
c. Payables at the end of March will comprise purchases made in March, not paid for until April.
d. The bank overdraft is the closing cash figure computed in the cash budget.

CHAPTER 3

INCOME STATEMENT
FORECAST TRADING AND COMPREHENSIVE INCOME STATEMENT
FOR THE SIX MONTHS ENDING 31 MARCH 20X4

78 | MANAGEMENT ACCOUNTING

FORECAST STATEMENT OF FINANCIAL POSITION AT 31 MARCH 20X4


$
Non-current assets $(8 000 800)
Current assets
Inventories
Receivables (2 $10 500)

$
7 200

5 000
21 000
26 000

Current liabilities
Bank overdraft
Trade payables (March purchases)
Net current assets
Total assets
Proprietor's interest
Capital introduced
Profit for the period
Less drawings
Retained loss
Total equity

12 100
7 000
19 100
6 900
14 100
15 000
5 100
6 000
(900)
14 100

Budget questions are often accompanied by a large amount of sometimes confusing detail. This
should not blind you to the fact that many figures can be entered very simply from the logic of the
trading situation described. For example, in the case of Petra Blair you might feel tempted to begin a
T-account to compute the figure for closing receivables. This kind of working is rarely necessary, since
you are told that credit customers take two months to pay. Closing receivables will equal total credit
sales in the last two months of the period.
Similarly, you may be given a simple statement that a business pays rates at $1 500 a year, followed by
a lot of detail to enable you to calculate a prepayment at the beginning and end of the year. If you are
preparing a budgeted comprehensive income statement for the year do not lose sight of the fact that
the rates expense can be entered as $1 500 without any calculation at all.

6 FLEXIBLE BUDGETS
LO
3.2
3.3

Section overview
A flexible budget is a budget which is designed to change as volume of activity changes.
Definitions
A fixed (static) budget is a budget which is set for a single activity level.
A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to
change as volume of activity changes.

Master budgets are based on planned volumes of production and sales but do not include any
provision for the event that actual volumes may differ from the budget. In this sense they may be
described as fixed (static) budgets.
A flexible budget has two advantages:
a. At the planning stage, it may be helpful to know what the effects would be if the actual outcome
differs from the prediction. For example, a company may budget to sell 10 000 units of its product,
but may prepare flexible budgets based on sales of, say, 8 000 and 12 000 units. This would enable
contingency plans to be drawn up if necessary.
b. At the end of each month or year, actual results may be compared with the relevant activity level in
the flexible budget as a control procedure.

BUDGETING | 79

Flexible budgeting uses the principles of marginal costing. In estimating future costs it is often
necessary to begin by looking at cost behaviour in the past. For costs which are wholly fixed or wholly
variable no problem arises. But you may be presented with a cost which appears to have behaved in
the past as a semi-variable cost (partly fixed and partly variable). A technique for estimating the level
of the cost for the future is called the high-low method. This is discussed in more detail in Chapter 4,
section 4.2
Worked Example: High-low method
The cost of factory power has behaved as follows in past years:
Units of output produced
20X1
20X2
20X3
20X4

7 900
7 700
9 800
9 100

Cost of factory power


$
38 700
38 100
44 400
42 300

Budgeted production for 20X5 is 10 200 units. Estimate the cost of factory power which will be
incurred. Ignore inflation.
Solution
20X3 (highest output)
20X2 (lowest output)

Units
9 800
7 700
2 100

$
44 400
38 100
6 300

The variable cost per unit is therefore $6 300/2 100 = $3.


$
44 400
29 400

Total cost of factory power in 20X3


Less variable cost of factory power (9 800 $3)
Fixed cost of factory power

15 000

An estimate of costs in 20X5 is as follows.


$
15 000
30 600

Fixed cost
Variable cost of budgeted production (10 200 $3)
Total budgeted cost of factory power

45 600

We can now look at a full example of preparing a flexible budget:


Worked Example: Preparing a flexible budget
a. Prepare a budget for 20X6 for the direct labour costs and overhead expenses of a production
department at the activity levels of 80%, 90% and 100%, using the information listed below:
The direct labour hourly rate is expected to be $3.75.
100% activity represents 60,000 direct labour hours.
Variable costs
Indirect labour
Consumable supplies
Other staff expenses

$0.75 per direct labour hour


$0.375 per direct labour hour
6% of direct and indirect labour costs

CHAPTER 3

The level of fixed cost can be calculated by looking at any output level.

80 | MANAGEMENT ACCOUNTING

Semi-variable costs are expected to relate to the direct labour hours in the same manner as for
the last five years.
Direct labour
hours

Year
20X1
20X2
20X3
20X4
20X5

Semi-variable
costs
$
20 800
19 800
18 600
17 800
16 000 (estimate)

64 000
59 000
53 000
49 000
40 000 (estimate)

Fixed costs
$
18 000
10 000
4 000
15 000
25 000

Depreciation
Maintenance
Insurance
Rates
Management salaries

Inflation is to be ignored.
b. Compile a flexible manufacturing budget for 20X6 assuming that 57,000 direct labour hours are
worked.
Solution
a.

Direct labour ($3.75/DLH)


Other variable costs
Indirect labour ($0.75/DLH)
Consumable supplies ($0.375/DLH)
Other staff expenses
Total variable costs ($5.145 per hour)
Semi-variable costs (W)
Fixed costs
Depreciation
Maintenance
Insurance
Rates
Management salaries
Total manufacturing costs

80% level
48 000 hrs
$ 000

90% level
54 000 hrs
$ 000

100% level
60 000 hrs
$ 000

180.00

202.50

225.00

36.00
18.00
12.96
246.96
17.60

40.50
20.25
14.58
277.83
18.80

45.00
22.50
16.20
308.70
20.00

18.00
10.00
4.00
15.00
25.00
336.56

18.00
10.00
4.00
15.00
25.00
368.63

18.00
10.00
4.00
15.00
25.00
400.70

Working
Using the high/low method:
$
20 800
16 000
4 800

Total cost of 64 000 hours


Total cost of 40 000 hours
Variable cost of 24 000 hours
Variable cost per hour ($4 800/24 000)

$0.20
$
20 800
12 800

Total cost of 64 000 hours


Variable cost of 64 000 hours ( $0.20)
Fixed costs

8 000

Semi-variable costs are calculated as follows:


60 000 hours
54 000 hours
48 000 hours

(60 000 $0.20) + $8 000


(54 000 $0.20) + $8 000
(48 000 $0.20) + $8 000

=
=
=

$
20 000
18 800
17 600

BUDGETING | 81

b. The budget manufacturing cost for 57,000 direct labour hours of work would be as follows:
$
293 265

Variable costs

(57 000 $5.145)

Semi-variable costs

($8 000 + (57 000 $0.20))

Fixed costs

19 400
72 000
384 665

6.1 BUDGETARY CONTROL


Budgetary control is a system of management control that is based on feedback comparisons of
actual results with the budget. Where actual results differ significantly from budget, the cause is
investigated and control action taken where appropriate. Control reports are prepared regularly,
typically every month, and budgetary control reports may be prepared for each responsibility centre
(cost centre or profit centre that is an areas of responsibility for an individual manager) as well as for
the organisation as a whole.
The most important method of budgetary control is variance analysis, which involves the comparison
of actual results achieved during a control period, usually a month, or four weeks, with a flexible
budget. The differences between actual results and expected results are called variances and these
are used to provide a guideline for control action by individual managers.
A less desirable approach to budgetary control is to compare actual results against a fixed (static)
budget. Consider the following example.
Worked Example: Windy Ltd: actual results compared to fixed (static) budget

Production and sales of the cloud (units)


Sales revenue (a)
Direct materials
Direct labour
Maintenance
Depreciation
Rent and rates
Other costs
Total costs (b)
Profit (a) (b)

Budget
2 000
$
20 000
6 000
4 000
1 000
2 000
1 500
3 600
18 100
1 900

Actual results
3 000
$
30 000
8 500
4 500
1 400
2 200
1 600
5 000
23 200
6 800

Variance
1 000F
$
10 000 (F)
2 500 (U)
500 (U)
400 (U)
200 (U)
100 (U)
1 400 (U)
5 100
4 900 (F)

Note. (F) denotes a favourable variance and (U) an unfavourable variance. Unfavourable variances are
sometimes denoted as (A) for 'adverse'.
a. In this example, some of the variances calculated above are not useful for the purposes of control.
Windy Ltd has earned $10 000 more revenue than budgeted but spent $5 100 more on costs.
However actual revenue and costs would inevitably be expected to be higher than the original
budget because the volume of output was also 50% higher. For example, even if the unit costs
were as budgeted, total variable costs such as direct material and direct labour would be expected
to increase by 50% above the budgeted costs in the fixed (static) budget, whereas fixed costs such
as rent and rates would be unaffected by the volume change.
b. For control purposes, it is necessary to adjust the original budget to ascertain the answers to
questions such as the following:
Were actual costs higher than they should have been to produce and sell 3 000 clouds? As
explained above, the unfavourable direct materials variance of $2 500 is misleading. It would be
more meaningful to compare the actual material cost of $8 500 to a restated budget figure of
$9 000 ($6 000 x 3 000/2 000), resulting in a favourable variance of $500 which implies that Windy
Ltd has in fact saved money on materials.

CHAPTER 3

Windy Ltd manufactures a single product, the cloud. Budgeted results and actual results for June 20X2
are shown below:

82 | MANAGEMENT ACCOUNTING

Was actual revenue satisfactory from the sale of 3 000 clouds? The budgeted selling price is $10
per cloud ($20 000/2 000 units), so budgeted revenue for 3 000 clouds would be $30 000
indicating that Windy Ltd has performed exactly as expected.
A more desirable approach to budgetary control which helps an organisation to identify where
corrective action needs to be taken can be seen in the worked example below:
a. Identify fixed and variable costs.
b. Produce a flexible budget using marginal costing techniques.
c. Ascertain the variances by comparing the actual result with the flexible budget.

Worked Example: Windy Ltd: actual results compared to flexible budget


Using the previous example of Windy Ltd, let us assume that we have the following estimates of cost
behaviour:
Direct materials, direct labour and maintenance costs are variable.
Rent and rates and depreciation are fixed costs.
Other costs consist of fixed costs of $1 600 plus a variable cost of $1 per unit made and sold.
Solution
The budgetary control analysis should be as follows:

Production & sales (units)


Sales revenue
Variable costs
Direct materials
Direct labour
Maintenance
Semi-variable costs
Other costs
Fixed costs
Depreciation
Rent and rates
Total costs
Profit

Fixed
(static)
budget
(a)
2 000

Flexible
budget
(b)
3 000

Actual
results
(c)
3 000

Budget
variance
(b) (c)

$
20 000

$
30 000

$
30 000

6 000
4 000
1 000

9 000
6 000
1 500

8 500
4 500
1 400

500 (F)
1 500 (F)
100 (F)

3 600

4 600

5 000

400 (U)

2 000
1 500
18 100
1 900

2 000
1 500
24 600
5 400

2 200
1 600
23 200
6 800

200 (U)
100 (U)
1 400 (F)
1 400 (F)

Note. (F) denotes a favourable variance and (U) an unfavourable variance.


We can analyse the above as follows:
a. In selling 3 000 units the expected profit should have been, not the fixed (static) budget profit of $1
900, but the flexible budget profit of $5 400. Instead, actual profit was $6 800 i.e. $1 400 more than
we should have expected. The reason for this $1 400 improvement is that, given output and sales
of 3 000 units, overall costs were lower than expected and sales revenue was exactly as expected.
For example, the direct material cost was $500 lower than expected.

BUDGETING | 83

b. Another reason for the improvement in profit above the fixed (static) budget profit is the sales
volume. Windy Ltd sold 3 000 clouds instead of 2 000 clouds, with the following result:
$
Budgeted sales revenue increased by
Budgeted variable costs increased by
direct materials
direct labour
maintenance
variable element of other costs
Budgeted fixed costs are unchanged
Budgeted profit increased by

$
10 000

3 000
2 000
500
1 000
6 500
3 500

Budgeted profit was therefore increased by $3 500 because sales volumes increased. This can be
calculated by comparing the fixed (static) budget to the flexible budget (5 400 1 900 = 3 500).
c. A full variance analysis statement would be as follows:
$
Fixed (static) budget profit
Variances
Sales volume (as calculated in (b) above)
Direct materials cost
Direct labour cost
Maintenance cost
Other costs
Depreciation
Rent and rates
Actual profit

$
1 900

3 500 (F)
500 (F)
1 500 (F)
100 (F)
400 (U)
200 (U)
100 (U)
4 900
6 800

(F)

Question 2: Fixed cost and variance reporting


A manufacturing organisation budgeted to produce 16 000 units in the budget period. The budgeted
variable cost per unit was $2.75. When output was 18 000 units, total expenditure was $98 000 and it
was found that fixed overheads were $11 000 over budget, while variable costs were in line with
budget.
What was the amount budgeted for fixed costs?
A $37 500
B $43 000
C $59 500
D $65 000
(The answer is at the end of the chapter)

CHAPTER 3

If management believes that any of these variances are large enough to justify it, they will
investigate the reasons for them to see whether any corrective action is necessary.

84 | MANAGEMENT ACCOUNTING

7 COST ESTIMATION

LO
4.2

Section overview
The production of a budget calls for the preparation of cost estimates and sales forecasts.
Cost estimation involves the measurement of historical costs to predict future costs.
In this section we will consider various cost estimation techniques.

7.1 COST ESTIMATION METHODS


Cost estimation involves the measurement of historical costs to predict future costs. Some
estimation techniques are more sophisticated than others and are therefore likely to be more reliable.
In practice, the simple techniques are more commonly found and should give estimates that are
sufficiently accurate for their purpose. It is these simple techniques which we will be examining here.

7.2 ACCOUNT-CLASSIFICATION METHOD


By this method, the manager responsible for estimating costs will go through a list of the individual
expenditure items which make up the total costs. Each item will be classified as fixed, variable or
semi-variable, and values will be assigned to these, probably by reference to the historical cost
accounts with an adjustment for estimated cost inflation.
This, in rough terms, is how the direct cost items (materials and labour costs) might be built-up when a
budgeted direct cost per unit of output is estimated. It is also commonly used by cost centre
managers in budgeting overhead costs and is quick and inexpensive. The technique does, however,
depend on the subjective judgment of each manager and his/her skill and realism in estimating
costs, and so only an approximate accuracy can be expected from its use.

7.3 HIGH/LOW METHOD


This method was introduced in section 6 of this chapter. The high/low method is used to calculate the
amount of variable and fixed cost within a semi variable cost. It involves the following steps:

Step 1

Take the highest and lowest output levels

Step 2

Find the difference

Step 3

Calculate the variable cost /unit


(Cost at highest level Cost at lowest level)/Difference in output level
Variable cost per unit =

Step 4

Total cost at high activity level _ total cost at low activity level
_
Total units at high activity level total units at low activity level

Calculate the fixed cost


Fixed costs = (total cost at high activity level ) (total units at high activity level variable
cost per unit)

The major drawback to the high/low method is that only two historical cost records from previous
periods are used in the cost estimation. Unless these two records are a reliable indicator of costs
throughout the relevant range of levels of activity, which is unlikely, only a 'loose approximation' of
fixed and variable costs will be obtained. The advantage of the method is its relative simplicity.

7.4 THE SCATTER GRAPH METHOD


A graph can be plotted of the historical costs from previous periods, and from the resulting scatter
diagram, a line-of-best-fit can be drawn by visual estimation.

BUDGETING | 85

The advantage of the scatter graph over the high/low method is that a greater quantity of historical
data is used in the estimation, but its disadvantage is that the cost line is drawn by visual judgment
and so is a subjective approximation.
A more accurate technique for plotting a line of best fit is to use regression analysis. This statistical
technique uses data from past periods to establish the relationship between costs and level of activity
as the equation of a straight line:
y = a + bx,
where a = fixed costs, b= variable cost per unit and x = volume of output.
The regression line can then be used to forecast costs for future periods.

8 INCREMENTAL AND ZERO-BASED BUDGETING


SYSTEMS

LOs
3.1
3.2

Section overview
Incremental budgeting is concerned mainly with the increments in costs and revenues
which will occur in a coming period.
Zero-based budgeting involves preparing a budget for each cost centre from a zero base.

The traditional approach to budgeting is to base next year's budget on the current year's results
plus an extra amount for estimated growth or inflation next year. This approach is known as
incremental budgeting since it is concerned mainly with the increments in costs and revenues which
will occur in the coming period.
Incremental budgeting is a reasonable procedure if current operations are as effective, efficient and
economical as they can be, and the organisation and the environment are largely unchanged.
In general, however, it is an inefficient form of budgeting as it encourages slack and wasteful spending
to creep into budgets: managers will spend to budget, even if the amount added for inflation proved
not to be necessary, so that the level of next year's budget is maintained. The result is that past
inefficiencies are perpetuated because cost levels are rarely subjected to close scrutiny.
To ensure that inefficiencies are not concealed, alternative approaches to budgeting have been
developed. One such approach is zero-based budgeting (ZBB).

8.2 THE PRINCIPLES OF ZERO-BASED BUDGETING


Zero-based budgeting rejects the assumption inherent in incremental budgeting that next year's
budget can be based on this year's costs. Existing practices and expenditures must be challenged.
ZBB requires each cost centre to justify all planned activities. Every aspect of the budget is examined
in terms of its cost and the benefits it provides and the selection of better alternatives is encouraged.
Definition

Zero-based budgeting involves preparing a budget for each cost centre from a zero base. Every item
of expenditure has to be justified in its entirety in order to be included in the next year's budget.

CHAPTER 3

8.1 TRADITIONAL (INCREMENTAL) BUDGETING

86 | MANAGEMENT ACCOUNTING

The basic approach of ZBB has three steps.

Step 1

Define decision packages


A decision package is a comprehensive description of a specific organisational activity, its
objectives, costs and benefits.

Step 2

Evaluate and rank packages


Using the decision packages, each activity is evaluated and ranked on the basis of its
benefit to the organization, in order of priority against other activities.
The ranking process provides managers with a technique to allocate scarce resources
between different activities. Minimum work requirements (those that are essential to get
a job done) will be given high priority and so too will work which meets legal obligations.
In the accounting department these would be minimum requirements to operate the
payroll, accounts receivable and accounts payable systems, and to maintain and publish a
set of accounts which satisfies the external auditors and regulatory authorities (e.g. tax
returns).

Step 3

Allocate resources
Resources in the budget are then allocated according to the funds available and the
evaluation and ranking of the competing packages.

8.3 THE ADVANTAGES OF IMPLEMENTING ZBB


It is possible to identify and remove inefficient or obsolete operations.
Cost reductions are possible.
It forces employees to avoid wasteful expenditure.
It can increase motivation if, as a result of preparing the decision packages, staff become more
involved in the budgeting process
It provides a budgeting and planning tool for management which responds to changes in the
business environment; 'obsolescent' items of expenditure are identified and dropped.
The documentation required provides all management with a coordinated, in-depth appraisal of
an organisation's operations.
It challenges the status quo and forces an organisation to examine alternative activities and
existing expenditure levels.
In summary, ZBB should result in a more efficient allocation and utilisation of resources to an
organisation's activities and departments.

8.4 THE DISADVANTAGES OF ZBB


The major disadvantage of zero-based budgeting is the time and energy required. The assumptions
about costs and benefits in each package must be continually updated and new packages developed
as soon as new activities emerge. The following problems might also occur:
Short-term benefits might be emphasised to the detriment of long-term benefits.
The false idea that all decisions have to be made in the budget might be encouraged.
Management must be able to meet unforeseen opportunities and threats at all times, and must not
feel restricted from carrying out new ideas simply because they were not approved by a decision
package, cost benefit analysis and the ranking process.
It may require management skills both in constructing decision packages and in the ranking
process which the organisation does not possess. Managers may therefore have to be trained in
ZBB techniques so that they can apply them sensibly and properly.
It may be difficult to 'sell' ZBB to managers as a useful technique for the following reasons:
costs and benefits of alternative courses of action are hard to quantify accurately.

Employees or trade union representatives may resist management ideas for changing the ways
in which work is done.

BUDGETING | 87

The organisation's information systems may not be capable of providing suitable cost and
benefit analysis.
The ranking process can be difficult. Managers face three common problems:
A large number of packages may have to be ranked.

There is often a conceptual difficulty in having to rank packages which managers regard as
being equally vital, for legal or operational reasons.
It is difficult to rank completely different types of activity, especially where activities have
qualitative rather than quantitative benefits, such as spending on staff welfare and working
conditions, where ranking must usually be entirely subjective.
In summary, perhaps the most serious drawback to ZBB is that it requires a lot of management
time and effort. One way of obtaining the benefits of ZBB and overcoming the drawbacks, is to apply
it selectively on a rolling basis throughout the organisation. For example, this year it applies to the
finance department, next year marketing department, the year after personnel department and so on.
In this way all activities will be thoroughly scrutinised over a period of time.

8.5 USING ZERO-BASED BUDGETING


ZBB can be used by both profit-making and non-profit-making organisations.

In manufacturing organisations, ZBB is best applied to expenditure incurred in departments that


support the essential production function. These include marketing, finance, quality control, repairs
and maintenance, production planning, research and development, engineering design, personnel,
data processing, sales and distribution. In many organisations, these expenses make up a large
proportion of the total expenditure. These activities are less easily quantifiable by conventional
methods and are more discretionary in nature.
ZBB can also be successfully applied to service industries and public sector organisations such as
local and central government departments, educational establishments, hospitals and so on. This is
because ZBB is a useful technique for identifying the cause of excess spending in administrative
activities, and eliminating wasteful and non-value-adding activities.
ZBB can be applied in any organisation where alternative levels of provision for each activity are
possible and where the costs and benefits are separately identifiable.
Some particular uses of ZBB are:
a. Budgeting for discretionary cost items, such as advertising, R & D and training costs. The
priorities for spending money could be established by ranking activities and alternative levels of
spending or service can be evaluated on an incremental basis. For example, is it worth spending $2
000 more to increase the number of employees to be trained on one type of training course by
10%? If so, what priority should this incremental spending on training be given, when compared
with other potential training activities?
b. Rationalisation measures. 'Rationalisation' means cutting back on production and activity levels,
and cutting costs. ZBB can be used to make rationalisation decisions when an organisation is
forced to make spending cuts. As indicated above, it is also a useful approach to eliminating
unnecessary and wasteful spending.

8.6 ROLLING BUDGETS


A rolling budget is a budget that always extends a set number of financial periods into the future, for
example four quarters. As the current period ends, a new period is added to the budget.
The advantages of rolling budgets include:
The forecast represented by the budget will be more accurate as managers are forced to reassess
the budget regularly and adjust for current conditions

CHAPTER 3

The procedures of ZBB do not lend themselves easily to direct manufacturing costs where standard
costing, work study and the techniques of management planning and control have long been
established as a means of budgeting expenditure.

88 | MANAGEMENT ACCOUNTING

Planning and control is based on a more recent, up-to-date plan


The budget will prompt managers to look further into the future than the traditional annual budget
The rolling budget can help to provide an early warning of whether the organisation is on track to
meet its goals.

Disadvantages include:
The budget preparation process may be more costly
Managers may be de-motivated by the additional volume of work involved, for example if standard
costs or stock valuations need to be revised.

9 BUDGETING, PERFORMANCE AND MOTIVATION


Section overview
Human behaviour affects the budgeting process, the resulting budgets and the
performance of managers and employees alike.
LO
3.1

In this chapter we have concentrated on the importance of the budgeting process for planning and
control by management. A further aspect of the budgeting process is the human behavioural aspect,
the effect that the budgeting process and resulting budgets has on the performance of managers and
other employees alike.

9.1 BUDGETS AND MOTIVATION


The motivational effect of the budgeting process on managers in a business is much written-about
and there are many conflicting views. It is well recognised that the budgetary process has the potential
to be a powerful motivating tool, but conversely it may also have a de-motivating effect.
The effect of the budget on the motivation of managers is largely due to the level of difficulty of the
targets set, and the manner in which they are set. Are the budgets imposed or have the managers
taken part in the budgeting process?

9.2 BUDGETS AND STANDARDS AS TARGETS


Once decided, budgets become targets. But how difficult should the targets be? And how might
people react to targets which are easy to achieve, or difficult to achieve?
The quantity of material and labour time included in the budget will depend on the level of
performance required by management. Four types of performance standard might be set:
Ideal standards are based on perfect operating conditions: no wastage, no spoilage, no
inefficiencies, no idle time, no breakdowns. Employees will often feel that the goals are
unattainable, become de-motivated and not work so hard.
Attainable standards are based on the hope that a standard amount of work will be carried out
efficiently, machines properly operated or materials properly used. Some allowance is made for
wastage and inefficiencies. If well-set they provide a useful psychological incentive by giving
employees a realistic, but challenging target of efficiency.
Current standards are based on current working conditions (current wastage, current
inefficiencies). They do not attempt to improve on current levels of efficiency.
Basic standards are kept unaltered over a long period of time, and may be out of date. They are
used to show change in efficiency or performance over a long period of time. They are perhaps the
least useful and least common type of standard in use.

Management must decide which of the four types of standard is most appropriate as a benchmark for
measuring performance.

BUDGETING | 89

Standards can be used as aspirational targets to drive improvements in performance, but when
benchmarking actual performance against such standards, management need to be aware that this
may result in de-motivated employees:
The impact on employee behaviour of budgets based on these different standards is summarised in
the table below:
TYPE OF STANDARD

IMPACT

Ideal standards

Some say that they provide employees with an incentive to be more efficient
even though it is highly unlikely that the standard will be achieved. Others
argue that they are likely to have an unfavourable effect on employee
motivation because the differences between standards and actual results will
always be adverse. The employees may feel that the goals are unattainable and
so they will not work so hard.

Attainable standards

Might be an incentive to work harder as they provide a realistic but challenging


target of efficiency.

Current standards

Will not motivate employees to do anything more than they are currently doing.

Basic standards

May have an unfavourable impact on the motivation of employees. Over time


they will discover that they are easily able to achieve the standards. They may
become bored and lose interest in what they are doing if they have nothing to
aim for.

Similar comments apply to budgets.

The various research projects into the behavioural effects of budgeting have given conflicting views on
certain points. However, there appears to be general agreement that a target must fulfil certain
conditions if it is to motivate employees to work towards it:
It must be sufficiently difficult to be a challenging target.
It must not be so difficult that it is not achievable.
It must be accepted by the employees as their personal goal.

9.3 PARTICIPATION
There are basically two ways in which a budget can be set: from the top down (imposed budget) or
from the bottom up (participatory budget).

9.4 TOP-DOWN STYLE OF BUDGETING


In this approach to budgeting, top management prepare a budget with little or no input from
operating personnel. This budget is then imposed upon the employees who have to work to the
budgeted figures.
The times when imposed budgets are effective are as follows:
In newly-formed organisations, because of employees' lack of knowledge.
In very small businesses, because the owner/manager has a complete overview of the business.
When operational managers lack budgeting skills.
When the organisation's different units require precise co-ordination.
When budgets need to be set quickly.

There are, of course, advantages and disadvantages to this style of setting budgets.
Advantages
The aims of long-term plans are more likely to be incorporated into short-term plans.
They improve the co-ordination between the plans and objectives.

CHAPTER 3

Budgets and standards are more likely to motivate employees if employees accept that the budget or
standard is achievable. If it can be achieved too easily, it will not provide sufficient motivation. If it is too
difficult, employees will not accept it because they will believe it to be unachievable. In extreme
circumstances, if employees believe a budget is impossible to achieve, they might be so de-motivated
that they attempt to prove that the budget is wrong. This is obviously the completely opposite effect to
that intended.

90 | MANAGEMENT ACCOUNTING

They use senior management's overall awareness of the organisation.


There is less likelihood of input from inexperienced or uninformed lower-level employees.
Budgets can be drawn up in a shorter period of time because a consultation process is not
required.

Disadvantages
Dissatisfaction, defensiveness and low morale amongst employees who have to work to meet the
targets. It is hard for people to be motivated to achieve targets set by somebody else. Employees
might put in only just enough effort to achieve targets, without trying to beat them.
The feeling of team spirit may disappear.
Organisational goals and objectives might not be accepted so readily and/or employees will not
be aware of them.
Employees might see the budget as part of a system of trying to find fault with their work: if they
cannot achieve a target that has been imposed on them they may be punished.
If consideration is not given to local operating and political environments, unachievable budgets
for overseas divisions could be produced.
Lower-level management initiative may be stifled if they are not invited to participate.

9.5 BOTTOM-UP STYLE OF BUDGETING


In this approach to budgeting, budgets are developed by lower-level managers who then submit
the budgets to their superiors. The budgets are based on the lower-level managers' available data
and forecasts of what is achievable and the associated necessary resources.
The advantages of participative budgets are as follows:
They are based on information from employees most familiar with the department. Budgets should
therefore be more realistic.
Knowledge spread among several levels of management is pulled together, again producing more
realistic budgets.
Because employees are more aware of organisational goals, they should be more committed to
achieving them.
Co-ordination and co-operation between those involved in budget preparation should improve.
Senior managers' overview of the business can be combined with operational-level details to
produce better budgets.
Managers should feel that they 'own' the budget and will therefore be more committed to the
targets and more motivated to achieve them.
Participation will broaden the experience of those involved and enable them to develop new skills.
Overall, participation in budget setting should give those involved a more positive attitude towards
the organisation, which should lead to better performance.

There are, on the other hand, a number of disadvantages of participative budgets:


They consume more time.
Any changes made by senior management to the budgets submitted by lower-level management
may cause dissatisfaction.
Budgets may be unachievable if managers are not qualified to participate.
Managers may not co-ordinate their own plans with those of other departments.
Managers may include budgetary slack (padding the budget) in their budgets. This means they
have over-estimated costs or under-estimated income. Actual results are then more likely to be
better than the budgeted target results.
An earlier start to the budgeting process could be required.

The research projects do not appear to provide definite conclusions about the motivational effects of
budgeting. The attitudes of the individuals involved have an impact.

BUDGETING | 91

Some managers may complain that they are too busy to spend time on setting standards and
budgeting.
Others may feel that they do not have the necessary skills.
Some may think that any budget they set will be used against them.

In such circumstances participation could be seen as an added pressure rather than as an opportunity.
For such employees an imposed approach might be better.

9.6 NEGOTIATED STYLE OF BUDGETING


At the two extremes, budgets can be dictated from above or simply emerge from below but, in
practice, different levels of management often agree budgets by a process of negotiation.
In the imposed budget approach, operational managers will try to negotiate with senior managers
the budget targets which they consider to be unreasonable or unrealistic.
Likewise senior management usually review and revise budgets presented to them under a
participative approach through a process of negotiation with lower level managers.
Final budgets are therefore most likely to lie between what top management would really like and
what lower level managers believe is feasible.

9.7 PADDING THE BUDGET


In the process of preparing budgets, managers might deliberately overestimate costs and
underestimate sales, so that they will not be blamed in the future for overspending and poor results.

A typical situation is for a manager to pad the budget and waste money on non-essential expenses so
that all the budget allowances are used. The reason behind this action is the fear that unless the
allowance is fully spent it will be reduced in future periods, making the future budget more difficult to
attain. If inefficiency and slack are allowed for in budgets, achieving a budget target means only that
costs have remained within the accepted levels of inefficient spending.
Budget bias can work in the other direction too. It has been noted that, after a run of mediocre
results, some managers deliberately overstate revenues and understate cost estimates, no doubt
feeling the need to make an immediate favourable impact by promising better performance in the
future. They may merely delay problems, however, as the managers may well be censured when they
fail to hit these optimistic targets.

9.8 GOAL CONGRUENCE AND DYSFUNCTIONAL DECISION MAKING


Individuals are motivated by personal desires and interests. These desires and interests may tie in with
the objectives of the organisation after all, some people 'live for their jobs'. Other individuals see
their job as a chore, and their motivations will have nothing to do with achieving the objectives of the
organisation for which they work.
It is therefore important that some of the desires, interests and goals motivating employees
correspond with the goals of the organisation as a whole. This is known as goal congruence. Such a
state would exist, for example, if the manager of department A worked to achieve a 10% increase in
sales for the department, this 10% increase being part of the organisation's overall plan to increase
organisational sales by 20% over the next three years.
On the other hand, dysfunctional behaviour can occur if a manager's goals are not in line with those
of the organisation as a whole. Attempts to enhance his or her own situation or performance (typically
'empire building' employing more staff, cutting costs to achieve favourable variances but causing
quality problems in other departments) will be at the expense of the best interests of the organisation
as a whole. Participation is not necessarily the answer. Goal congruence does not necessarily result
from allowing managers to develop their own budgets.

CHAPTER 3

In controlling actual operations, managers must then ensure that their spending rises to meet their
budget, otherwise they will be 'blamed' for careless budgeting.

92 | MANAGEMENT ACCOUNTING

A well designed standard costing and budgetary control system can help to ensure goal congruence.
Continuous feedback prompting appropriate control action should steer the organisation in the right
direction.
Question 3: Eskafield

Eskafield Industrial Museum opened ten years ago and soon became a market leader with many
working exhibits. In the early years there was a rapid growth in the number of visitors but with no
further investment in new exhibits, this growth has not been maintained in recent years.
Two years ago, John Derbyshire was appointed as the museum's chief executive. His initial task was to
increase the number of visitors to the museum and, following his appointment, he had made several
improvements to make the museum more successful.
Another of John's tasks is to provide effective financial management. This year the museum's Board of
Management has asked him to take full responsibility for producing the 20X3 budget. He has asked
you to prepare estimates of the number of visitors next year.
Shortly after receiving your notes, John Derbyshire contacts you. He explains that he had prepared a
draft budget for the Board of Management based on the estimated numbers for 20X3. This had been
prepared on the basis that:
Most of the museum's expenses such as salaries and rates are fixed costs;
The museum has always budgeted for a deficit;

The deficit in the draft budget for 20X3 is $35 000.


At the meeting with the Board of Management, John was congratulated on bringing the deficit down
from $41 000 in 20X1 to $37 000 (latest estimate) in 20X2. However, the Board of Management raised
two issues:
1. They felt that the planned deficit of $35 000 for 20X3 should be reduced to $29 000 as this would
represent a greater commitment.
2. They also queried why the budget had been prepared without any consultation with the museum
staff, i.e. a top down approach.
Requirements:
a. Which one of the following factors is LEAST likely to influence the views of John Derbyshire about
whether the further reduction in the deficit is achievable?
A
B
C
D

Variable cost estimates in the budget


The amount of padding in the budget
The morale and commitment of museum staff
The amount of discretionary costs in the budget

b. Which of the following factors would affect whether or not a top-down approach to budgeting is
appropriate for the museum?
I Financial awareness of the management team
II The level in the management hierarchy where spending decisions are made
III The size and culture of the organisation
A I only
B I and III only
C II and III only
D I, II and III
(The answer is at the end of the chapter)

BUDGETING | 93

10 BUDGETING AND QUALITY


Section overview
Many businesses, both manufacturing and service businesses, are wholly concerned with
quality.
The concept behind quality control is the principle of 'get it right first time'.

10.1 TOTAL QUALITY MANAGEMENT (TQM)


As discussed in Chapter 1, Total Quality Management (TQM) is a management approach that means
that quality is the aim of every part of the organisation. The aim is to 'get it right first time' which
means striving for continuous improvement in order to eliminate faulty work and prevent mistakes. It
must apply to every part of the business and every activity that the business undertakes, whether it is
in making the product, providing the service, selling the product or general administration. Under
TQM each person, in every function of the business, has to recognise that s/he has customers. In some
cases, these are external customers but in many cases these are internal customers, the employees'
colleagues and managers.

10.2 BUDGETING AND TQM


The budgeting process is about setting standards or targets for all aspects and functions of the
business to meet. If the budgeting process is successful it can help in this continuous process of
improvement by setting targets that eventually eliminate all unnecessary waste and mistakes.

CHAPTER 3

However, since TQM seeks continuous improvement, it is not altogether consistent with a budget
approach to planning that uses current or attainable standards as a target.

94 | MANAGEMENT ACCOUNTING

KEY CHAPTER POINTS


A budget is a quantitative statement, for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows.
The main purpose and benefit of using a budget is to assist with the achievement of the
organisation's objectives.
Towards the end of the strategy planning stage, the budget will be prepared. While the mechanics
of budget preparation is the focus of your immediate study, it is important to appreciate how
important budgets are in co-ordination and control.
The co-ordination and administration of budgets is usually the responsibility of a budget
committee.
The budget manual is a collection of instructions governing the responsibilities of persons, and the
procedures, forms and records relating to the preparation and use of budgetary data.
The principal budget factor is the factor which limits the activities of an organisation.
A functional operating or departmental budget is a budget forecasting income and expenditure
for a particular department or process. It could be a production budget, a sales budget or a
purchasing budget depending on the function and the nature of its activities.
A cash budget is a statement in which estimated future cash receipts and payments are compiled
in such a way as to show the forecast cash balance of a business at defined intervals.

A budget is one of the most important planning tools that an organisations can use. It shows the
cash effect of all plans made within the budgetary process.
In addition to forecasting its cash position, a business may want to estimate its profitability and its
financial position for a coming period.
Budgeted statements of comprehensive income and financial position form the master budget.
A fixed (static) budget is a budget which is set for a single activity level, whereas a flexible budget
is a budget which is designed to change as volume of activity changes.
Cost estimation involves the measurement of historical costs to predict future costs.
Incremental budgeting is concerned mainly with the increments in costs and revenues which will
occur in a coming period.
Zero-based budgeting involves preparing a budget for each cost centre from a zero base.
Human behaviour affects the budgeting process, the resulting budgets and the performance of
managers and employees alike.

BUDGETING | 95

QUICK REVISION QUESTIONS


1 Which of the following is a definition of feedback?
A The planning and control cycle within a budgetary system
B Control action on the basis of comparing actual results with a plan or budget
C Information gathered internally for comparing actual results against a plan or budget
D Information gathered internally and externally for comparing actual results against a plan or
budget
2 Which of the following is not a functional budget?
A Cash budget
B Production budget
C Selling cost budget
D Distribution cost budget
3 The principal budget factor is normally assumed to be
A cash.
B sales demand.
C production capacity.
D skilled labour resources.

5 In comparing a fixed budget with a flexible budget, what is the reason for the difference between
the profit figures in the two budgets?
A
B
C
D

Different levels of activity


Different levels of spending
Different levels of efficiency
The difference between actual and budgeted performance

6 When budget allowances are set without the involvement of the budget owner, the budgeting
process can be described as
A
B
C
D

top down budgeting.


negotiated budgeting.
zero based budgeting.
participative budgeting.

7 For which of the following would zero based budgeting be most suitable?
A
B
C
D

Building construction
Mining company operations
Transport company operations
Government department activities

CHAPTER 3

4 When preparing a production budget, the quantity to be produced equals


A sales quantity + opening inventory of finished goods + closing inventory of finished goods
B sales quantity opening inventory of finished goods + closing inventory of finished goods
C sales quantity opening inventory of finished goods closing inventory of finished goods
D sales quantity + opening inventory of finished goods closing inventory of finished goods

96 | MANAGEMENT ACCOUNTING

ANSWERS TO QUICK REVISION QUESTIONS


1 C Feedback is information for control purposes. It is not the control system itself, nor is it control
action. Feedback is collected as output from the system and so is internally-obtained
information.
2 A A functional budget is a budget prepared for a particular function or department. A cash
budget is the resultant cash balance of the planning decisions included in all the functional
budgets. It is not a functional budget itself. Therefore the correct answer is A.
The production budget (option B), the distribution cost budget (option D) and the selling cost
budget (option C) are all prepared for specific functions, therefore they are functional budgets.
3 B Unless there are good reasons for suspecting anything different, sales demand is assumed to
be the principal or limiting budget factor when the first draft budgets are prepared. The first
draft budget to prepare is therefore the sales budget.
4 B Any opening inventory available at the beginning of a period will reduce the additional quantity
required from production in order to satisfy a given sales volume. Any closing inventory
required at the end of a period will increase the quantity required from production in order to
satisfy sales and leave a sufficient volume in inventory. Therefore, we need to deduct the
opening inventory and add the required closing inventory.
5 A The difference in profit between the fixed budget and a flexible budget is due to differences in
the activity levels, resulting in differences in both costs and revenues.
6 A The budget is imposed by senior management at the top.
7 D Zero based budgeting, when used, is most suitable for activities that are away from front line
production or operating activities, where standards of performance can be set to plan and
monitor performance. ZBB is therefore best suited for back office operations, or administrative
work. It may therefore be appropriate for budgeting for government departments, especially
when the government is trying to reduce expenditure.

BUDGETING | 97

ANSWERS TO CHAPTER QUESTIONS


1 (a) B
Cash sales: (40% $130 000)
From credit sales in December: (60% $100
000)
Total cash receipts in February

$
52 000
60 000
112 000

(b) D
$
Cash sales: (40% $110 000)
From credit sales in November: (60% $80 000)
Total cash receipts in January
Payments for Decembers purchases
Payments for wages (Dec: 25% 12 000) + (Jan:
75% 16 000)
Payments for Decembers overheads (10 000
2 000)*
Total cash payments in January
Excess of cash receipts over payments
Cash balance at beginning of January
Cash balance at end of January

$
44 000
48 000
92 000

60 000
15 000

8 000
83 000
9 000
15 000
24 000

(c) A Overheads are paid the month after they are incurred so payments in January-June 20X5
relate to overheads incurred in December-May. Depreciation is not a cash cost and
therefore needs to be excluded:
Payments in:
January (10 000 2 000)
February April: [3 (15 500 2 500)]
May June: [2 (20 000 3 000)]
Total payments

$
8 000
39 000
34 000
81 000

(d) C
Receivables at 1 January: 60% (80 000 + 100
000)
Sales January to June
Less
Receivables at 30 June: 60% (160 000 + 180
000)
Cash receipts from sales

$
108 000
870 000
978 000
(204 000)

774 000

CHAPTER 3

* Depreciation is not a cash cost and therefore needs to be excluded:

98 | MANAGEMENT ACCOUNTING

(e) A
Payables at 1 January
Purchases January to June
Less Payables at 30 June
Cash payments for purchases

$
60 000
700 000
760 000
(150 000)
610 000

Alternatively since purchases are paid in the month after they are incurred, cash payments
Jan-June relate to purchases from Dec-May: (60+80+90+110+130+140) = 610 000
(f) A Budgeted wages costs are expected to rise substantially, but extra staff should not be taken
on unless they are expected to do simple casual work, or unless they are expected to remain
with the organisation for a long time. Otherwise training costs would be high. It would take
too long to re-negotiate wages and salary arrangements, and it will not be easy to speed up
collections from customers unless customers are in breach of their credit arrangements and
paying later than they should. Deferring some or all of the capital expenditure is likely to be
the easiest and most practical option.
2 A
Total expenditure
Variable cost, as expected (18 000 $2.75)
Actual fixed costs incurred
Unfavourable fixed overhead expenditure variance
Budgeted fixed costs

$
98 000
49 500
48 500
11 000
37 500

3 (a) A If John is aware of padding in the budget, he will be able to cut budgeted expenditure
without too much trouble simply by reducing the amount of padding. He may need to
consider the attitudes of staff and whether they are likely to have the commitment to cut
costs further. Most costs are fixed costs: some of these may be discretionary, and so
controllable. Since variable costs are small, they are unlikely to be a key factor in trying to
reduce the deficit, since potential savings in variable costs will not be significant.
(b) D If the management team is financially aware, they should be more capable of drafting
bottom-up budgets. However, responsibility for budgeting expenditures should not go
lower in the management hierarchy than the managers who make the spending decisions. If
John Derbyshire makes most of the spending decisions himself, and has the responsibility
for expenditures, he should retain the responsibility for budgeting. The approach to
budgeting, top-down or bottom-up, also depends on the culture and size of the
organisation. Very small organisations and large bureaucratic organisations are likely to have
a strong top-down culture.

99

CHAPTER 4
COST BEHAVIOUR AND
CVP ANALYSIS
Learning objectives

Reference

Cost behaviour

LO4

Describe the nature of costs and their behaviour

LO4.1

Apply relevant techniques to separate costs into their fixed and variable components

LO4.2

Apply the principles of cost-volume-profit analysis in organisations

LO4.3

Topic list

1 Fixed costs and variable costs


2 Introduction to cost behaviour
3 Cost behaviour patterns
4 Determining the fixed and variable elements of semi-variable costs
5 CVP analysis and break-even point
6 The contribution to sales (C/S) ratio
7 The safety margin
8 Break-even calculations and profit targets
9 Break-even graphs, contribution charts and profit/volume charts
10 Limitations of CVP analysis

100 | MANAGEMENT ACCOUNTING

INTRODUCTION
This chapter introduces the concept of the separation of costs into those that vary directly with
changes in activity levels (variable costs) and those that do not (fixed costs). This chapter examines
further this two-way split of cost behaviours and explains the high-low method as one method of
splitting semi-variable costs into these two elements.
The cost accountant, must also be fully aware of cost behaviour because, to be able to estimate
costs, he or she must know what a particular cost will do given particular conditions.
The application of cost-volume-profit analysis, which is based on the cost behaviour principles and
marginal costing ideas, is sometimes necessary so that the appropriate decision-making information
can be provided to management. This chapter is going to conclude with that very topic, cost-volumeprofit analysis or break-even analysis.
The chapter content is summarised in the diagram below.

Cost behaviour
and
CVP analysis

Fixed and
variable costs

Cost behaviour
patterns

CVP
analysis

Contribution to Sales
(C/S) ratio

Safety margin

Breakeven

COST BEHAVIOUR AND CVP ANALYSIS | 101

BEFORE YOU BEGIN


If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What is a fixed cost?

(Section 1)

2 What is a variable cost?

(Section 1)

3 Draw graphs to show fixed, variable and step-fixed costs

(Section 3)

4 What are the steps to follow to estimate the fixed and variable elements
of semi-variable costs?

(Section 4.2)

5 What is CVP analysis?

(Section 5.1)
(Section 6)

7 What is the formula for target profits?

(Section 8.1)

8 Draw and label a break-even chart

(Section 9.1)

9 What are the limitations of CVP analysis?

(Section 10)

CHAPTER 4

6 What is the C/S ratio (or P/V ratio)?

102 | MANAGEMENT ACCOUNTING

1 FIXED COSTS AND VARIABLE COSTS

LO
4.1

Section overview
Costs may be classified into fixed costs and variable costs. Many items of expenditure are
part-fixed and part-variable and are so termed step-fixed or semi-variable (or mixed)
costs.
Definitions
Cost is a measure of the resources given up to achieve an objective.
A fixed cost is a cost which is incurred for a particular period of time and which, within certain activity
levels, is unaffected by changes in the level of activity.
A variable cost is a cost which varies with the level of activity. Variable costs tend to be constant per
unit but total variable costs will increase or decrease with changes in production or service volume.
A semi-variable (or mixed) cost is a cost that contains both a fixed cost and a variable cost
component.
A step-fixed cost is a cost that is fixed for a certain range of activity but increases to a new fixed level
once a critical level of activity is reached.

1.1 EXAMPLES OF FIXED AND VARIABLE COSTS


a. Direct material costs (cost of materials consumed in the manufacturing process) are variable costs
because they rise as more units of a product are manufactured.
b. Sales commission is often a fixed percentage of sales turnover, and so is a variable cost that varies
with the level of sales.
c. Telephone call charges are likely to increase if the volume of business expands, but there is also a
fixed element of line rental, and so they are a semi-variable overhead cost.
d. The rental cost of business premises is a constant amount, at least within a stated time period, and
so it is a fixed cost.
e. The salary paid to a factory supervisor might be considered a step-fixed cost. For example the
factory may be able to produce up to 20,000 product units with one supervisor, but needs a second
supervisor once this level of activity is exceeded.

2 INTRODUCTION TO COST BEHAVIOUR

LO
4.1

2.1 COST BEHAVIOUR AND DECISION-MAKING


Section overview
The basic principle of cost behaviour is that as the level of activity rises, costs will usually
rise.
Definition
Cost behaviour is the way in which costs are affected by changes in the level of activity.

COST BEHAVIOUR AND CVP ANALYSIS | 103

Management decisions will often be based on how costs and revenues vary at different activity levels.
Examples of such decisions are as follows:
What should the planned activity level be for the next period?
Should the selling price be reduced in order to sell more units?
Should a particular component be manufactured internally or bought in?
Should a contract be undertaken?
There are many factors which may influence costs. The major influence is volume of output, or the
level of activity. Examples of cost drivers or level of activity may include one of the following:
Number of units produced.
Number of invoices issued.
Number of units of electricity consumed.
Value of items sold.
Number of items sold.
An understanding of cost behaviour is useful for:
Cost control - the level of costs incurred, will in part, be a result of an organisation's activities.
Budgeting - knowledge of cost behaviour is essential for the tasks of budgeting, decision making
and management control.

2.2 COST BEHAVIOUR PRINCIPLES


The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise. It will
cost more to produce 2 000 units of output than it will cost to produce 1 000 units.
This principle is common sense. The challenge for the accountant, however, is to be able to analyse
each item of cost, in terms of the factors that drive the cost and to determine the amount by which the
cost increases as the level of activity changes. For our purposes here, the level of activity for
measuring cost will generally be taken to be the volume of production.
Worked Example: Cost behaviour and activity level
Bart Hurst has a fleet of company cars for sales representatives. Running costs have been estimated as
follows:
a. Cars cost $12 000 when new, and have a guaranteed trade-in value of $6 000 at the end of two
years. Depreciation is charged on a straight-line basis (in equal annual amounts over the life of the
car).
b. Petrol and oil cost 15 cents per km.
d. Routine maintenance costs $325 per annum per car.
e. Repairs are thought to vary with mileage. The average car travels 25 000 kms per annum and incurs
annual repair costs of $200.
f. Tax, insurance, and membership of motoring organisations cost $400 per annum per car.
Calculate the total annual cost of a car which travels 15 000 kms per annum and a car which travels 30
000 kms per annum.
Solution
Costs may be analysed into variable, fixed, and step-fixed elements. A step-fixed cost being a cost
which is fixed in nature but only within a certain level of activity.
a. Variable costs
Petrol and oil
Repairs ($200 25 000 km)

Cents per km
15.0
0.8
15.8

CHAPTER 4

c. Tyres cost $300 per set to replace; replacement occurs every 15 000 kms.

104 | MANAGEMENT ACCOUNTING

b. Fixed costs
$ per annum
3 000
325
400
3 725

Depreciation $(12 000 6 000) 2


Routine maintenance
Tax, insurance etc

c. Step-fixed costs are tyre replacement costs, which are $300 after every 15 000 kms.
The estimated costs per annum of cars travelling 15 000 kms per annum and 30 000 kms per annum
would therefore be:

Variable costs (15.8c per km 15 000/30 000)


Fixed costs
Step-fixed costs
Cost per annum

15 000 kms
per annum
$
2 370
3 725
300
6 395

30 000 kms
per annum
$
4 740
3 725
600
9 065

3 COST BEHAVIOUR PATTERNS


3.1 FIXED COSTS
Section overview
A fixed cost is a cost which tends to be unaffected by increases or decreases in the volume
of output. A step-fixed cost is a cost which is fixed in nature but only within certain levels of
activity, while a variable cost is cost which tends to vary directly with the volume of output.
The variable cost per unit is the same for each unit produced. Many costs contain both a
fixed and variable element a semi-variable cost and are partly affected by changes in
the level of activity.
LO
4.1

Fixed costs are a period charge, in that they relate to a span of time; as the time span increases, so
too will the fixed costs (which are sometimes referred to as period costs for this reason). It is important
to understand that fixed costs always have a variable element, since an increase or decrease in
production may also bring about an increase or decrease in per unit fixed costs.
A sketch graph of fixed cost would look like this:
$
Total cost

Total fixed cost

Volume of output (level of activity)

Examples of a fixed cost would be:


The rent of a single factory building (per month or per annum)
Straight line depreciation of a single machine (per month or per annum)

COST BEHAVIOUR AND CVP ANALYSIS | 105

3.2 STEP-FIXED COSTS


A step-fixed cost is a cost which is fixed in nature but only within a certain range of activity. It is fixed
for a certain range of activity but increases to a new fixed level once a critical level of activity is
reached.
Consider the depreciation of a machine which may be fixed if production remains below 1 000 units
per month. If production exceeds 1 000 units, a second machine may be required, and the cost of
depreciation (on two machines) would go up a step. A sketch graph of a step-fixed cost could look like
this:
Graph of step-fixed cost
$
Cost

Volume of output

Other examples of step-fixed costs are:


a. Rent is a step-fixed cost in situations where rental space requirements increase as output levels get
higher.
b. Basic pay of employees is nowadays usually fixed, but as output rises, more employees (direct
workers, supervisors, managers and so on) are required.
c. Royalties e.g. fees of $10 000 payable if sales are below 5 000 units. Fees increase to $15 000 if
sales exceed this.

3.3 VARIABLE COSTS


A variable cost is a cost which varies directly with the volume of output. The variable cost per unit is
the same amount for each unit produced but the total variable cost of production increases/decreases
as the volume of output (activity) increases/decreases.
Graph of variable cost (1)

Volume of output

A constant variable cost per unit implies that the price per unit of say, material purchased is constant,
and that the rate of material usage is also constant.
a. The most important variable cost is the cost of raw materials (where there is no discount for bulk
purchasing since bulk purchase discounts reduce the cost of purchases).
b. Direct labour costs are most often classed as a variable cost even though basic wages are usually
fixed.
c. Sales commission is variable in relation to the volume or value of sales.

CHAPTER 4

$
Cost

106 | MANAGEMENT ACCOUNTING

d. Bonus payments for productivity to employees might be variable once a certain level of output is
achieved, as the following diagram illustrates.
Graph of variable cost (2)

$
Cost

nu

Bo

Volume of output

Up to output A, no bonus is earned.

3.4 NON-LINEAR OR CURVILINEAR VARIABLE COSTS


If the relationship between total variable cost and volume of output can be shown as a curved line on
a graph, the relationship is said to be curvilinear.
Two typical relationships are as follows:
a.

b.

$
Cost

$
Cost

Volume of output

Volume of output

Each extra unit of output in graph (a) causes a less than proportionate increase in cost whereas in
graph (b), each extra unit of output causes a more than proportionate increase in cost.
The cost of a piecework scheme for individual workers with differential rates could behave in a
curvilinear fashion if the rates increase by small amounts at progressively higher output levels.

3.5 SEMI-VARIABLE COSTS (OR MIXED COSTS)


A semi-variable/mixed cost is a cost which contains both fixed and variable components and so is
partly affected by changes in the level of activity.
Examples of these costs include the following:
a. Electricity and gas bills
i. Fixed cost = rental charge
ii. Variable cost = charge per unit of electricity used
b. Salesman's salary
i. Fixed cost = basic salary
ii. Variable cost = commission on sales made
c. Costs of running a car
i. Fixed cost = registration, insurance
ii. Variable costs = petrol, oil, repairs (which vary with km travelled)

COST BEHAVIOUR AND CVP ANALYSIS | 107

3.6 OTHER COST BEHAVIOUR PATTERNS


Other cost behaviour patterns may be appropriate to certain cost items. Examples of two other cost
behaviour patterns are shown below:
a.

Cost behaviour pattern (1)

b.

$
Cost

Cost behaviour pattern (2)


$
Cost

Maximum
cost
Minimum
charge

Volume of output

Volume of output

Graph (a) represents an item of cost which is variable with output up to a certain maximum level of
cost.
Graph (b) represents a cost which is variable with output, subject to a minimum (fixed) charge.

3.7 THE RELATIONSHIP BETWEEN TOTAL COSTS AND UNIT COSTS


The following example relates to different levels of production of a product zed. The variable cost of
producing a zed is $5. Fixed costs are $5 000.
1 zed
$
5
5
5 000
5 000
5 005
5 005

Total variable cost


Variable cost per unit
Total fixed cost
Fixed cost per unit
Total cost (fixed and variable)
Total cost per unit

10 zeds
$
50
5
5 000
500
5 050
505

50 zeds
$
250
5
5 000
100
5 250
105

What happens when activity levels rise can be summarised as follows:


The variable cost per unit remains constant
The fixed cost per unit falls
The total cost per unit falls
This may be illustrated graphically as follows:
Fixed cost
Cost per
unit
$

Number of units

Total cost
Cost per
unit
$

Number of units

Question 1: Fixed, variable and mixed costs


Are the following likely to be fixed, variable or mixed costs?
a. Telephone bill
b. Annual salary of the chief accountant
c. The company accountant's annual membership fee (paid by the company)
d. Cost of materials used to pack 20 units of product X into a box
e. Wages of warehouse employees
(The answer is at the end of the chapter)

CHAPTER 4

Variable cost
Cost per
unit
$

Number of units

108 | MANAGEMENT ACCOUNTING

3.8 ASSUMPTIONS ABOUT COST BEHAVIOUR


Assumptions about cost behaviour include the following.
a. Within the normal or relevant range of output (the range of activity over which a particular cost
behaviour pattern is assumed valid), costs are often assumed to be either fixed, variable or semivariable (mixed).
b. Departmental costs within an organisation are assumed to be mixed costs, with both a fixed and a
variable element.
c. Departmental costs are assumed to rise in a straight line as the volume of activity increases. In
other words, these costs are said to be linear.
The high-low method of determining fixed and variable elements of mixed costs relies on the
assumption that mixed costs are linear. We shall now go on to look at this method of cost
determination.

4 DETERMINING THE FIXED AND VARIABLE


ELEMENTS OF SEMI-VARIABLE COSTS
4.1 ANALYSING COSTS
Section overview
The fixed and variable elements of semi-variable costs can be determined by the high-low
method.
LO
4.2

It is generally assumed that costs are one of the following:


Variable
Semi-variable
Fixed
Cost accountants tend to separate semi-variable costs into their variable and fixed elements. They
therefore generally tend to treat costs as either fixed or variable.
There are several methods for identifying the fixed and variable elements of semi-variable costs (for
example regression analysis). Each method is only an estimate, and each will produce different results.
One of the principal methods is the high-low method.

4.2 HIGH-LOW METHOD


Follow the steps below to estimate the fixed and variable elements of semi-variable costs:

Step 1

Review records of costs in previous periods:


Select the period with the highest activity level.
Select the period with the lowest activity level.

Step 2

Determine the following:

Step 3

Total cost at high activity level.


Total costs at low activity level.
Total units at high activity level.
Total units at low activity level.

Calculate the following:

Total cost at high activity level _ total cost at low activity level
= variable cost per unit (v)
_
Total units at high activity level total units at low activity level

COST BEHAVIOUR AND CVP ANALYSIS | 109

Step 4

The fixed costs can be determined as follows:


(Total cost at high activity level ) (total units at high activity level variable cost per unit)

The following graph demonstrates the high-low method:


$
Total cost

Demonstration of high-low
method

st

tal co

d to
sume

As

Variable costs

Fixed costs (same at all


levels of output)
Low

High

Level of activity

a = Total cost at high activity level - Total cost at low activity level.
Note. As only two data points are used to estimate the cost behaviour, we have no assurance that it
accurately represents cost behaviour across or within the relevant range
Worked Example: The high-low method

DG Co has recorded the following total costs during the last five years:
Year

Output volume
Units
65 000
80 000
90 000
60 000
75 000

20X0
20X1
20X2
20X3
20X4

Total cost
$
145 000
162 000
170 000
140 000
160 000

Required

Calculate the total cost that should be expected in 20X5 if output is 85 000 units.
Solution

Step 1

Period with highest activity = 20X2

Step 2

Total cost at high activity level = 170 000


Total cost at low activity level = 140 000
Total units at high activity level = 90 000
Total units at low activity level = 60 000

Step 3

Step 4

Variable cost per unit


=

Total cost at high activity level _ total cost at low activity level
_
Total units at high activity level total units at low activity level

170 000 14 0000 30 000


= $1

90 000 60 000
30 000

Fixed costs = (total cost at high activity level) (total units at high activity level variable
cost per unit)
= 170 000 (90 000 $1) = 170 000 90 000 = $80 000

CHAPTER 4

Period with lowest activity = 20X3

110 | MANAGEMENT ACCOUNTING

Therefore the costs in 20X5 for output of 85 000 units are as follows:
$
85 000
80 000
165 000

Variable costs = 85 000 $1


Fixed costs

Worked Example: The high-low method with step-fixed costs

The following data relate to the overhead expenditure of contract cleaners (for industrial cleaning) at
two activity levels.
Square metres cleaned 12 750
Overheads
$73 950

15 100
$83 585

When more than 14 000 square metres are industrially cleaned, there will be a step up in fixed costs of
$4 700.
Required

Calculate the estimated total cost if 14 500 square metres are to be industrially cleaned.
Solution

Before we can compare high activity level costs with low activity level costs in the normal way, we must
eliminate the part of the high activity level costs that are due to the step up in fixed costs:
Total cost for 15 100 without step up in fixed costs = $83 585 $4 700 = $78 885
We can now proceed in the normal way using the revised cost above.
Units
15 100
12 750
2 350

High activity level


Low activity level

Variable cost

Total cost
Total cost

$
78 885
73 950
4 935

$4 935
2 350

= $2.10 per square metre


Before we can calculate the total cost for 14 500 square metres we need to find the fixed costs. As the
fixed costs for 14 500 square metres will include the step up of $4 700, we can use the activity level of
15 100 square metres for the fixed cost calculation:
Total cost (15 100 square metres) (this includes the step up in fixed costs)
Total variable costs (15 100 x $2.10)
Total fixed costs

$
83 585
31 710
51 875

Estimated overhead expenditure if 14 500 square metres are to be industrially cleaned:


Fixed costs
Variable costs (14 500 $2.10)

$
51 875
30 450
82 325

Worked Example: The high-low method with a change in the variable cost
per unit

Same data as the previous example.


Additionally, assume wage negotiations have just taken place which will cost an additional $1 per
square metre.
What is the revised estimated total cost of cleaning 14 500 square metres?

COST BEHAVIOUR AND CVP ANALYSIS | 111

Solution

Estimated overheads to clean 14 500 square metres.


Per square metre
$
2.10
1.00
3.10

Variable cost
Additional wages cost (variable)
Total variable cost

Cost for 14 500 square metres:


$
51 875
44 950
96 825

Fixed
Variable costs (14 500 $3.10)

Question 2: High-low method

The valuation department of a large firm of surveyors wishes to develop a method of predicting its
total costs in a period. The following costs have been previously recorded at two activity levels:
Number of valuations
(V)
420
515

Period 1
Period 2

Total cost
(TC)
82 200
90 275

The total cost model for a period could be represented as follows:


A TC = $42 000 + 95V
B TC = $46 500 + 85V
C TC = $46 500 85V
D TC = $51 500 95V
(The answer is at the end of the chapter)

5 CVP ANALYSIS AND BREAK-EVEN POINT

Section overview
Cost-volume-profit (CVP)/break-even analysis is the study of the interrelationships between
costs, volume and profit at various levels of activity.
LO
4.3

The management of an organisation usually wishes to know the profit likely to be made if the
budgeted/target production and sales for the year are achieved. Management may also be interested
to know:
a. The break-even point which is the activity level at which there is neither profit nor loss.
b. The amount by which actual sales can fall below anticipated sales, without a loss being incurred
(the safety margin).

CHAPTER 4

5.1 INTRODUCTION

112 | MANAGEMENT ACCOUNTING

5.2 BREAK-EVEN POINT


Formula to learn

Break-even point

Total fixed costs


Contribution required to break-even
=
Contribution per unit
Contribution per unit

= Number of units to be sold to break even

Please note, contribution per unit = sales price per unit variable cost per unit
Worked Example: Break-even point

Expected sales
Variable cost
Fixed costs

10 000 units at $8 = $80 000


$5 per unit
$21 000

Required

Compute the break-even point.


Solution

The contribution per unit (sales price - variable costs) is $(85)

= $3

Contribution required to break even

= fixed costs = $21 000

Break-even point (BEP)

= 21 000 3
= 7 000 units

In revenue, BEP

= (7 000 $8) = $56 000

Sales above $56 000 will result in profit of $3 per unit of additional sales and sales below $56 000 will
mean a loss of $3 per unit for each unit by which sales fall short of 7 000 units. In other words, profit
will improve or worsen by the amount of contribution per unit.

Revenue
Less variable costs
Contribution
Less fixed costs
Profit

7 000 units
$
56 000
35 000
21 000
21 000
0

7 001 units
$
56 008
35 005
21 003
21 000
3

6 THE CONTRIBUTION TO SALES (C/S) RATIO


Section overview
The C/S ratio (or Profit/Volume ratio) is a measure of how much contribution is earned from
each $1 of sales. It provides an alternative way of calculating the break-even point in terms
of sales revenue.
Formula to learn
Fixed costs
Contribution required to break-even
=
= Break-even point in terms of sales revenue
C / S ratio
C / S ratio

(The contribution/sales (C/S) ratio is also sometimes called a profit/volume or P/V ratio.)

COST BEHAVIOUR AND CVP ANALYSIS | 113

An alternative way of calculating the break-even point in terms of sales revenue.


In the example in Paragraph 5.2 the C/S ratio is
Break-even is where sales revenue equals

$3
= 37.5%
$8

$21 000
= $56 000
37.5%

At a price of $8 per unit, this represents 7 000 units of sales.


The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each $1 of
sales.
The C/S ratio of 37.5% in the above example means that for every $1 of sales, a contribution of 37.5c is
earned. Thus, in order to earn a total contribution of $21 000 (fixed costs) and if the contribution
increases by 37.5c per $1 of sales, sales must be:
$1
$21 000 = $56 000
37.5c
Worked Example: Break-even point

Assume the C/S ratio of product W is 20%. IB, the manufacturer of product W, wishes to make a
contribution of $50 000 towards fixed costs. How many units of product W must be sold if the selling
price is $10 per unit?
Solution

Required contribution
$50 000
=
= $250 000
C / S ratio
20%
Therefore the number of units = $250 000 $10 = 25 000

Worked Example: C/S ratio

A company manufactures a single product with a variable cost of $44. The contribution to sales ratio is
45%. Monthly fixed costs are $396 000. What is the break-even point in units?
Solution

Contribution per unit = $80 0.45


= $36
Break-even point

= Fixed costs/contribution per unit


= $396 000/$36
= 11 000 units

7 THE SAFETY MARGIN


Section overview
The safety margin is the difference in units between the budgeted sales volume and the
break-even sales volume. It is sometimes expressed as a percentage of the budgeted sales
volume. The safety margin may also be expressed in sales revenue rather than volume
terms.

CHAPTER 4

Contribution/sales ratio = 45%


Therefore Variable cost/sales ratio = 55%
Therefore sales price = $44/0.55 = $80

114 | MANAGEMENT ACCOUNTING

Worked Example: Safety margin

Mal de Mer makes and sells a product which has a variable cost of $30 and which sells for $40.
Budgeted fixed costs are $70 000 and budgeted sales are 8 000 units.
Calculate the break-even point and the safety margin.
Solution

a. Break-even point

Total fixed costs


$70 000
=
Contribution per unit
$(40 30)

= 7 000 units
b. Safety margin

= 8 000 7 000 units = 1 000 units

which may be expressed as

1000 units
100% = 12.5% of budget
8 000 units

c. The safety margin indicates to management that actual sales can fall short of budget by 1 000 units
or 12.5% before the break-even point is reached and no profit at all is made.

8 BREAK-EVEN CALCULATIONS AND PROFIT


TARGETS
Section overview
At the break-even point, sales revenue equals total costs and there is no profit. At the
break-even point total contribution = fixed costs.
The target profit is achieved when sales revenue equals total variable costs plus total fixed
costs, plus required profit.
Formula to learn

S=V+F
where
S = break-even sales revenue
V = total variable costs
F = total fixed costs
Subtracting V from each side of the equation, we get:
S V = F, that is, total contribution = fixed costs

Worked Example: Break-even calculation

Butterfingers makes a product which has a variable cost of $7 per unit.


If fixed costs are $63 000 per annum, calculate the selling price per unit if the company wishes to break
even with a sales volume of 12 000 units.
Solution

Fixed costs (F)

= $63 000

Total variable costs (V)

= 12 000 units $7
= $84 000

COST BEHAVIOUR AND CVP ANALYSIS | 115

A business will breakeven when total contribution (S V) = total fixed costs (F)
SV

=F

S $84 000

= $63 000

S
S

= $63 000 + $84 000

Breakeven sales revenue per unit

= $147 000 / 12 000 units

= $147 000
= $12.25 per unit

8.1 TARGET PROFITS


The target profit is achieved when S = V + F + P (where P= required profit). Therefore, the total
contribution required for a target profit = fixed costs + required profit
A similar formula may be applied where a company wishes to achieve a certain profit during a period.
To achieve this profit, sales must cover all costs and leave the required profit.
Formula to learn

The target profit is achieved when: S = V + F + P,


where

P = required profit

Subtracting V from each side of the equation, we get:


SV

= F + P, so

Total contribution required

=F+P

Worked Example: Target profit

Riding Breeches makes and sells a single product, for which variable costs are as follows:
$
10
8
6
24

Direct materials
Direct labour
Variable production overhead

The sales price is $30 per unit, and fixed costs per annum are $68 000. The company wishes to make a
profit of $16 000 per annum.
Solution

Required contribution = fixed costs + profit = $68 000 + $16 000 = $84 000
Required sales can be calculated in one of two ways:
(a)

Required contribution
Contribution per unit

$84 000
= 14 000 units, or $420 000 in revenue
$(30 24)

(b)

Required contribution
C / S ratio

$84 000
= $420 000 of revenue, or 14 000 units
20% *

* C/S ratio =

$30 $24
$6
=
= 0.2 = 20%
$30
$30

CHAPTER 4

Determine the sales required to achieve this profit.

116 | MANAGEMENT ACCOUNTING

Question 3: Target profit

Seven League Boots wishes to sell 14 000 units of its product, which has a variable cost of $15 to make
and sell. Fixed costs are $119 000 and the required profit is $70 000.
Required

What sales price per unit is required to achieve this target profit?
A
$13.50
B
$20.00
C
$23.50
D
$28.50
(The answer is at the end of the chapter)

8.2 DECISIONS TO CHANGE SALES PRICE OR COSTS


You may come across a problem in which you have to work out the effect of altering the selling price,
variable cost per unit or fixed cost. Such problems are slight variations on basic break-even
calculations.
Worked Example: Change in selling price

Stomer Cakes bake and sell a single type of cake. The variable cost of production is 15c and the
current sales price is 25c. Fixed costs are $2 600 per month, and the annual profit for the company at
current sales volume is $36 000. The volume of sales demand is constant throughout the year.
The sales manager, Ian Digestion, wishes to raise the sales price to 29c per cake, but considers that a
price rise will result in some loss of sales.
Ascertain the minimum volume of sales required each month to raise the price to 29c.
Solution

The minimum volume of sales which would justify a price of 29c is one which would leave total profit at
least the same as before, ie $3 000 per month. Required profit should be converted into required
contribution, as follows:
Monthly fixed costs
Monthly profit, minimum required
Current monthly contribution
Contribution per unit (25c 15c)
Current monthly sales

$
2 600
3 000
5 600
10c
56 000 cakes

The minimum volume of sales required after the price rise will be an amount which earns a
contribution of $5 600 per month. The contribution per cake at a sales price of 29c would be 14c.
Required sales =

$5 600
required contribution
= 40 000 cakes per month.
=
14c
contribution per unit

Worked Example: Change in production costs

Close Brickett makes a product which has a variable production cost of $8 and a variable sales cost of
$2 per unit. Fixed costs are $40 000 per annum, the sales price per unit is $18, and the current volume
of output and sales is 6 000 units.
The company is considering hiring an improved machine for production. Annual hire costs would be
$10 000 and it is expected that the variable cost of production would fall to $6 per unit.

COST BEHAVIOUR AND CVP ANALYSIS | 117

a. Determine the number of units that must be produced and sold to achieve the same profit as is
currently earned, if the machine is hired.
b. Calculate the annual profit with the machine if output and sales remain at 6 000 units per annum.
Solution

The current unit contribution is $(18 (8+2)) = $8


a.
$
48 000
40 000
8 000

Current contribution (6 000 $8)


Less current fixed costs
Current profit

With the new machine fixed costs will go up by $10 000 to $50 000 per annum. The variable cost
per unit will fall to $(6 + 2) = $8, and the contribution per unit will be $10.
$
8 000
50 000
58 000

Required profit (as currently earned)


Fixed costs
Required contribution
Contribution per unit
Sales required to earn $8 000 profit

$10
5 800 units

b. If sales are 6 000 units


$
Sales (6 000 $18)
Variable costs:
production (6 000 $6)
sales (6 000 $2)
Contribution (6 000 $10)
Less fixed costs
Profit

$
108 000

36 000
12 000
48 000
60 000
50 000
10 000

Alternative calculation
Profit at 5 800 units of sale (see (a))
Contribution from sale of extra 200 units ( $10)
Profit at 6 000 units of sale

$
8 000
2 000
10 000

Given no change in fixed costs, total profit is maximised when the total contribution is at its maximum.
Total contribution in turn depends on the unit contribution and on the sales volume.
An increase in the sales price will increase unit contribution, but sales volume is likely to fall because
fewer customers will be prepared to pay the higher price. A decrease in sales price will reduce the unit
contribution, but sales volume may increase because the goods on offer are now cheaper. The
optimum combination of sales price and sales volume is arguably the one which maximises total
contribution.
Worked Example: Profit maximisation

High Ladders has developed a new product which is about to be launched on to the market. The
variable cost of selling the product is $12 per unit. The marketing department has estimated that at a
sales price of $20, annual demand would be 10 000 units.
However, if the sales price is set above $20, sales demand would fall by 500 units for each 50c increase
above $20. Similarly, if the price is set below $20, demand would increase by 500 units for each 50c
stepped reduction in price below $20.
Determine the price which would maximise High Ladder's profit in the next year.

CHAPTER 4

8.3 SALES PRICE AND SALES VOLUME

118 | MANAGEMENT ACCOUNTING

Solution

At a sales price of $20 per unit, the unit contribution would be $(20 12) = $8. Each 50c increase (or
decrease) in price would raise (or lower) the unit contribution by 50c. The total contribution is
calculated at each sales price by multiplying the unit contribution by the expected sales volume.
Unit price
$
20.00

Unit contribution
$
8.00

Sales volume
units
10 000

7.50
7.00

10 500
11 000

Total contribution
$
80 000

a. Reduce price
19.50
19.00

78 750
77 000

b. Increase price
Unit price
$
20.50
21.00
21.50
22.00
22.50

Unit contribution
$
8.50
9.00
9.50
10.00
10.50

Sales volume
units
9 500
9 000
8 500
8 000
7 500

Total contribution
$
80 750
81 000
80 750
80 000
78 750

The total contribution would be maximised, and therefore profit maximised, at a sales price of $21 per
unit, and sales demand of 9 000 units.
Question 4: Break-even output level

Betty Battle manufactures a product which has a selling price of $20 and a variable cost of $10 per
unit. The company incurs annual fixed costs of $29 000. Annual sales demand is 9,000 units.
New production methods are under consideration, which would cause a $1 000 increase in fixed costs
and a reduction in variable cost to $9 per unit. The new production methods would result in a superior
product and would enable sales to be increased to 9 750 units per annum at a price of $21 each.
If the change in production methods were to take place, the break-even output level would be
A 100 units higher.
B 100 units lower.
C 400 units higher.
D 400 units lower.
(The answer is at the end of the chapter)

9 BREAK-EVEN CHARTS, CONTRIBUTION CHARTS


AND PROFIT/VOLUME CHARTS
9.1 BREAK-EVEN CHARTS
Section overview
The break-even point can also be determined graphically using a break-even chart or a
contribution break-even chart. These charts show approximate levels of profit or loss at
different sales volume levels within a limited range.
The profit/volume (P/V) chart is a variation of the break-even chart which illustrates the
relationship of costs and profits to sales and the safety margin. It shows clearly the effect on
profit and break-even point of any change in selling price, variable cost, fixed cost and/or
sales demand.

COST BEHAVIOUR AND CVP ANALYSIS | 119

A break-even chart has the following axes:


A horizontal axis showing the sales/output (in value or units)
A vertical axis showing $ for sales revenues and costs
The following lines are drawn on the break-even chart:
a. The sales line
i. Starts at the origin
ii. Ends at the point signifying expected sales
b. The fixed costs line
i. Runs parallel to the horizontal axis
ii. Meets the vertical axis at a point which represents total fixed costs
c. The total costs line
i. Starts where the fixed costs line meets the vertical axis
ii. Ends at the point which represents anticipated sales on the horizontal axis and total costs of
anticipated sales on the vertical axis
The break-even point is the intersection of the sales line and the total costs line.
The distance between the break-even point and the expected (or budgeted) sales, in units,
indicates the safety margin.
Worked Example: A break-even chart

The budgeted annual output of a factory is 120 000 units. The fixed overheads amount to $40 000 and
the variable costs are 50c per unit. The sales price is $1 per unit.
Construct a break-even chart showing the current break-even point and profit earned up to the
present maximum capacity.
Solution

We begin by calculating the profit at the budgeted annual output.


Sales (120 000 units)
Variable costs
Contribution
Fixed costs
Profit

$
120 000
60 000
60 000
40 000
20 000

Break-even chart (1) is shown on the following page.


The chart is drawn as follows:
a. The vertical axis represents money (costs and revenue) and the horizontal axis represents the level
of activity (production and sales).
b. The fixed costs are represented by a straight line parallel to the horizontal axis (in our example, at
$40 000).
c. The variable costs are added 'on top of' fixed costs, to give total costs. It is assumed that fixed
costs are the same in total and variable costs are the same per unit at all levels of output.
The line of costs is therefore a straight line and only two points need to be plotted and joined up.
Perhaps the two most convenient points to plot are total costs at zero output, and total costs at the
budgeted output.
At zero output, costs are equal to the amount of fixed costs only, $40 000, since there are no
variable costs.
At the budgeted output of 120 000 units, costs are $100,000.
Fixed costs
Variable costs 120 000 50c
Total costs

$
40 000
60 000
100 000

CHAPTER 4

LO
4.3

120 | MANAGEMENT ACCOUNTING

d. The sales line is also drawn by plotting two points and joining them up.
i. At zero sales, revenue is nil.
ii. At the budgeted output and sales of 120 000 units, revenue is $120 000.
-

$000

120

es

l
Sa

Budgeted profit

100
Break-even point
80

60

a
Tot

Budgeted variable costs

ts
cos
Fixed costs

40
Safety
margin

20

20

40

60

80

100

Budgeted fixed costs

120

Units

The break-even point is where total costs are matched exactly by total revenue. From the chart,
this can be seen to occur at output and sales of 80 000 units, when revenue and costs are both $80
000. This break-even point can be proved mathematically as:
$40 000
Required contribution (= fixed costs)
= 80 000 units
=
50c per unit
Contribution per unit
The safety margin can be seen on the chart as the difference between the budgeted level of activity
and the break-even level.

9.2 THE VALUE OF BREAK-EVEN CHARTS


Break-even charts are used as follows:
To plan the production of a company's products
To plan the marketing of a company's products
To give a visual display of break-even calculations
Worked Example: Variations in the use of break-even charts

Break-even charts can be used to show variations in the possible sales price, variable costs or fixed
costs. Suppose that a company sells a product which has a variable cost of $2 per unit. Fixed costs are
$15 000. It has been estimated that if the sales price is set at $4.40 per unit, the expected sales volume
would be 7 500 units; whereas if the sales price is lower, at $4 per unit, the expected sales volume
would be 10 000 units.
Draw a break-even chart to show the budgeted profit, the break-even point and the safety margin at
each of the possible sales prices.

COST BEHAVIOUR AND CVP ANALYSIS | 121

Solution
Workings
Sales price $4.40 per unit
$
15 000
15 000
(10 000 $2.00)
30 000

Fixed costs
Variable costs (7 500 $2.00)
Total costs
Budgeted revenue (7 500 $4.40)

33 000

Sales price $4 per unit


$
15 000
20 000
35 000

(10 000 $4.00)

40 000

Break-even chart (2)

$000

Profit

40

Revenue ($4.00)
Profit

35
Break-even point A

Total costs

Revenue ($4.40)

30
Break-even point B
25
20
Fixed costs

15
10
5

8
Safety
margin A

10

Units
(000s)

Safety
margin B

(check:

$15 000
Required contribution to break - even
= 6 250 units)
$2.40 per unit
Contribution per unit

The safety margin (A) is 7 500 units 6 250 units = 1 250 units or 16.7% of expected sales.
b. Break-even point B is the break-even point at a sales price of $4 per unit which is 7 500 units or
$30 000 in costs and revenues.
(check:

Required contribution to break - even $15 000


= 7 500 units)
$2 per unit
Contribution per unit

The safety margin (B) = 10 000 units 7 500 units = 2 500 units or 25% of expected sales.
Since a price of $4 per unit gives a higher expected profit and a wider safety margin, this price will
probably be preferred even though the break-even point is higher than at a sales price of $4.40 per
unit.

CHAPTER 4

a. Break-even point A is the break-even point at a sales price of $4.40 per unit, which is 6 250 units or
$27 500 in costs and revenues.

122 | MANAGEMENT ACCOUNTING

9.3 CONTRIBUTION (OR CONTRIBUTION BREAK-EVEN) CHARTS


As an alternative to drawing the fixed cost line first, it is possible to start with variable costs. This is
known as a contribution chart. An example is shown below using the data in Paragraph 9.2.

Contribution chart
$000
120
Profit

Break-even point

Contribution
Fixed
costs

80

al
Tot

ts

cos

ue

n
ve

40

e
sr

e
al

t
cos
ble

Safety
margin

ia
Var

Fixed
costs
0

40

80

120

Units

One of the advantages of the contribution chart is that is shows clearly the contribution for different
levels of production (indicated here at 120 000 units, the budgeted level of output) as the 'wedge'
shape between the sales revenue line and the variable costs line. At the break-even point, the
contribution equals fixed costs exactly. At levels of output above the break-even point, the
contribution is larger, and not only covers fixed costs, but also leaves a profit. Below the break-even
point, the loss is the amount by which contribution fails to cover fixed costs.

9.4 THE PROFIT/VOLUME (P/V) CHART


The profit/volume (P/V) chart is a variation of the break-even chart which illustrates the relationship of
costs and profits to sales and the safety margin.
A P/V chart is constructed as follows (look at the graph in the example that follows as you read the
explanation).
a. 'P' is on the y axis and actually comprises not only 'profit' but contribution to profit (in monetary
terms), extending above and below the x axis with a zero point at the intersection of the two axes,
and the negative section below the x axis representing fixed costs. This means that at zero
production, the company is incurring a loss equal to the fixed costs.
b. 'V' is on the x axis and comprises either volume of sales or value of sales (revenue).
c. The profit-volume line is a straight line drawn with its starting point (at zero production) at the
intercept on the y axis representing the level of fixed costs, and with a gradient of contribution/unit
(or the P/V ratio if sales value is used rather than units). The P/V line will cut the x axis at the breakeven point of sales volume. Any point on the P/V line above the x axis represents the profit to the
company (as measured on the vertical axis) for that particular level of sales.

COST BEHAVIOUR AND CVP ANALYSIS | 123

Worked Example: P/V chart

Let us draw a P/V chart for our example (Paragraph 9.1). At sales of 120 000 units, total contribution
will be
120 000 $(1 0.5) = $60 000 and total profit will be $20 000.
P/V chart (1)

Profit/loss
$000
20
PROFIT

Budgeted
profit
Sales volume
(units)

10
BREAK-EVEN

120,000
Break-even point

10
LOSS

Budgeted
contribution

Fixed
costs

20
30
40

9.5 THE ADVANTAGE OF THE P/V CHART


The P/V chart shows clearly the effect on profit and break-even point of any changes in selling
price, variable cost, fixed cost and/or sales demand.
If the budgeted selling price of the product in our example is increased to $1.20, with the result that
demand drops to 105 000 units despite additional fixed advertising costs of $10 000. At sales of
105 000 units, contribution will be 105 000 $(1.20 0.50) = $73 500 and total profit will be $23 500
(fixed costs being $50 000).
Profit/loss
$000
30

P/V chart (2)

20
PROFIT
10

Break-even point 2

Sales volume
000 (units)

BREAK-EVEN
10
LOSS 20
30
40 x
50 x

105
Break-even point 1

120

CHAPTER 4

124 | MANAGEMENT ACCOUNTING

The diagram shows that if the selling price is increased, the break-even point occurs at a lower level of
sales revenue (71 429 units instead of 80 000 units), although this is not a particularly large increase
when viewed in the context of the projected sales volume. It is also possible to see that for sales
above 50 000 units, the profit achieved will be higher (and the loss achieved lower) if the price is $1.20.
For sales volumes below 50 000 units the first option will yield lower losses.
The P/V chart is the clearest way of presenting such information; two conventional break-even charts
on one set of axes would be very confusing.
Changes in the variable cost per unit or in fixed costs at certain activity levels can also be easily
incorporated into a P/V chart. The profit or loss at each point where the cost structure changes should
be calculated and plotted on the graph so that the profit/volume line becomes a series of straight lines.
For example, suppose that in our example, at sales levels in excess of 120 000 units the variable cost
per unit increases to $0.60 (perhaps because of overtime premiums that are incurred when production
exceeds a certain level). At sales of 130 000 units, contribution would therefore be 130 000 $(1 0.60)
= $52 000 and total profit would be $12 000.
P/V chart (3)

Profit/loss
$000

20

PROFIT 10
Sales volume
000 (units)

Break-even point
BREAK-EVEN
120
10
Fixed
costs

LOSS 20
30
40

Question 5: Profit/volume chart

The profit/volume chart for a single product company is as follows:


Profit
($ 000)
140

500

Sales revenue ($ 000)

(60)

What is the product's contribution to sales ratio (expressed as a %)?


A 16%
B 28%
C 40%
D 72%
(The answer is at the end of the chapter)

130

COST BEHAVIOUR AND CVP ANALYSIS | 125

10 LIMITATIONS OF CVP ANALYSIS


Section overview
Break-even analysis is a useful technique for managers as it can provide simple and quick
estimates. Break-even charts provide a graphical representation of break-even calculations.
Break-even analysis does, however, have number of limitations.
The limitations of break-even analysis are described in the list that follows:
It can only apply to a single product or a group of products that are produced and sold in a fixed
mix. Firms generally do not produce a single product or products in a fixed mix.
A break-even chart may be time-consuming to prepare.
It assumes fixed costs are constant at all levels of output.
It assumes that variable costs are the same per unit at all levels of output.
It assumes that sales prices are constant at all levels of output.
It assumes production and sales are the same (inventory levels are ignored).

CHAPTER 4

It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.

126 | MANAGEMENT ACCOUNTING

KEY CHAPTER POINTS


Costs may be classified into fixed costs and variable costs. Many items of expenditure are partfixed and part-variable and are termed step-fixed or semi-variable costs.
Cost behaviour is the way in which costs are affected by changes in the levels of activity.
The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise. It will
cost more to produce 2 000 units of output than it will to produce 1 000 units.
A fixed cost is a cost which tends to be unaffected by increases or decreases in the levels of
activity.
A step-fixed cost is a cost which is fixed in nature but only within certain levels of activity.
A variable cost is a cost which tends to vary directly with the levels of activity.
The variable cost per unit is the same amount for each unit produced.
If the relationship between total variable cost and levels of activity can be shown as a curved line
on a graph, the relationship is said to be curvilinear.
A semi-variable (mixed) cost is a cost which contains both fixed and variable components and so is
partly affected by changes in the level of activity.
The fixed and variable elements of semi-variable costs can be determined by the high-low method.
Cost-volume-profit (CVP)/break-even analysis is the study of the interrelationships between costs,
volume and profits at various levels of activity.
Break-even point in terms of sales volume
Total fixed costs
Contribution required to break - even
=
Contribution per unit
Contribution per unit

Break-even point in terms of sales revenue


Fixed costs
Contribution required to break - even
=
C / S ratio
C / S ratio

The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each $1 of sales.
C/S ratio

= Total Contribution/Sales Revenue or


= Contribution per unit/Sales price per unit

The safety margin is the difference in units between the budgeted sales volume and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. The
safety margin may also be expressed in sales revenue terms.
At the break-even point, sales revenue = total costs and there is no profit. At the break-even point
total contribution = fixed costs.
The target profit is achieved when S = V + F + P. Therefore the total contribution required for a
target profit = fixed costs + required profit.
The break-even point can also be determined graphically using a break-even chart or a
contribution break-even chart. These charts show approximate levels of profit or loss at different
sales volume levels within a limited range.
The profit/volume (PV) chart is a variation of the break-even chart which illustrates the relationship
of costs and profits to sales and the safety margin.

COST BEHAVIOUR AND CVP ANALYSIS | 127

The P/V chart shows clearly the effect on profit and break-even point of any changes in selling
price, variable cost, fixed cost and/or sales demand.

CHAPTER 4

Break-even analysis is a useful technique for managers as it can provide simple and quick
estimates. Break-even charts provide a graphical representation of break-even calculations. Breakeven analysis does, however, have a number of limitations.

128 | MANAGEMENT ACCOUNTING

QUICK REVISION QUESTIONS


THE FOLLOWING INFORMATION RELATES TO QUESTIONS 1 TO 3
$

Level of activity

Level of activity
Graph 1
$

Graph 2
$

Level of activity
Graph 4

Level of activity
Graph 3
$

Level of activity
Graph 5

Level of activity
Graph 6

Which one of the above graphs illustrates the costs described in questions 1 to 3?

1 A linear variable cost when the vertical axis represents cost incurred.
A graph 1
B graph 2
C graph 4
D graph 5
2 A fixed cost when the vertical axis represents cost incurred.
A graph 1
B graph 2
C graph 3
D graph 6
3 A step fixed cost when the vertical axis represents cost incurred.
A graph 3
B graph 4
C graph 5
D graph 6
4 A company manufactures a single product. The total cost of making 4 000 units is $20 000 and the
total cost of making 20 000 units is $40 000. Within this range of activity the total fixed costs remain
unchanged.
What is the variable cost per unit of the product?
A
B
C
D

$0.80
$1.20
$1.25
$2.00

COST BEHAVIOUR AND CVP ANALYSIS | 129

5 A production worker is paid a salary of $650 per month, plus an extra 5 cents for each unit
produced during the month. This labour cost is best described as
A a fixed cost.
B a variable cost.
C a step-fixed cost.
D a semi-variable cost.
THE FOLLOWING DATA RELATES TO QUESTIONS 6 AND 7

Data concerning a company's single product is as follows:


Selling price
Variable production cost
Variable selling cost
Fixed production cost
Fixed selling cost

$ per unit
6.00
1.20
0.40
4.00
0.80

Budgeted production and sales for the year are 10 000 units.
6 What is the company's break-even point, to the nearest whole unit?
A
B
C
D

8 000 units
8 333 units
10 000 units
10 909 units

7 It is now expected that the variable production cost per unit and the selling price per unit will each
increase by 10%, and fixed production costs will rise by 25%.
What will be the new break-even point, to the nearest whole unit?
A
B
C
D

8 788 units
11 600 units
11 885 units
12 397 units

8 Which of the following statements about profit-volume graphs is/are correct?


I The profit-volume line starts at the origin.
II The profit-volume line crosses the x axis at the break-even point.

A
B
C
D

I and II only
I and III only
II and III only
I, II and III

9 A company's break-even point is 6 000 units per annum. The selling price is $90 per unit and the
variable cost is $40 per unit. What are the company's annual fixed costs?
A
B
C
D

$120
$240 000
$300 000
$540 000

10 A company makes a single product which it sells for $16 per unit. Fixed costs are $76 800 per
month and the product has a profit/volume ratio of 40%. In a period when actual sales were
$224 000, the company's safety margin, in units, was
A 2 000.
B 12 000.
C 14 000.
D 32 000
.

CHAPTER 4

III Any point on the profit-volume line above the x axis indicates the profit (as measured on the
vertical axis) at that level of activity.

130 | MANAGEMENT ACCOUNTING

ANSWERS TO QUICK REVISION QUESTIONS


1 B Graph 2 shows that costs increase in line with activity levels
2 A Graph 1 shows that fixed costs remain the same whatever the level of activity
3 A Graph 3 shows that the step fixed costs go up in 'steps' as the level of activity increases
4 C Using the high-low method:
Units

Cost
$
40 000
20 000
20 000

20 000
4 000
16 000

Variable cost per unit =

$20 000
= $1.25
16 000 units

5 D The salary is part fixed ($650 per month) and part variable (5 cents per unit). Therefore it is a
semi-variable cost and answer D is correct.
If you chose option A or option B you were considering only part of the cost.
Option C, a step cost, involves a cost which remains constant up to a certain level and then
increases to a new, higher, constant fixed cost.
6 D Breakeven point =
=

Fixed costs
Contributi on per unit

10000 ($4.00 0.80)


$48 000
=
= 10 909 units
$6.00 ($1.20 $0.40)
$4.40

If you selected option A you divided the fixed cost by the selling price, but the selling price
also has to cover the variable cost.
Option B ignores the selling costs, but these are costs that must be covered before the
breakeven point is reached.
Option C is the budgeted sales volume, which happens to be below the breakeven point.
7 C
New selling price ($6 1.1)
New variable cost ($1.20 1.1) + $0.40
Revised contribution per unit

$ per unit
6.60
1.72
4.88

New fixed costs ($40 000 1.25) + $8 000 = $58 000


Revised breakeven point =

$58 000
= 11 885 units
$4.88

If you selected option A you divided the fixed cost by the selling price, but the selling price
also has to cover the variable cost.
Option B fails to allow for the increase in variable production cost
Option D increases all of the costs by the percentages given, rather than the production costs
only.

COST BEHAVIOUR AND CVP ANALYSIS | 131

8 C Therefore the correct answer is C, statements II and III are correct.


Statement II is correct. The point where the profit-volume line crosses the x axis is the point of
zero profit and zero loss, ie the breakeven point.
Statement III is correct. The profit can be read from the y axis at any point beyond the
breakeven point.
Statement I is incorrect. The starting point of the profit-volume line is the point on the y axis
representing the loss at zero activity, which is the fixed cost incurred.
9 C Contribution per unit = $90 $40 = $50. The sale of 6 000 units just covers the annual fixed
costs, therefore the fixed costs must be $50 6 000 = $300 000.
If you selected option A you calculated the correct contribution of $50 per unit, but you then
divided the 6 000 by $50 instead of multiplying.
Option B is the total annual variable cost.
Option D is the annual revenue.
10 A Breakeven point =

Fixed costs
$76 800
= $192 000
=
P/V ratio
0.40

Actual sales =
Margin of safety in terms of sales value
selling price per unit
Margin of safety in units

$224 000
$32 000
$16
2 000

If you selected option B you calculated the breakeven point in units, but forgot to take the next
step to calculate the margin of safety.
Option C is the actual sales in units.

CHAPTER 4

Option D is the margin of safety in terms of sales value.

132 | MANAGEMENT ACCOUNTING

ANSWERS TO CHAPTER QUESTIONS


1 (a) mixed
(b) fixed
(c) fixed
(d) variable
(e) variable
2 B
Valuations
V
515
420
95

Period 2
Period 1
Change due to variable cost

Total cost
$
90 275
82 200
8 075

Variable cost per valuation = $8 075/95 = $85.


Period 2: fixed cost= $90 275 (515 $85) = $46 500
You should have managed to eliminate C and D as incorrect options straightaway. The variable
cost must be added to the fixed cost, rather than subtracted from it. Once you had calculated
the variable cost as $85 per valuation (as shown above), you should have been able to select
option A without going on to calculate the fixed cost (we have shown this calculation above for
completeness).
3 D
Required profit
Fixed costs
Required contribution

$
70 000
119 000
189 000

Required contribution per unit = $189 000/14 000 = $13.50


$
Required contribution per unit
Variable cost per unit
Required sales price per unit

13.50
15.00
28.50

4 D

Selling price
Variable costs
Contribution per unit

Current
$
20
10
10

Revised
$
21
9
12

Fixed costs
Break-even point (units)

$29 000
2 900

$30 000
2 500

Break-even point =

Total fixed costs


Contribution per unit

Current BEP =

$29 000
= 2 900 units
$10

Revised BEP =

$30 000
= 2 500 units
$10

Difference

400 lower

COST BEHAVIOUR AND CVP ANALYSIS | 133

5 C The profit/volume graph shows levels of profit at different levels of sales. In order to answer the
question, you must determine contribution for $500 000 sales revenue.
Remember that profit = contribution fixed costs.
When sales revenue = 0, contribution = 0 and the graph shows a loss of $60 000 at zero sales
revenue. This means that fixed costs must be $60 000.
Contribution at $500 000 sales revenue = $140 000 (profit) + $60 000 (fixed costs)
= $200 000

CHAPTER 4

Contribution to sales ratio = contribution/sales revenue = ($200 000/$500 000) = 0.4 or 40%

134 | MANAGEMENT ACCOUNTING

135

CHAPTER 5
OVERHEADS, ABSORPTION
AND MARGINAL COSTING
Learning objectives

Reference

Overhead costing product and service costing

LO5

Explain key methods of departmental overhead allocation

LO5.1

Explain the concepts underpinning product costing in organisations

LO5.2

Develop different product costing statements involving production resource costs

LO5.3

Evaluate the difference between direct production costs and indirect overhead costs

LO5.4

Apply the principles of absorption and variable costing to product costing analysis

LO5.5

Topic list

1
2
3
4
5
6
7
8
9
10

Cost classification
Overheads
Absorption costing: an introduction
Overhead allocation
Overhead apportionment
Overhead absorption
Blanket absorption rates and departmental absorption rates
Marginal cost and marginal costing
The principles of marginal costing
Marginal costing, absorption costing and the calculation of profit

136 | MANAGEMENT ACCOUNTING

INTRODUCTION
The classification of costs, as either direct or indirect for example, is essential to determine the cost of
a unit of product or service.
Absorption costing is a method of accounting for overheads. It is basically a method of sharing out
overheads incurred amongst units produced.
This chapter explains why absorption costing might be necessary and then provides an overview of
how the cost of a unit of product is built up under a system of absorption costing. A detailed analysis
of this costing method is then provided, covering the three stages of absorption costing: allocation,
apportionment and absorption.
This chapter concludes when it defines marginal costing and compares it with absorption costing.
Whereas absorption costing recognises fixed costs, usually fixed production costs, as part of the cost
of a unit of output and hence as product costs, marginal costing treats all fixed costs as period costs.
Two such different costing methods obviously each have their supporters and detractors so we will be
looking at the arguments both in favour of and against each method. Each costing method, because
of the different inventory valuation used, produces a different profit figure and we will be looking at
this particular point in detail.
The chapter content is summarised in the diagram below.

Overheads, absorption
and marginal costing

Cost
classification

Overhead
allocation

Overheads

Overhead
apportionment

Overhead
absorption

Blanket absorption rates and


departmental absorption rates

Marginal cost
and marginal
costing

Principles of
marginal costing

Marginal costing, absorption


costing and the calculation of profit

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 137

BEFORE YOU BEGIN


If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What is a direct cost?

(Section 1.2)

2 What is an indirect cost?

(Section 1.2)

3 What are direct wages?

(Section 1.2)
(Section 2)

5 What are the practical reasons for using absorption costing?

(Section 3.2)

6 What are the three stages of absorption costing?

(Section 3.4)

7 What are the steps involved in the calculation of overhead absorption rates?

(Section 6.2)

8 What is a marginal cost?

(Section 8)

9 What are the principles of marginal costing?

(Section 9)

CHAPTER 5

4 What is an overhead?

138 | MANAGEMENT ACCOUNTING

1 COST CLASSIFICATION
Section overview
Materials, labour costs and other expenses can be classified as either direct costs or
indirect costs.
Classification by function involves classifying costs as production/manufacturing costs,
administration costs or marketing and distribution costs.

1.1 TOTAL PRODUCT/SERVICE COSTS


LO
5.2

The total cost of making a product or providing a service consists of the following:
a. Cost of materials.
b. Cost of the wages and salaries (labour costs).
c. Cost of other expenses such as:
i. Rent and rates.
ii. Electricity and gas bills.
iii. Depreciation.

1.2 DIRECT COSTS AND INDIRECT COSTS


1.2.1 MATERIALS, LABOUR AND EXPENSES
Definitions
A direct cost is a cost that can be traced in full to the product, service, or department.
LO
5.4

An indirect cost, or overhead is a cost that is incurred in the course of making a product, providing a
service or running a department, but which cannot be traced directly and in full to the product, service
or department.

Materials, labour costs and other expenses can be classified as either direct costs or indirect costs.
a. Direct material costs are the costs of materials that are known to have been used in making a
product, or providing a service.
b. Direct labour costs are the specific costs of the labour used to make a product or provide a
service. Direct labour costs are established by measuring the time taken for a job, or the time taken
in 'direct production work'.
c. Other direct expenses are those expenses that have been incurred in full as a direct consequence
of making a product, or providing a service, or running a department.
Examples of indirect costs include supervisors' wages, cleaning materials and buildings insurance.

1.2.2 ANALYSIS OF TOTAL COST


Materials
+
Labour
+
Expenses
Total cost

=
=
=
=

Direct materials
+
Direct labour
+
Direct expenses
Direct cost

+
+
+
+

Indirect materials
+
Indirect labour
+
Indirect expenses
Overhead

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 139

1.2.3 DIRECT MATERIAL


Direct material is all material consumed in the manufacture of the product or the provision of the
service.
Direct material costs are charged to the product as part of the prime cost. Examples of direct material
are as follows:
Component parts, specially purchased for a particular job, order or process.
Part-finished work which for example is transferred from department 1 to department 2. It
becomes finished work of department 1 and a direct material cost in department 2.
Primary packing materials like cartons and boxes.

1.2.4 DIRECT LABOUR


Definition
Direct wages are all wages paid for labour, either as basic hours or as overtime, expended on work on
the product itself.

Direct wages costs are charged to the product as part of the prime cost. Prime costs are the total of
all direct costs.
Examples of groups of labour receiving payment as direct wages are as follows:
Workers engaged in altering the condition or composition of the product.
Inspectors, analysts and testers specifically required for such production.
Supervisors, shop clerks and anyone else whose wages are specifically identified as working on a
particular product.
As production becomes more capital intensive:
The ratio of direct labour costs to total product cost falls as the use of machinery increases, and
hence depreciation charges increase.
Skilled labour costs and sub-contractors' costs increase as direct labour costs decrease.
Question 1: Labour costs
Which of the following labour costs are normally treated as indirect labour costs?
I
II
III
IV
V

Overtime premium paid to direct workers


Bonus payments to direct workers
Payroll taxes
Idle time of direct workers
Work on installation of equipment

A I, II and IV only
B I, IV and V only
C II, III and IV only
D III, IV and V only
(The answer is at the end of the chapter)

1.2.5 DIRECT EXPENSES

Direct expenses are any expenses which are incurred on a specific product other than direct material
cost and direct labour.
Direct expenses are charged to the product as part of the prime cost. Examples of direct expenses
are as follows:
The hire of tools or equipment for a particular job.
Maintenance costs of tools, fixtures and so on.

CHAPTER 5

Definition

140 | MANAGEMENT ACCOUNTING

Direct expenses are also referred to as chargeable expenses.

1.2.6 PRODUCTION OVERHEAD


Definition
Production (or factory) overhead includes all indirect material costs, indirect wages and indirect
expenses incurred in the factory to facilitate the order completion.

Production overhead includes the following:


Indirect materials which cannot be traced to the finished product.
Consumable stores, e.g. material used in negligible amounts.
Indirect wages, meaning all wages not charged directly to a product.
Wages of personnel in the production department not directly involved in the manufacture of the
product, e.g. supervisors.
Indirect expenses, other than material and labour, not charged directly to production.
i. Rent, rates and insurance of a factory.
ii. Depreciation, fuel, power, maintenance of plant, machinery and buildings.

1.2.7 ADMINISTRATION OVERHEAD


Definition
Administration overhead is all indirect material costs, wages and expenses incurred in the direction,
control and administration of a business.

Examples of administration overhead are as follows:


Depreciation of office buildings and equipment.
Office salaries, including salaries of directors, support staff and accountants.
Lighting, cleaning and telephone charges.

1.2.8 MARKETING OVERHEAD


Definition
Marketing overhead is all indirect materials costs, wages and expenses incurred in promoting
products and services and retaining customers.

Examples of marketing overhead are as follows:


Printing and stationery, such as catalogues and price lists.
Salaries and commission of sales representatives and sales department staff.
Advertising and sales promotion, market research.
Rent, rates and insurance of sales offices and showrooms.

1.2.9 DISTRIBUTION OVERHEAD


Definition
Distribution overhead is all indirect material costs, wages and expenses incurred in making the
packed product ready for despatch and delivering it to the customer.

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 141

Examples of distribution overhead are as follows:


Cost of packing cases
Wages of packers, drivers and despatch clerks
Insurance charges, rent, rates
Question 2: Direct labour cost
A direct labour employee's wage in week 5 consists of the following:
a.
b.
c.
d.

Basic pay for normal hours worked, 36 hours at $4 per hour =


Pay at the basic rate for overtime, 6 hours at $4 per hour =
Overtime shift premium, with overtime paid at time-and-a-quarter
6 hours $4 per hour =
A bonus payment under a group bonus (or 'incentive') scheme bonus for the month =
Total gross wages in week 5 for 42 hours of work

$
144
24
6
30
204

What is the direct labour cost for this employee in week 5?


A $144
B $168
C $198
D $204
(The answer is at the end of the chapter)

1.3 FUNCTIONAL COSTS


1.3.1 CLASSIFICATION BY FUNCTION
Classification by function involves classifying costs as production/manufacturing costs, administration
costs or marketing and distribution costs.
In a 'traditional' costing system for a manufacturing organisation, costs are classified as follows:
a. Production or manufacturing costs. These are costs associated with the factory.
b. Administration costs. These are costs associated with general office departments.
c. Marketing and distribution costs. These are costs associated with sales, marketing, warehousing
and transport departments.
Classification in this way is known as classification by function. Expenses that do not fall fully into one
of these classifications might be categorised as general overheads or even listed as a classification on
their own, for example, research and development costs and financing costs.

1.3.2 FULL COST OF SALES


In costing a small product made by a manufacturing organisation, direct costs are usually restricted to
some of the production costs.
A commonly found build-up of costs is therefore as follows:
$
Production costs
Direct materials
Direct wages
Direct expenses
Prime cost
Production overheads
Full factory cost
Administration costs
Distribution costs
Full cost of sales

A
B
C
A+B+C
D
A+B+C+D
E
F
A+B+C+D+E+F

CHAPTER 5

LO
5.3

142 | MANAGEMENT ACCOUNTING

1.3.3 FUNCTIONAL COSTS


a. Production costs are the costs which are incurred by the sequence of operations beginning with
the supply of raw materials, and ending with the completion of the product ready for warehousing
as a finished goods item. Packaging costs are production costs where they relate to 'primary'
packing (boxes, wrappers and so on).
b. Administration costs are the costs of managing an organisation, but only insofar as such
administration costs are not related to the production, sales, distribution or research functions.
c. Marketing costs are the costs of creating demand for products and securing firm orders from
customers.
d. Distribution costs are the costs associated with the sequence of activities commencing with the
receipt of finished goods from the production department and making them ready for despatch.
e. Research costs are the costs of searching for new or improved products, whereas development
costs are the costs incurred between the decision to produce a new or improved product and the
commencement of full manufacture of the product.
f. Financing costs are costs incurred to finance the business, such as loan interest.
Question 3: Cost classification
Within the costing system of a manufacturing company the following types of expense are incurred:
Reference number
1. Cost of oils used to lubricate production machinery
2. Motor vehicle licences for trucks
3. Depreciation of factory plant and equipment
4. Cost of chemicals used in the laboratory
5. Commission paid to sales representatives
6. Salary of the secretary to the finance director
7. Trade discount given to customers
8. Holiday pay of machine operators
9. Salary of security guard in warehouse stocked with raw material
10. Fees to advertising agency
11. Rent of finished goods warehouse
12. Salary of scientist in laboratory
13. Insurance of the company's premises
14. Salary of supervisor working in the factory
15. Cost of toner cartridges for printers in the general office
16. Protective clothing for machine operators
Complete the following table by placing each expense in the correct cost classification.
COST CLASSIFICATION

REFERENCE NUMBER

Production costs
Marketing and distribution costs
Administration costs
Research and development costs

Each type of expense should appear only once in your response. You may use the reference numbers
in your response.
(The answer is at the end of the chapter)

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 143

2 OVERHEADS
Section overview
Overhead is the cost incurred in the course of making a product, providing a service or
running a department, but which cannot be traced directly and in full to the product,
service or department.
Overhead is actually the total of the following:
Indirect materials
Indirect labour
Indirect expenses
The total of these indirect costs is usually split into the following categories:
Production
Marketing and distribution
Administration
In cost accounting there are two schools of thought as to the correct method of dealing with
overheads:
Absorption costing
Marginal costing

3 ABSORPTION COSTING: AN INTRODUCTION


Section overview
The objective of absorption costing is to include in the total cost of a product an
appropriate share of the organisation's total overhead. An appropriate share is generally
taken to mean an amount which reflects the amount of time and effort that has gone into
producing a unit or completing a job.
LO
5.5

An organisation with one production department that produces identical units will divide the total
overheads among the total units produced. Absorption costing is a method for sharing overheads
between different products on a fair basis.

3.1 IS ABSORPTION COSTING NECESSARY?


Suppose that a company makes and sells 100 units of a product each week. The prime cost per unit is
$6 and the unit sales price is $10. Production overhead costs $200 per week and administration,
marketing and distribution overhead costs $150 per week.
The weekly profit could be calculated as follows:
$
Sales (100 units $10)

Profit

600
200
150
950
50

CHAPTER 5

Prime costs (100 $6)


Production overheads
Administration, marketing and distribution costs

$
1 000

144 | MANAGEMENT ACCOUNTING

In absorption costing, overhead costs will be added to each unit of product manufactured and
sold.
Prime cost per unit
Production overhead ($200 per week for 100 units)
Full factory cost

$ per unit
6
2
8

The weekly profit would be calculated as follows:


Sales
Less factory cost of sales
Gross profit
Less administration, marketing and distribution costs
Net profit

$
1 000
800
200
150
50

Sometimes, but not always, the overhead costs of administration, marketing and distribution are also
added to unit costs, to obtain a full cost of sales.
Prime cost per unit
Factory overhead cost per unit
Administration costs per unit ($150 per week for 100 units)
Full cost of sales

$ per unit
6.00
2.00
1.50
9.50

The weekly profit would be calculated as follows:


Sales
Less full cost of sales
Profit

$
1 000
950
50

It may already be apparent that the weekly profit is $50 no matter how the figures have been
presented.
So, how does absorption costing serve any useful purpose in accounting?
The theoretical justification for using absorption costing is that all production overheads are incurred
in the production of the organisation's output and so each unit of the product receives some benefit
from these costs. Each unit of output should therefore be charged with some of the overhead costs.

3.2 PRACTICAL REASONS FOR USING ABSORPTION COSTING


The main reasons for using absorption costing are for inventory valuations, pricing decisions, and
establishing the profitability of different products.
a. Inventory valuations. Inventory on hand must be valued for two reasons:
i. For the closing inventory figure in the statement of financial position
ii. For the cost of sales figure in the statement of comprehensive income
The valuation of inventory will affect profitability during a period because of the way in which the
cost of sales is calculated.
The cost of goods produced (extract)
+ the value of opening inventories
the value of closing inventories
= the cost of goods sold
In our example, (under Section 3.1), closing inventories might be valued at prime cost, $6, but in
absorption costing, they would be valued at a fully absorbed factory cost, $8 per unit. They would
not be valued at $9.50, the full cost of sales, because the only costs incurred in producing goods
for finished inventory are factory costs.
b. Pricing decisions. Many companies attempt to fix selling prices by calculating the full cost of
production or sales of each product, and then adding a margin for profit. In our example, the
company might have fixed a gross profit margin at 25% on factory cost, or 20% of the sales price, in
order to establish the unit sales price of $10. 'Full cost plus pricing' can be particularly useful for

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 145

companies which do contract work, where each job or contract is different, so that a standard unit
sales price cannot be fixed. Without using absorption costing, a full cost is difficult to ascertain.
c. Establishing the profitability of different products. This argument in favour of absorption costing
is more contentious. If a company sells more than one product, it will be difficult to judge how
profitable each individual product is, unless overhead costs are shared on a fair basis and charged
to the cost of sales of each product.

3.3 INTERNATIONAL ACCOUNTING STANDARD 2 (IAS 2)


Absorption costing is recommended in financial accounting by IAS 2 Inventories. IAS 2 deals with
financial accounting systems. The cost/management accountant is, in theory, free to value inventories
by whatever method seems best, but where companies integrate their financial accounting and cost
accounting systems into a single system of accounting records, the valuation of closing inventories will
be determined by IAS 2.
IAS 2 states that costs of all inventories should comprise those costs which have been incurred in the
normal course of business in bringing the inventories to their 'present location and condition'.
These costs incurred will include all related production overheads, even though these overheads may
accrue on a time basis. In other words, in financial accounting, closing inventories should be valued at
full factory cost, and it may therefore be convenient and appropriate to value inventories by the same
method in the cost accounting system.

3.4 ABSORPTION COSTING STAGES


The three stages of absorption costing are:
Allocation
Absorption
Apportionment
We shall now begin our study of absorption costing by looking at the process of overhead allocation.

4 OVERHEAD ALLOCATION
4.1 INTRODUCTION
Section overview
Allocation is the process by which whole cost items are charged direct to a product unit or
cost centre.
Cost centres may be one of the following types:
a. A production department, to which production overheads, such as the wages of factory
supervisor, are charged.
b. A service department, such as quality control or maintenance, to which overheads incurred in
providing that service are charged.
c. An administrative department, to which administration overheads are charged.
d. A marketing or a distribution department, to which marketing and distribution overheads are
charged.
e. An overhead cost centre, to which items of expense, such as rent and rates, heating and lighting,
which will ultimately be shared by a number of departments, are charged.

CHAPTER 5

LO
5.1

146 | MANAGEMENT ACCOUNTING

Where a cost is specifically attributable to a cost centre, it is allocated directly to the cost centre that
caused the cost to be incurred, for example:
Direct labour for the packing staff will be allocated to the packing department (production) cost
centre.
The cost of a warehouse security guard will be charged to the warehouse cost centre.
Paper (recording computer output) will be charged to the computer department.
Worked Example: Overhead allocation
Consider the following costs of a company.
Wages of the foreman of department A
Wages of the foreman of department B
Indirect materials consumed in department A
Rent of the premises shared by departments A and B

$200
$150
$50
$300

The cost accounting system might have the below three overhead cost centres.
Cost centre:

101
102
201

Department A
Department B
Rent

Solution
Overhead costs would be allocated directly to each cost centre, i.e. $200 + $50 to cost centre 101,
$150 to cost centre 102 and $300 to cost centre 201. The rent of the factory will be subsequently
shared between the two production departments, but for the purpose of day to day cost recording,
the rent will first of all be charged in full to a separate cost centre (201).

5 OVERHEAD APPORTIONMENT
Section overview
Apportionment is a procedure whereby indirect costs are spread fairly between cost
centres. Service cost centre costs may be apportioned to production cost centres by using
the reciprocal method.
The following data will be used to illustrate the overhead apportionment process.
Worked Example:
Cups Inc has two production departments (A and B) and two service departments (maintenance and
stores). Details of next year's budgeted overheads are shown below:
Total
$
19 200
9 600
54 000
38 400
9 000
25 000

Heat and light


Building repair costs
Machinery depreciation
Rent and rates
Cafeteria
Machinery insurance

Details of each department are as follows:


Floor area (m2)
Machinery book value ($ 000)
Number of employees
Allocated overheads ($ 000)

A
6 000
48
50
15

B
4 000
20
40
20

Maintenance
3 000
8
20
12

Stores
2 000
4
10
5

Total
15 000
80
120
52

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 147

Service departments' services were used as follows:


Maintenance hours worked
Number of stores requisitions

A
5 000
3 000

B
4 000
1 000

Maintenance
-------

Stores
1 000
----

Total
10 000
4 000

5.1 STAGE 1: APPORTION GENERAL OVERHEADS


Overhead apportionment follows on from overhead allocation. The first stage of overhead
apportionment is to identify all overhead costs as production department, production service
department, administration or marketing and distribution overhead. These costs may include
expenses such as heat and light, rent and rates and cafeteria, i.e. costs allocated to general overhead
cost centres, must therefore be shared out between the other cost centres.

5.1.1 BASES OF APPORTIONMENT


Overhead costs should be shared out on a fair basis. You will appreciate that because of the
complexity of items of cost it is rarely possible to use only one method of apportioning costs to the
various departments of an organisation. An example of some of the bases of apportionment for
common overhead expenses are given below:
OVERHEAD TO WHICH THE BASIS APPLIES

BASIS

Rent, rates, heating and lighting, repairs and


depreciation of buildings

Floor area occupied by each department (cost centre)

Depreciation of equipment, insurance of equipment

Cost or book value of equipment held by a particular


department/cost centre

Personnel costs, cafeteria costs, superannuation

Number of employees, or labour hours worked in each


cost centre

Note that heating and lighting may also be apportioned using volume of space occupied by each cost
centre.
Worked Example:
Using the Cups question above, show how overheads should be apportioned between the four
departments.
Solution
Item of cost

Heat and light


Building repair costs
Machine depn
Rent and rates
Cafeteria
Machine insurance
Total

Basis of apportionment

Floor area
Floor area
Book value of machinery
Floor area
No of employees
Book value of machinery

A
$
7 680
3 840
32 400
15 360
3 750
15 000
78 030

Department
B
Maintenance
$
$
5 120
3 840
2 560
1 920
13 500
5 400
10 240
7 680
3 000
1 500
6 250
2 500
40 670
22 840

Stores
$
2 560
1 280
2 700
5 120
750
1 250
13 660

Workings

Overhead apportioned to department =

Floor area occupied by department


total overhead
Total floor area

For example:
Heat and light apportioned to dept A =

6 000
19 200 = $7 680
15 000

CHAPTER 5

Overhead apportioned by floor area

148 | MANAGEMENT ACCOUNTING

Overheads apportioned by machinery value

Overheads apportioned to department

Value of department'smachinery
total overhead
Total value of machinery

Overheads apportioned by number of employees

Overheads apportioned to department

No of employees in department
total overhead
Total no of employees

Question 4: Apportionment

Match the following overheads with the most appropriate basis of apportionment.
OVERHEAD
Cafeteria costs
Heat and light costs
Insurance of computers
Depreciation of equipment

A
B
C
D

I
II
III
IV

BASIS OF APPORTIONMENT
Floor area
Number of employees
Book value of computers
Book value of equipment

(The answer is at the end of the chapter)

5.2 STAGE 2: APPORTION SERVICE DEPARTMENT COSTS


Only production departments produce goods that will ultimately be sold. In order to calculate a
correct price for these goods, we must determine the total cost of producing each unit that is, not
just the cost of the labour and materials that are directly used in production, but also the indirect
costs of services provided by such departments as maintenance and stores.
Our aim is to apportion all the service department costs to the production departments, in one of
three ways.
a. The direct method, where the service centre costs are apportioned to production departments
only.
b. The step-down method, where each service centre's costs are not only apportioned to production
departments but initially to some, but not all, of the other service centres that make use of the
services provided. The costs of the service centres are then apportioned to the production
departments.
c. The repeated distribution (or reciprocal) method, where service centre costs are apportioned to
both the production departments and service departments that use the services. The service
centre costs are then gradually apportioned to the production departments. This method is used
only when service departments work for each other that is, service departments use each
other's services. For example, the maintenance department will use the cafeteria, while the
cafeteria may rely on the maintenance department to ensure its equipment is functioning properly
or to replace bulbs, plugs, etc.
The difference between the step down and reciprocal method is that step-down only partially
recognises the relationships between service departments, whereas the reciprocal method
recognises these fully.

5.2.1 BASIS OF APPORTIONMENT


Whichever method is used to apportion service cost centre costs, the basis of apportionment must
be fair. A different apportionment basis may be applied for each service cost centre. This is
demonstrated in the following table:
SERVICE COST CENTRE

POSSIBLE BASIS OF APPORTIONMENT

Stores

Number or cost value of material requisitions

Maintenance

Hours of maintenance work done for each cost centre

Production planning

Direct labour hours worked in each production cost centre

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 149

Although both the direct and step-down methods are not in your syllabus, the following illustration
will give you an idea of how to carry out simple apportionments before we move onto the more
complex reciprocal method.
Worked Example: Simple apportionment using the step-down method

Using the information contained in the Cups Worked Example regarding allocated overheads (section
5) and the results of the overhead apportionment calculations in 5.2 above, apportion the
maintenance and stores departments' overheads to production departments A and B and calculate
the total overheads for each of these production departments.
Solution

1. Decide how the service departments' overheads will be apportioned. The table above tells us that
maintenance overheads can be apportioned according to the hours of maintenance work done,
while we can use the number or cost value of stores/material requisitions for apportioning stores.
The question gives us information about maintenance hours worked and the number of stores
requisitions.
2. Apportion the overheads of the service department whose services are also used by another
service department (in this case, maintenance). This allows us to obtain a total overhead cost for
stores.
Total overheads for maintenance department
$
22 840
12 000

General overheads
Allocated overheads

(see section 5.2 above)


(from information given in worked example
section 5 above)

34 840

Apportioned as follows:
Maintenance hours worked in department
$34 840
Total maintenance hours worked
Production department A =

5 000
$34 840 = $17 420
10 000

Production department B =

4 000
$34 840 = $13 936
10 000

Stores department =

1 000
$34 840 = $3 484
10 000

3. Apportion stores department's overheads.


Total overheads for stores
$
13 660
5 000

General overheads
Allocated overheads
Apportioned from maintenance

3 484
22 144

(see section 5.2 above)


(from information given in worked example
section 5 above)
(see above)

Apportioned as follows:

Production department A =

3 000
$22 144 = $16 608
4 000

Production department B =

1 000
$22 144 = $5 536
4 000

CHAPTER 5

Number of stores requisitions for department


$22 144
Total number of stores requisitions

150 | MANAGEMENT ACCOUNTING

4. Total overheads for each production department

General overheads
Allocated overheads
Maintenance
Stores

A
$
78 030
15 000

B
$
40 670
20 000

17 420
16 608
127 058

13 936
5 536
80 142

(see section 5.2 above)


(from information in worked
example section 5 above)

5.3 THE RECIPROCAL (REPEATED DISTRIBUTION) METHOD OF


APPORTIONMENT
Now that we have looked at the 'simple' scenario of only one service department making use of the
other service department's services, we can move onto the more complicated situation of 'reciprocal'
servicing. This is where each service department makes use of the other service department. In the
Cups example, stores services would use maintenance services and maintenance services would use
stores services.
Worked Example: using repeated distribution method

Assume the usage of Cups's service departments' services were amended to be as follows:
Maintenance hours used
Number of stores requisitions

A
5 000
3 000

B
4 000
1 000

Maintenance

1 000

Stores
1 000

Total
10 000
5 000

Show how the maintenance and stores departments' overheads would be apportioned to the two
production departments and calculate total overheads for each of the production departments.
Solution

Remember to apportion both the general and allocated overheads (see above). The bases of
apportionment for maintenance and stores are the same as for the example above, that is,
maintenance hours worked and number of stores requisitions.
A
$

B
$

Maintenance
$

Stores
$

Total overheads (general and


allocated)
Apportion maintenance (note (a))

93 030
17 420

60 670
13 936

Apportion stores (note (b))

13 286

4 429

2 215

1 772

332
126 283

110
80 917

34 840
(34 840)
NIL
4 429
4 429
(4 429)
NIL
NIL
NIL

18 660
3 484
22 144
(22 144)
NIL
442
442
(442)
NIL

Apportion maintenance (note (c))


Apportion stores (note (d))
Total overheads

Notes

a. It does not matter which department you choose to apportion first. Maintenance overheads were
apportioned using the calculations illustrated above.
b. Stores overheads are apportioned using the same formula as used above but with the amended
number of stores requisitions given above. For example A = 3 000/5 000 $22 144 = $ 13 286
c. Then the new figure for maintenance overheads is reapportioned. For example
A= 5 000/10 000 $4 429 = $2 215

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 151

d. The problem with the repeated distribution method is that you can keep performing the same
calculations many times. When you are dealing with a small number (such as $442 above) you can
take the decision to apportion the figure between the production departments only. In this case,
we ignore the stores requisitions for maintenance and base the apportionment on the total stores
requisitions for the production departments, that is, 4 000. The amount apportioned to production
department A was calculated as follows:
Stores requisitions for A
3 000
stores overheads =
$442 = $332
Total stores requisitions (A + B)
4 000

5.4 THE RECIPROCAL (ALGEBRAIC) METHOD OF APPORTIONMENT


The results of the reciprocal method of apportionment may also be obtained using algebra and
simultaneous equations.
Worked Example: Cups using the algebraic method of apportionment

Whenever you are using equations you must define each variable.
Let M = total overheads for the maintenance department
S = total overheads for the stores department
Remember that total overheads for the maintenance department consist of general overheads
apportioned, allocated overheads and the share of stores overheads (1 000/5 000 = 20%).
Similarly, total overheads for stores will be the total of general overheads apportioned, allocated
overheads and the 1 000/10 000 (10%) share of maintenance overheads.
M = 0.2S + $34 840
S = 0.1M + $18 660

1
2

($34 840 was calculated above)


($18 660 was calculated above)

We now solve the equations.


Multiply equation 1 by 5 to give us
5M = S + 174 200
S = 5M 174 200

3, which can be rearranged as


4

Subtract equation 2 from equation

S = 5M 174 200

S = 0.1M + 18 660

0 = 4.9M 192 860


4.9M = 192 860
M=

192 860
= $39 359
4.9

Substitute M = 39 359 into equation 2


S = 0.1 39 359 + 18 660
S = 3 936 + 18 660 = 22 596

Overhead costs
Apportion maintenance
Apportion stores
Total

A
$
93 030
19 680
13 558
126 268

B
$
60 670
15 743
4 519
80 932

Maintenance
$
34 840
(39 359)
4 519
Nil

Stores
$
18 660
3 936
(22 596)
Nil

You will notice that the total overheads for production departments A and B are the same regardless
of the method used (minor difference is due to rounding).

CHAPTER 5

These overheads can now be apportioned to the production departments using the proportions in
Section 5.2.1 above.

152 | MANAGEMENT ACCOUNTING

Question 5: Reapportionment

Sandstorm is a contracting engineering company which has three production departments (forming,
machines and assembly) and two service departments (maintenance and general).
The following analysis of overhead costs has been made for the year just ended.
$
Rent and rates
Power
Light, heat
Repairs, maintenance:
Forming
Machines
Assembly
Maintenance
General

$
8 000
750
5 000

800
1 800
300
200
100
3 200

Departmental expenses:
Forming
Machines
Assembly
Maintenance
General

1 500
2 300
1 100
900
1 500
7 300

Depreciation:
Plant
Fixtures and fittings
Insurance:
Plant
Buildings
Indirect labour:
Forming
Machines
Assembly
Maintenance
General

10 000
250
2 000
500
3 000
5 000
1 500
4 000
2 000
15 500
52 500

Other available data are as follows:

Forming
Machines
Assembly
Maintenance
General

Floor
area

Plant
value

sq. ft
2 000
4 000
3 000
500
500
10 000

$
25 000
60 000
7 500
7 500

100 000

Fixtures
& fittings
value
$

Effective
horsepower

1 000
500
2 000
1 000
500
5 000

40
90
15
5

150

Direct
Labour
cost for
Hours
year
Worked
$
20 500
14 400
30 300
20 500
24 200
20 200

75 000

Machine
hours
worked
12 000
21 600
2 000

55 100
35 600

Service department costs are apportioned as follows:

Forming
Machines
Assembly
General
Maintenance

Maintenance
%
20
50
20
10

100

General
%
20
60
10

10
100

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 153

Using the data provided prepare an analysis showing the distribution of overhead costs to
departments. Reapportion service cost centre costs (maintenance and general) using the repeated
reciprocal method.
(The answer is at the end of the chapter)

6 OVERHEAD ABSORPTION
Section overview
Overhead absorption is the process whereby overhead costs allocated and apportioned to
production cost centres are added to unit, job or batch costs. Overhead absorption is
sometimes called overhead recovery.

6.1 INTRODUCTION
Having allocated and/or apportioned all overheads, the next stage in the costing treatment of
overheads is to add them to, or absorb them into the cost of the product.
Overheads are usually added to the cost of the product using a predetermined overhead
absorption rate, which is calculated using figures from the budget.

6.2 CALCULATION OF OVERHEAD ABSORPTION RATES


Step 1
Step 2

Estimate the overhead likely to be incurred during the coming period.

Step 3

Divide the estimated overhead by the budgeted activity level. This produces the
overhead absorption rate.

Step 4

Absorb the overhead into the product cost by applying the calculated overhead
absorption rate.

Estimate the activity level for the period. This could be total labour hours, units, or direct
costs or whatever basis is to be used for the overhead absorption rates.

Worked Example: The basics of absorption costing

Athena Co makes two products, the Greek and the Roman. Greeks take 2 labour hours each to make
and Romans take 5 labour hours. Athena Co budgets its total overhead for the coming year at $50
000, and estimates that 100 000 labour hours will be worked. What is the overhead cost per unit for
Greeks and Romans respectively if overheads are absorbed on the basis of labour hours?
Solution

Step 1

Estimate the overhead likely to be incurred during the coming period.


Athena Co estimates that the total overhead will be $50 000.

Step 2

Estimate the activity level for the period.


Athena Co estimates that a total of 100 000 direct labour hours will be worked.
Divide the estimated overhead by the budgeted activity level.
Absorption rate =

$50 000
= $0.50 per direct labour hour
100 000hrs

CHAPTER 5

Step 3

154 | MANAGEMENT ACCOUNTING

Step 4

Absorb the overhead into the product cost by applying the calculated absorption rate.
Labour hours per unit
Absorption rate per labour hour
Overhead absorbed per unit

Greek
2
$0.50
$1

Roman
5
$0.50
$2.50

It should be obvious that, even if a company is trying to be 'fair', there is a great lack of precision
about the way the absorption base is chosen and overhead is absorbed.
This arbitrariness is one of the main criticisms of absorption costing. If absorption costing is to be
used, because of its other virtues, then it is important that the methods used are kept under regular
review where necessary. Changes in working conditions should lead to changes in the way in which
work is accounted for.
For example, a labour intensive department may become mechanised. If a direct labour hour rate of
absorption had been used prior to the mechanisation, it would probably now be more appropriate to
change to using a machine hour rate.

6.3 CHOOSING THE APPROPRIATE ABSORPTION BASE


Some bases of absorption, or 'overhead recovery rates', are as follows:
A percentage of direct materials cost.
A percentage of direct labour cost (note a).
A percentage of prime cost.
A rate per machine hour (note b).
A rate per direct labour hour.
A rate per unit of product (note c).
A percentage of factory cost - for administration overhead.
A percentage of sales or factory cost - for marketing and distribution overhead.

The choice of an absorption basis is a matter of judgment. What is required is an absorption basis
which realistically reflects the characteristics of a given cost centre and which avoids undue anomalies.
Many factories use a direct labour hour rate or machine hour rate in preference to a rate based on a
percentage of direct materials cost, wages or prime cost.
a. A direct labour hour basis is most appropriate in a labour intensive environment.
b. A machine hour rate would be used in departments where production is controlled or dictated by
machines.
c. A rate per unit of product would be effective only if all units were identical.
Worked Example: Bridge Cottage

The budgeted production overheads and other budget data of Bridge Cottage are as follows:
Budget
Overhead cost
Direct materials cost
Direct labour cost
Machine hours
Direct labour hours
Units of production

Production
dept A
$36 000
$32 000
$40 000
10 000
18 000

Production
dept B
$5 000

1 000

Calculate the absorption rate for Department A using the bases of apportionment below:
Percentage of direct materials cost.
Percentage of direct labour cost.
Percentage of prime cost.
Rate per machine hour.

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 155

Rate per direct labour hour.


Units of production

Calculate an absorption rate for Department B using units of output as the absorption rate.
Solution

Department A
i. Percentage of direct materials cost

$36 000
100% = 112.5%
$32 000

ii. Percentage of direct labour cost

$36 000
100% = 90%
$40 000

iii. Percentage of prime cost

$36 000
100% = 50%
$72 000

iv. Rate per machine hour

$36 000
= $3.60 per machine hour
10 000 hrs

v. Rate per direct labour hour

$36 000
= $2 per direct labour hour
18 000 hrs

The department B absorption rate based on units of output:


$5 000
= $5 per unit produced
1 000 units

6.4 BASES OF ABSORPTION


The choice of the basis of absorption is significant in determining the cost of individual units, or jobs,
produced. Using the previous example, suppose that an individual product has a material cost of $80,
a labour cost of $85, and requires 36 labour hours and 23 machine hours to complete. The overhead
cost of the product would vary, depending on the basis of absorption used by the company for
overhead recovery.
a. As a percentage of direct material cost, the overhead cost would be
112.5% $80

= $90.00

b. As a percentage of direct labour cost, the overhead cost would be


90% $85

= $76.50

c. As a percentage of prime cost, the overhead cost would be 50% $165


d. Using a machine hour basis of absorption, the overhead cost would be
23 hrs $3.60

= $82.50
= $82.80

CHAPTER 5

e. Using a labour hour basis, the overhead cost would be 36 hrs $2


= $72.00
In theory, each basis of absorption would be possible, but the company should choose a basis which
seems to it to be the 'fairest'.

156 | MANAGEMENT ACCOUNTING

7 BLANKET ABSORPTION RATES AND


DEPARTMENTAL ABSORPTION RATES
7.1 INTRODUCTION
Section overview
A blanket overhead absorption rate is a single absorption rate, that is used throughout a
factory.

For example, if total overheads were $500 000 and there were 250 000 direct machine hours during the
period, the blanket overhead rate would be $2 per direct machine hour and all jobs passing through
the factory would be charged at that rate.
Blanket overhead rates are not appropriate in the following circumstances:
Products or jobs pass through more than one department, and
products/jobs do not spend an equal amount of time in each department.
If a single factory overhead absorption rate is used, some products will receive a higher overhead
charge than they ought 'fairly' to bear, whereas other products will be under-charged.

If a separate absorption rate is used for each department, charging of overheads will be more fair
and the full cost of production of items will more closely represent the amount of the effort and
resources used to make them.
Worked Example: Stoakley

Stoakley Ltd has two production departments, for which the following budgeted information is
available:
Budgeted overheads
Budgeted direct labour hours

Department A
$360 000
200 000 hrs

Department B
$200 000
40 000 hrs

Total
$560 000
240 000 hrs

If a single factory overhead absorption rate is applied, the rate of overhead recovery would be:
$560 000
= $2.33 per direct labour hour
240 000 hours
If separate departmental rates are applied, these would be:
Department A =
Department B =

$360 000
= $1.80 per direct labour hour
200 000 hours
$200 000
= $5 per direct labour hour
40 000 hours

Jobs using Department B would get charged a higher overhead rate in terms of cost per hour worked
than department A.
Now let us consider two separate jobs.
Job X has a prime cost of $100, takes 30 hours in department B and does not involve any work in
department A.
Job Y has a prime cost of $100, takes 28 hours in department A and 2 hours in department B.
What would be the factory cost of each job, using the following rates of overhead recovery?
a. A single factory rate of overhead recovery
b. Separate departmental rates of overhead recovery

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 157

Solution
a. Single factory rate
Prime cost
Factory overhead (30 $2.33)
Factory cost

b. Separate departmental rates


Prime cost
Factory overhead:
department A
department B
Factory cost

(30 $5)

Job X
$
100.00
69.90

Job Y
$
100.00
69.90

169.90

169.90

$
100.00
0
150.00

$
100.00
50.40
10.00

(28 $1.80)
(2 $5)

250.00

160.40

Using a single factory overhead absorption rate, both jobs would cost the same. However, since job X
is done entirely within department B where overhead costs are higher, whereas job Y is done mostly
within department A, where overhead costs are lower, it is arguable that job X should cost more than
job Y. This will occur if separate departmental overhead recovery rates are used to reflect the work
done on each job in each department separately.
If all jobs do not spend approximately the same time in each department then, to ensure that all jobs
are charged with their fair share of overheads, it is necessary to establish separate overhead rates for
each department.

Question 6: Single factory rate

What is the problem with using a single factory overhead absorption rate?
(The answer is at the end of the chapter)

8 MARGINAL COST AND MARGINAL COSTING


Section overview
Marginal cost is the variable cost of one unit of product or service.

Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only
variable costs are charged as a cost of sale and a contribution is calculated (sales revenue minus
variable cost of sales). Closing inventories of work in progress or finished goods are valued at marginal
(variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the
statement of comprehensive income in the accounting period in which they are incurred.
The marginal production cost per unit of an item usually consists of the following:
Direct materials
Variable production overheads

Direct labour costs might be excluded from marginal costs when the work force is a given number of
employees on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a
variable cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you
should treat direct labour as a variable cost unless given clear indications to the contrary. Direct labour
is often a step-fixed cost, usually with sufficiently short steps to make labour costs act in a variable
fashion.

CHAPTER 5

Direct labour

158 | MANAGEMENT ACCOUNTING

The marginal cost of sales usually consists of the marginal cost of production adjusted for inventory
movements plus the variable marketing costs, which would include items such as sales commission,
and possibly some variable distribution costs.

8.1 CONTRIBUTION
Contribution is an important measure in marginal costing, and it is calculated as the difference
between sales price and marginal or variable cost of sales.
Contribution is of fundamental importance in marginal costing, and the term 'contribution' is really
short for 'contribution towards covering fixed overheads and making a profit'.

9 THE PRINCIPLES OF MARGINAL COSTING


Section overview
Period fixed costs are the same, for any volume of sales and production.

The principles of marginal costing are as follows:


a. Period fixed costs are the same, for any volume of sales and production (provided that the
level of activity is within the 'relevant range'). Therefore, by selling an extra item of product or
service the following will happen:
i. Revenue will increase by the sales value of the item sold.
ii. Costs will increase by the variable cost per unit.
iii. Profit will increase by the amount of contribution earned from the extra item.
b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution
earned from the item.
c. Profit measurement can be based on an analysis of total contribution. Since fixed costs relate
to a period of time, and do not change with increases or decreases in sales volume, it is misleading
to charge units of sale with a share of fixed costs. Absorption costing can therefore be misleading,
and it is more appropriate to deduct fixed costs from total contribution for the period to derive a
profit figure.
d. When a unit of product is made, the extra costs incurred in its manufacture are the variable
production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when
output is increased. Using marginal costing the valuation of closing inventories is the
variable production cost (direct materials, direct labour, direct expenses (if any) and variable
production overhead) because these are the only costs properly attributable to the product.
Worked Example: Marginal costing principles

Rain Until September Co makes a product, the Splash, which has a variable production cost of $6 per
unit and a sales price of $10 per unit. At the beginning of September 20X0, there were no opening
inventories and production during the month was 20 000 units. Fixed costs for the month were $45 000
(production, administration, sales and distribution). There were no variable marketing costs.
Calculate the contribution and profit for September 20X0, using marginal costing principles, if sales
were as follows:
a. 10 000 Splashes
b. 15 000 Splashes
c. 20 000 Splashes

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 159

Solution

The stages in the profit calculation are as follows:


To identify the variable cost of sales, and then the contribution.
Deduct fixed costs from the total contribution to derive the profit.
Value all closing inventories at (marginal) production cost ($6 per unit).

Sales (at $10)


Opening inventory
Variable production cost
Less value of closing
inventory (at marginal cost)
Variable cost of sales
Contribution
Less fixed costs
Profit/(loss)

10 000 Splashes
$
$
100 000
0
120 000
120 000
60 000

Profit (loss) per unit


Contribution per unit

15 000 Splashes
$
$
150 000
0
120 000
120 000

20 000 Splashes
$
$
200 000
0
120 000
120 000
0

30 000
60 000
40 000
45 000
(5 000)

90 000
60 000
45 000
15 000

120 000
80 000
45 000
35 000

$(0.50)

$1

$1.75

$4

$4

$4

The conclusions which may be drawn from this example are as follows:
a. The profit per unit varies at differing levels of sales, because the average fixed overhead cost per
unit changes with the volume of output and sales.
b. The contribution per unit is constant at all levels of output and sales. Total contribution, which is
the contribution per unit multiplied by the number of units sold, increases in direct proportion to
the volume of sales.
c. Since the contribution per unit does not change, the most effective way of calculating the
expected profit at any level of output and sales would be as follows:
i. First calculate the total contribution.
ii. Then deduct fixed costs as a period charge in order to find the profit.
d. In our example the expected profit from the sale of 17 000 Splashes would be as follows:
$
Total contribution (17 000 $4)
Less fixed costs
Profit

68 000
45 000
23 000

CHAPTER 5

i. If total contribution exceeds fixed costs, a profit is made.


ii. If total contribution exactly equals fixed costs, no profit or loss is made.
iii. If total contribution is less than fixed costs, there will be a loss.

160 | MANAGEMENT ACCOUNTING

Question 7: Mill Stream

Mill Stream makes two products, the Mill and the Stream. Information relating to each of these
products for April 20X1 is as follows:
Opening inventory
Production (units)
Sales (units)

Mill
Nil
15 000
10 000

Sales price per unit

$20

Unit costs
Direct materials
Direct labour
Variable production overhead
Variable sales overhead
Fixed costs for the month
Production costs
Administration costs
Sales and distribution costs

$
8
4
2
2

Stream
Nil
6 000
5 000
$30
$
14
2
1
3
$
40 000
15 000
25 000

Using marginal costing principles, what was the profit in April 20X1?
A $10 000
B $40 000
C $45 000
D $70 000
(The answer is at the end of the chapter)

9.1 PROFIT OR CONTRIBUTION INFORMATION


The main advantage of contribution information, rather than profit information, is that it allows an easy
calculation of profit if sales increase or decrease from a certain level. By comparing total contribution
with fixed overheads, it is possible to determine whether profits or losses will be made at certain sales
levels. Profit information, on the other hand, does not lend itself to easy manipulation but note how
easy it was to calculate profits using contribution information in the Worked Example Marginal costing
principles. Contribution information is also more useful for decision making than profit information.

10 MARGINAL COSTING, ABSORPTION COSTING


AND THE CALCULATION OF PROFIT
Section overview
In marginal costing, fixed production costs are treated as period costs and are written off as
they are incurred. In absorption costing, fixed production costs are absorbed into the cost
of units and are partially carried forward in inventory to be charged against sales for the
next period. Inventory values using absorption costing are greater than those calculated
using marginal costing.

Marginal costing as a cost accounting system is significantly different from absorption costing. It is an
alternative method of accounting for costs and profit, which rejects the principles of absorbing fixed
overheads into unit costs.

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 161

MARGINAL COSTING

ABSORPTION COSTING

Closing inventories are valued at marginal production


cost.

Closing inventories are valued at full production cost.

Fixed costs are period costs.

Fixed costs are absorbed into unit costs.

Cost of sales does not include a share of fixed


overheads.

Cost of sales does include a share of fixed overheads


(see note below).

Note. The share of fixed overheads included in cost of sales are from the previous period (in opening
inventory values). Some of the fixed overheads from the current period will be excluded by being
carried forward in closing inventory values.

In marginal costing, it is necessary to identify the following:


Variable costs.
Fixed costs.
Contribution.

In absorption costing (sometimes known as full costing), it is not necessary to distinguish variable
costs from fixed costs.
Worked Example: Marginal and absorption costing compared

This example will lead you through the various steps in calculating marginal and absorption costing
profits, and will highlight the differences between the two techniques.
Big Possum Ltd manufactures a single product, the Bark, details of which are as follows:
Per unit
Selling price
Direct materials
Direct labour
Variable overheads

$
180.00
40.00
16.00
10.00

Annual fixed production overheads are budgeted to be $1.6 million and Big Possum Ltd expects to
produce 1 280 000 units of the Bark each year. Overheads are absorbed on a per unit basis. Actual
overheads are $1.6 million for the year.
Budgeted fixed marketing costs are $320 000 per quarter.
Actual sales and production units for the first quarter of 20X8 are given below:
January March
240 000
280 000

Sales
Production

There is no opening inventory at the beginning of January.


Prepare a statement of comprehensive income for the quarter, using
a. Total cost per unit (marginal costing).
b. Total cost per unit (absorption costing).
Solution

Calculate the overhead absorption rate per unit.


Remember that overhead absorption rate is based only on budgeted figures.
Overhead absorption rate =

Budgeted fixed overheads


Budgeted units

Also be careful with your calculations. You are dealing with a three-month period but the
figures in the question are for a whole year. You will have to convert these to quarterly
figures.
Budgeted overheads (quarterly) =

$1.6 million
= $400 000
4

CHAPTER 5

Step 1

162 | MANAGEMENT ACCOUNTING

Budgeted production (quarterly) =

1280 000
= 320 000 units
4

Overhead absorption rate per unit =

Step 2

$400 000
= $1.25 per unit
320 000

Calculate total cost per unit.


Total cost per unit (marginal costing) = Variable cost per unit
= (40 + 16 + 10) = $66
Total cost per unit (absorption costing)

Step 3

= Variable cost + fixed production cost


= $66 + 1.25
= $67.25

Calculate closing inventory in units.


Closing inventory = Opening inventory + production sales
Closing inventory = 0 + 280 000 240 000 = 40 000 units

Step 4

Calculate under/over absorption of overheads.


This is based on the difference between actual production and budgeted production.
Actual production = 280 000 units
Budgeted production = 320 000 units (see step 1 above)
Under-production = 40 000 units
As Big Possum Ltd produced 40 000 fewer units than expected, there will be an underabsorption of overheads of 40 000 x $1.25 (see step 1 above) = $50 000. This will be
added to production costs in the statement of comprehensive income.

Step 5

Produce statements of comprehensive income.

Sales (240 000 x $180)


Less Cost of sales
Opening inventory
Add Production cost
280 000 x $66
280 000 x $67.25
Less Closing inventory
40 000 x $66
40 000 x $67.25

Marginal costing
$ 000
$ 000
43 200
0

18 480
18 830
(2 640)
(2 690)
16 140
50

Add Under absorbed O/H


(15 840)
27 360

Contribution
Gross profit
Less
Fixed production O/H
Fixed marketing O/H
Net profit

Absorption costing
$ 000
$ 000
43 200

(16 190)
27 010

400
320

Nil
320
(720)
26 640

(320)
26 690

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 163

Question 8: Marginal and absorption

A company makes a single product. Its budgeted data for a period is as follows.
Opening inventory
Variable production cost per unit of opening
inventory
Production
Sales
Variable production cost per unit produced in
the period
Variable selling cost per unit
Sales price per unit
Production fixed costs
Other fixed overhead costs

3 000 units
$6
16 000 units
17 000 units
$7
$1
$20
$80 000
$60 000

The company uses marginal costing, but is considering whether to use absorption costing instead. If
absorption costing were to be used, the fixed production overhead in the opening inventory would
have been $4 per unit. Inventory is valued using the FIFO (first in, first out) method.
a. Using marginal costing principles, what is the budgeted profit for the period?
A
B
C
D

$55 000
$64 000
$67 000
$69 000

b. If absorption costing were to be used instead of marginal costing, by how much would the
reported profit for the period be higher or lower?

CHAPTER 5

A $2 000 lower
B $2 000 higher
C $10 000 lower
D $10 000 higher
(The answer is at the end of the chapter)

164 | MANAGEMENT ACCOUNTING

KEY CHAPTER POINTS


Materials, labour costs and other expenses can be classified as either direct costs or indirect costs.
Classification by function involves classifying costs as production/manufacturing costs,
administration costs or marketing and distribution costs.
Overhead is the cost incurred in the course of making a product, providing a service or running a
department, but which cannot be traced directly and in full to the product, service or department.
The objective of absorption costing is to include in the total cost of a product an appropriate share
of the organisation's total overhead. An appropriate share is generally taken to mean an amount
which reflects the amount of time and effort that has gone into producing a unit or completing a
job.
Allocation is the process by which whole cost items are charged direct to a product's cost.
Apportionment is a procedure whereby indirect costs are spread fairly between cost centres.
Service cost centre costs may be apportioned to production cost centres by using the reciprocal
method.
Overhead absorption is the process whereby overhead costs allocated and apportioned to
production cost centres are added to unit, job or batch costs. Overhead absorption is sometimes
called overhead recovery.
A blanket overhead absorption rate is an absorption rate used throughout a factory and for all jobs
and units of output irrespective of the department in which they were produced.
Marginal cost is the variable cost of one unit of product or service.
Period fixed costs are the same, for any volume of sales and production.
In marginal costing, fixed production costs are treated as period costs and are written off as they
are incurred. In absorption costing, fixed production costs are absorbed into the cost of units and
are partially carried forward in inventory to be charged against sales for the next period. Inventory
values using absorption costing are therefore greater than those calculated using marginal costing.

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 165

QUICK REVISION QUESTIONS


1 A company has to pay a 20c per unit royalty to the inventor of a device which it manufactures and
sells.
The royalty charge would be classified in the company's accounts as a/an
A
B
C
D

direct expense.
marketing expense.
production overhead.
administrative overhead.

2 Which of the following would be classed as indirect labour?


A A stores assistant in a factory store
B Plasterers in a construction company
C Assembly workers in a company manufacturing televisions
D Employees responsible for packaging the product at the end of the production line
3 A manufacturing company is very busy and overtime is being worked.
The amount of overtime premium contained in direct wages would normally be classed as
A
B
C
D

part of prime cost.


factory overheads.
direct labour costs.
administrative overheads.

4 The following extract of information is available concerning the four cost centres of EG Limited.

Number of direct employees


Number of indirect employees
Overhead allocated and apportioned

Production cost centres


Machinery
Finishing
Packing
7
6
2
3
2
1
$28 500
$18 300
$8 960

Service cost
centre
Cafeteria

4
$8 400

The overhead cost of the cafeteria is to be re-apportioned to the production cost centres on the
basis of the number of employees in each production cost centre. After the re-apportionment, the
total overhead cost of the packing department, to the nearest $, will be
$1 200.
$9 968.
$10 080.
$10 160.

CHAPTER 5

A
B
C
D

166 | MANAGEMENT ACCOUNTING

THE FOLLOWING INFORMATION RELATES TO QUESTIONS 5 AND 6

Budgeted information relating to two departments in a company for the next period is as follows:
Department
1
2

Production
overhead
$
27 000
18 000

Direct
material cost
$
67 500
36 000

Direct
labour cost
$
13 500
100 000

Direct
Labour hours
2 700
25 000

Machine
hours
45 000
300

Individual direct labour employees within each department earn differing rates of pay, according to
their skills, grade and experience.
5 What is the most appropriate production overhead absorption rate for department 1?
A $0.60 per machine hour
B $10 per direct labour hour
C 40% of direct material cost
D 200% of direct labour cost
6 What is the most appropriate production overhead absorption rate for department 2?
A $0.72 per direct labour hour
B 18% of direct labour cost
C 50% of direct material cost
D $60 per machine hour

7 Which of the following statements about predetermined overhead absorption rates are true?
I Using a predetermined absorption rate offers the administrative convenience of being able to
record full production costs sooner.
II Using a predetermined absorption rate avoids fluctuations in unit costs caused by abnormally
high or low overhead expenditure or activity levels.
III Using a predetermined absorption rate avoids problems of under/over absorption of overheads
because a constant overhead rate is available.
A
B
C
D

I, II and III
I and II only
I and III only
II and III only

8 A direct labour hour basis is most appropriate in which of the following environments?
A Labour-intensive
B Machine-intensive
C When all units produced are identical
D When there are several production departments

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 167

ANSWERS TO QUICK REVISION QUESTIONS


1 A The royalty cost can be traced in full to the product, i.e. it has been incurred as a direct
consequence of making the product. It is therefore a direct expense. Options B, C and D are
all overheads or indirect costs which cannot be traced directly and in full to the product.
2 A The wages paid to the stores assistant cannot be traced in full to a product or service, therefore
this is an indirect labour cost.
The wages paid to plasterers in a construction company can be traced in full to the contract or
building they are working on (option B). This is also a direct labour cost. The assembly workers'
wages can be traced in full to the televisions manufactured (option C), therefore this is a direct
labour cost. The same is true of the packaging employees (option D).
3 B Overtime premium is always classed as factory overheads unless it is:
worked at the specific request of a customer to get the order completed.
worked regularly by a production department in the normal course of operations, in which
case it is usually incorporated into the direct labour hourly rate.

4 D Number of employees in packing department = 2 direct + 1 indirect = 3


Number of employees in all production departments = 15 direct + 6 indirect = 21
Packing department overhead
Cafeteria cost apportioned to packing department

Original overhead allocated and apportioned


Total overhead after apportionment of cafeteria costs

=
=
=

$8 400
3
21
$1 200
$8 960
$10 160

If you selected option A you forgot to include the original overhead allocated and apportioned
to the packing department.
If you selected option B you included the four cafeteria employees in your calculation, but the
question states that the basis for apportionment is the number of employees in each
production cost centre. If you selected option C you based your calculations on the direct
employees only.
5 A Department 1 appears to undertake primarily machine-based work, therefore a machine-hour
rate would be most appropriate.
$27 000
= $0.60 per machine hour
45 000

Therefore the correct answer is A.


Option C is not the most appropriate because it is not time-based, and most items of overhead
expenditure tend to increase with time.
Options B and D are not the most appropriate because labour activity is relatively insignificant
in department 1, compared with machine activity.

$18 000
= $0.72 per direct labour hour
25 000
Option B is based on labour therefore it could be suitable. However differential wage rates
exist and this could lead to inequitable overhead absorption.
Option C is not the most appropriate because it is not time-based.
Option D is not suitable because machine activity is not significant in department 2.

CHAPTER 5

6 A Department 2 appears to be labour-intensive therefore a direct labour-hour rate would be most


appropriate.

168 | MANAGEMENT ACCOUNTING

7 B Statement (I) is correct because a constant unit absorption rate is used throughout the period.
Statement (II) is correct because 'actual' overhead costs, based on actual overhead
expenditure and actual activity for the period, cannot be determined until after the end of the
period. Statement (III) is incorrect because under/over absorption of overheads is caused by
the use of predetermined overhead absorption rates.
8 A A direct labour hour absorption rate is most appropriate for labour-intensive work when output
consists of non-standard units.

OVERHEADS, ABSORPTION AND MARGINAL COSTING | 169

ANSWERS TO CHAPTER QUESTIONS


1 A The cost of overtime premiums paid to direct workers is treated as an indirect labour cost
unless the overtime is worked specifically at the request of a customer, in which case the
overtime premium becomes a direct cost of the job. Bonus payments to direct workers may be
paid annually, and are normally treated as an indirect cost. The cost of idle time is also an
indirect labour cost. Payroll taxes are part of the total cost of employing either direct or indirect
workers, however they do not normally feature in management accounting analysis and are
therefore not a relevant issue for management accounting purposes. The labour cost of work to
install capital equipment is normally included in the cost of the capital asset.
2 B The correct answer is B because the basic rate for overtime is a part of direct wages cost. It is
only the overtime premium that is usually regarded as an overhead or indirect cost.
3
COST CLASSIFICATION

REFERENCE NUMBER

Production costs

14

Marketing and distribution costs

10

11

Administration costs

13

15

Research and development costs

12

Maint.
$

General
$

Total
$

4 D IV

A II

BI

16

C III

5 Analysis of distribution of actual overhead costs


Basis
Directly allocated overheads:
Repairs, maintenance
Departmental expenses
Indirect labour
Apportionment of other
overheads:
Rent, rates
Power
Light, heat
Depreciation of plant
Depreciation of F and F
Insurance of plant
Insurance of buildings

1
2
1
3
4
3
1

Forming Machines
$
$

Ass
$

800
1 500
3 000

1 800
2 300
5 000

300
1 100
1 500

200
900
4 000

100
1 500
2 000

3 200
7 300
15 500

1 600
200
1 000
2 500
50
500
100
11 250

3 200
450
2 000
6 000
25
1 200
200
22 175

2 400
75
1 500
750
100
150
150
8 025

400
25
250
750
50
150
25
6 750

400
0
250
0
25
0
25
4 300

8 000
750
5 000
10 000
250
2 000
500
52 500

Basis of apportionment:
1 floor area
2 effective horsepower

3 plant value
4 fixtures and fittings value

Overheads

Forming
$
11 250
1 350

Machines
$
22 175
3 375

Assembly
$
8 025
1 350

995
99
10
1
13 705

2 985
249
30
3
28 817

498
99
5
1
9 978

Maintenance
$
6 750
(6 750)
497
(497)
5
(5)
0

General
$
4 300
675
4 975
(4 975)
50
(50)

Total
$
52 500

52 500

CHAPTER 5

Apportionment of service department overheads to production departments, using the repeated


reciprocal method.

170 | MANAGEMENT ACCOUNTING

6 The problem with using a single factory overhead absorption rate is that some products will receive
a higher overhead charge than they ought 'fairly' to bear and other products will be undercharged.
7 A
$
Contribution from Mills (unit contribution = $20 $16 = $4 10 000)
Contribution from Streams (unit contribution = $30 $20 = $10 5 000)
Total contribution
Fixed costs for the period
Profit

40 000
50 000
90 000
80 000
10 000

8 (a) C
$
18 000
112 000

Opening inventory (3 000 $6)


Variable production costs (16 000 $7)

130 000
(14 000)

Closing inventory (2 000 $7)


Variable production cost of sales

116 000
17 000

Variable selling costs (17 000 $1)


Total variable costs

133 000
340 000

Sales (17 000 $20)


Contribution
Fixed costs (80 000 + 60 000)
Profit

207 000
(140 000)
67 000

(b) A Absorption costing: fixed production cost per unit in the period $80 000/16 000 = $5.
Therefore value of closing inventory (per unit) = $7 + $5 = $12.

Opening inventory (3 000 $6)


Closing inventory (2 000 $7)
Reduction in inventory

Marginal
costing

Absorption
costing

$
18 000
14 000

$
30 000
24 000

4 000

(3 000 $10)
(2 000 $12)

6 000

The reduction in inventory is an addition to the cost of sales in the period; therefore with
absorption costing the cost of sales in the period would be $2 000 higher, and reported
profit $2 000 lower.

171

CHAPTER 6
OVERHEAD COSTING
ACTIVITY BASED COSTING
Learning objectives

Reference

Overhead costing activity-based costing

LO6

Identify and apply the principles of activity-based costing to allocate overheads in


organisations

LO6.1

Topic list

1
2
3
4
5
6

The reasons for the development of ABC


Outline of an ABC system
Absorption costing versus ABC
Marginal costing versus ABC
Introducing an ABC system into an organisation
Advantages and disadvantages of ABC

172 | MANAGEMENT ACCOUNTING

INTRODUCTION
In this chapter we look at a costing system that has been developed to suit modern practices: activity
based costing.
Basically, activity based costing (ABC) is the modern alternative to traditional absorption costing.
The chapter content is summarised in the diagram below.

Overhead costing
activity based
costing

Reasons for
development

Introducing
ABC

Absorption costing
versus ABC

Outline of
ABC system

Merits and
criticisms

Marginal costing
versus ABC

OVERHEAD COSTING ACTIVITY BASED COSTING | 173

If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What are the reasons for the development of ABC?
2 Define ABC.
3 Explain the concept of cost drivers.

(Section 1)
(Section 2.1)
(Sections 2.2, 3.2)

4 When should an ABC system be introduced?

(Section 5.1)

5 What are product-sustaining activities?

(Section 5.2)

6 What are facility-sustaining activities?

(Section 5.2)

7 List the advantages of ABC.

(Section 6.1)

8 Define customer profitability analysis.

(Section 6.1)

9 List the disadvantages of ABC.

(Section 6.2)

CHAPTER 6

BEFORE YOU BEGIN

174 | MANAGEMENT ACCOUNTING

1 THE REASONS FOR THE DEVELOPMENT OF ABC


Section overview
Traditional costing systems assume that all products consume all resources in proportion to
their production volumes. The use of a predetermined overhead absorption rate tends to
allocate too great a proportion of overheads to high volume products, which use relatively
fewer support services, and too small a proportion of overheads to low volume products,
which use relatively more support services. Activity based costing (ABC) attempts to
overcome this problem by identifying core activities involved in the production of a product
and charging overheads on the basis of each product's consumption of those
activities/support services, rather than based on volume of production.
LO
6.1

The traditional system of absorption costing was developed when cost accounting systems were
used mainly for manufacturing organisations that produced only a narrow range of products and
when overhead costs were only a very small fraction of total costs. Direct labour and direct
material costs accounted for the largest proportion of the costs. Production overhead costs were not
too significant, and were usually considered to be 'driven' by direct labour hours worked. Similarly
selling and distribution costs were relatively small, and were considered to be 'driven' by the volume
of sales activity.
Nowadays, however, with the advent of advanced manufacturing technology (AMT), production
overheads are a much more significant proportion of total production costs. Direct labour costs in
a highly automated production system may account for as little as 5% of a product's cost. There are
now many different ways of delivering products to different types of customer, and selling and
distribution costs depend on factors such as the channel of distribution used and the type of customer,
not just on sales volumes.
It may therefore now be difficult to justify the use of direct labour or direct production cost as the
basis for absorbing production overheads.
Many resources are used in support activities that are not directly related to production (or selling)
volume. The increase in costs of non-volume-related activities is due to AMT: they include costs
relating to setting-up production runs, production scheduling, customer order handling, inspection
and data processing. These support activities assist the efficient manufacture of a wide range of
products (necessary if businesses are to compete effectively) and are not, in general, affected by
changes in production volume. They tend to vary in the long term according to the range and
complexity of the products manufactured rather than the volume of output.
The wider the range and the more complex the products, the more support services will be required.
Consider, for example, factory X which produces 10 000 units of one product, the Alpha, and factory Y
which produces 1 000 units each of ten slightly different versions of the Alpha. Support activity costs in
the factory Y are likely to be a lot higher than in factory X but the factories produce an identical
number of units. For example, factory X will only need to set-up once whereas Factory Y will have to
set-up the production run at least ten times for the ten different products. Factory Y will therefore
incur more set-up costs for the same volume of production.
Activity based costing is a system of costing that analyses overhead costs in a different way. Overhead
costs are allocated initially to activities, and the key factors that 'drive' each of these activities are also
identified. Costs are then attributed to products (or services or customers) on the basis of the use they
make of each of these activities.

OVERHEAD COSTING ACTIVITY BASED COSTING | 175

2 OUTLINE OF AN ABC SYSTEM

Activity based costing (ABC) is an alternative to the traditional method of accounting for
costs - absorption costing. ABC divides production into core activities which drive the
need for resources, assigns costs to those activities based on the resources they use, and
then allocates those costs to products based on their consumption of the activities.

2.1 THE CONCEPT OF ABC


Definition
Activity based costing (ABC) is an approach to the costing and monitoring of activities and the
costing of final outputs which involves tracing an activity's resource consumption.
The cost of the various resources consumed by an activity are collected by way of activity cost pools.
Each activity cost pool is then assigned to individual products based on the product's consumption of
that activity. This is done using cost drivers.

The major ideas behind activity based costing are as follows:


a. Activities cause an organisation to consume resources and incur costs.
For a manufacturing organisation, activities might include ordering, materials handling, production
scheduling, machine set-up, assembly, quality testing, and product despatch.
Activities are seen as driving the need for resources and are known as resource drivers. For
example the ordering of materials will consume a variety of resources including labour, office
space, utilities and technology.
b. Making and selling products/services is what creates demand for the various activities. The product
or service is known as a cost object.
c. The costs of all the resources used in an activity are collected into an activity cost pool.
e. The organisation needs to ascertain the causes of the costs behind each activity known as the
cost drivers. For example the cost driver for quality control costs might be the number of product
inspections carried out; the cost driver for material ordering might be the number of orders placed.
f. Using the cost drivers, the costs of each activity are then assigned to the cost objects (products)
that demand that activity on the basis of each product's consumption of the activity.
Definition
Activity based management (ABM) uses the information provided by an activity based cost analysis
to identify ways to improve an organisation's profitability through performing certain activities more
efficiently or eliminating activities that do not add value. ABM attempts to ensure customer needs are
satisfied whilst reducing the demand on an organisation's resources.

2.2 THE OPERATION OF AN ABC SYSTEM


Definitions
A resource driver is an activity that causes an organisation to consume resources and incur costs.
A cost driver is a factor influencing the level of cost. Often used in the context of ABC to denote the
factor which links activity resource consumption to product outputs, for example, the number of
purchase orders would be a cost driver for procurement cost.

CHAPTER 6

Section overview

176 | MANAGEMENT ACCOUNTING

An activity cost pool is a grouping of costs relating to a particular activity in an activity based costing
system.
An ABC system operates as follows:

Step 1

Identify an organisation's major activities.


Unit-level activities are those activities that have a one-to-one relationship with a unit
of output. For example, a manufacturer may have to perform a final quality control
check on each unit of finished product, so quality inspection might be a unit level
activity.
Batch-level activities are those activities that must be performed, but can relate to
one or more units of output. Despatch of orders by an online retailer of DVDs is an
example of a batch-level activity. In each case the customer's order must be boxed
and shipped, requiring the same activity regardless of the number of items being
packaged in the box.
Product-level activities are carried out at the product level, regardless of the number
of units or batches produced. Product design/development and marketing are
examples of activities that may relate to the existence of a particular product.
Other levels of activity which do not relate to products may also be used. For example
some organisations consider customer-level activities which relate to the number of
customers e.g. activities such as operating a technical support help line; or the
production and distribution of product catalogues.

Step 2

Identify the factors which determine the size of the costs of an activity/cause the
incurrence of costs of an activity. These are known as cost drivers.
Look at the following examples:
COSTS

POSSIBLE COST DRIVER

Ordering costs

Number of orders

Materials handling costs

Number of production runs

Production scheduling costs

Number of production runs

Despatching costs

Number of despatches

Quality control costs

Number of product inspections

For those costs that vary with production levels in the short term, ABC uses volumerelated cost drivers such as labour or machine hours. The cost of oil used as a lubricant
on the machines would therefore be added to products on the basis of the number of
machine hours, since oil would have to be used for each hour the machine ran.
Overheads that vary with some other activity, and not volume of production, should be
traced to products using transaction-based cost drivers such as production runs or
number of orders received.

Step 3

Collect the costs of the resources associated with each activity into what are known as
activity cost pools.

Step 4

Charge the costs of each cost pool to products on the basis of their usage of the
activity, measured by the number of the activity's cost driver a product generates, using
a cost driver rate (total costs in cost pool/number of cost drivers).

Question 1: Cost drivers


Which of the following definitions best describes a cost driver?
A A cost that varies with production levels
B Any activity which causes an increase in costs
C A collection of costs associated with a particular activity
D Any factor which causes a change in the cost of an activity
(The answer is at the end of the chapter)

OVERHEAD COSTING ACTIVITY BASED COSTING | 177

An organisation has estimated that the resources incurred in the production set-up activity will cost
$200 000 for a particular period. The machinery for production has to be set-up each time a batch of a
particular product is manufactured and there are expected to be 40 machine set-ups in total. In the
period the company expects to manufacture 150 000 units of Product X (in batches of 5 000 units) and
500 000 units of Product Y (in batches of 50 000 units).
Calculate the production set-up costs to be assigned to a single unit of Product X and Y, using Activity
based costing.
Solution

Step 1

The resource driver (activity) is production set-up

Step 2

The appropriate cost-driver is the number of machine set-ups, which is 40.

Step 3

The activity cost pool for production set-ups is $200 000.

Step 4

The cost driver rate is therefore $200 000/40 = $5 000 per machine set-up.

The production set-up costs can then be assigned to the products based on the number of machine
set-ups each requires (which because production set-up is a batch level activity is driven by the
number of batches of each product that are made):
a. Number of units produced
b. Units per batch
c. Total number of batches = (a)/(b) (each
batch requires one machine set-up)
d. Total machine set-up costs assigned to
product
= No. of machine set-ups (c)x $5 000
cost per set-up
Production set-up cost per unit of
product = (d)/(a)

Product X
150 000
5 000
30

Product Y
500 000
50 000
10

$150 000

$50 000

$1.00

$0.10

The production set-up costs determined above would then form part of the overhead cost of each
product.

3 ABSORPTION COSTING VERSUS ABC


Section overview
The principle difference between absorption costing and activity based costing is the way
in which overheads are absorbed into products.
Absorption costing commonly uses either a labour hour or machine hour basis to charge
overheads to products. ABC attempts to absorb the costs of the various activities involved
in the production of a product according to that product's demand for/usage of each
activity.
The principle difference between the two approaches is the way in which overheads are absorbed into
products.
Under absorption costing, overheads are typically charged to products using either labour hours or
machine hours. As a result, the more time spent on production of a product, the greater the absorbed
overhead per unit and the more units produced, the greater the share of total overhead that that
product receives.

CHAPTER 6

Worked Example: Activity based costing

178 | MANAGEMENT ACCOUNTING

ABC uses multiple cost drivers to absorb costs and by considering each activity separately, attempts
to more closely link the absorption rate to the actual cause of the overhead. When using ABC, for
costs that vary with production levels in the short term, the cost driver will be volume related (labour or
machine hours). Overheads that vary with some other activity, and not volume of production, should
be traced to products using transaction-based cost drivers such as production runs or number of
orders received.
The following example illustrates the point that traditional cost accounting techniques may result in a
misleading and inequitable division of costs between low-volume and high-volume products, and that
ABC can provide a more meaningful allocation of costs.
Worked Example: Absorption costing vs Activity based costing
Suppose that Cooplan manufactures four products, W, X, Y and Z. Output and cost data for the period
just ended are as follows:
Number of
production
runs in the
period

Output units
W
X
Y
Z

10
10
100
100

2
2
5
5
14

Direct labour cost per hour

$5

Overhead costs
Short run variable costs
Set-up costs
Scheduling costs
Materials handling costs

Material cost
per unit
$
20
80
20
80

Direct labour
hours per unit

Machine
hours per unit

1
3
1
3

1
3
1
3

$
3 080
10 920
9 100
7 700
30 800

Prepare unit costs for each product using conventional absorption costing and ABC.
Solution
Using a conventional absorption costing approach and an absorption rate for overheads based on
either direct labour hours or machine hours, the product costs would be as follows:

Direct material
Direct labour
Overheads *
Units produced
Cost per unit

W
$
200
50
700
950
10
$95

X
$
800
150
2 100
3 050

Y
$
2 000
500
7 000
9 500

Z
$
8 000
1 500
21 000
30 500

10
$305

100
$95

100
$305

Total
$

44 000

* $30 800 440 hours = $70 per direct labour or machine hour.
Using activity based costing and assuming that the number of production runs is the cost driver for
set-up costs, scheduling costs and materials handling costs and that machine hours are the cost driver
for short-run variable costs, unit costs would be as follows:

OVERHEAD COSTING ACTIVITY BASED COSTING | 179

Units produced
Cost per unit

10
$428

X
$
800
150
210
1 560
1 300
1 100
5 120

Y
$
2 000
500
700
3 900
3 250
2 750
13 100

Z
$
8 000
1 500
2 100
3 900
3 250
2 750
21 500

10
$512

100
$131

100
$215

Total
$

44 000

Workings
1
2
3
4

$3 080 440 machine hours =


$10 920 14 production runs =
$9 100 14 production runs =
$7 700 14 production runs =

$7 per machine hour


$780 per run
$650 per run
$550 per run

Summary
Product
W
X
Y
Z

Conventional costing
Unit cost
$
95
305
95
305

ABC
Unit cost
$
428
512
131
215

Difference per
unit
$
+ 333
+ 207
+ 36
90

Difference in
total
$
+3 330
+2 070
+3 600
9 000

The figures suggest that the traditional volume-based absorption costing system is flawed.
a. It under-allocates overhead costs to low-volume products (here, W and X) and over-allocates
overheads to higher-volume products (here Z in particular).
b. It under-allocates overhead costs to smaller-sized products (here W and Y with just one hour of
work needed per unit) and over allocates overheads to larger products (here X and particularly Z).

3.1 ABC VERSUS TRADITIONAL COSTING METHODS


Both traditional absorption costing and ABC systems adopt the two stage allocation process.

3.1.1 ALLOCATION OF OVERHEADS


ABC establishes separate cost pools for support activities such as despatching. As the costs of
these activities are assigned directly to products through cost driver rates, reapportionment of
service department costs is avoided.

3.1.2 ABSORPTION OF OVERHEADS


The principal difference between the two systems is the way in which overheads are absorbed into
products.
(a) Absorption costing most commonly uses two absorption bases, labour hours and/or machine
hours, to charge overheads to products. There may be a different absorption rate for each
production department.
(b) ABC uses many cost drivers as absorption bases; number of orders, number of despatches and so
on. There is an absorption rate for each activity.
Absorption rates under ABC should therefore be closely linked to the causes of overhead costs.

3.2 COST DRIVERS


The principal idea of ABC is to focus attention on what causes costs to increase, i.e. the cost
drivers.

CHAPTER 6

Direct material
Direct labour
Short-run variable overheads (W1)
Set-up costs (W2)
Scheduling costs (W3)
Materials handling costs (W4)

W
$
200
50
70
1 560
1 300
1 100
4 280

180 | MANAGEMENT ACCOUNTING

a. Those costs that do vary with production volume, such as power costs, should be traced to
products using production volume-related cost drivers as appropriate, such as direct labour hours
or direct machine hours. Such costs tend to be short-term variable overheads.
Overheads which do not vary with output but with some other activity should be traced to products
using transaction-based cost drivers, such as number of production runs and number of orders
received. Such costs tend to be long-term variable overhead (overhead that traditional accounting
would classify as fixed).
b. Traditional costing systems allow overhead to be related to products in rather more arbitrary ways
producing, it is claimed, less accurate product costs.
Question 2: ABC versus traditional costing
A company manufactures two products, L and M, using the same equipment and similar processes.
An extract of the production data for these products in one period is shown below:
L
5 000
1
3
10
15

Quantity produced (units)


Direct labour hours per unit
Machine hours per unit
Set-ups in the period
Orders handled in the period

M
7 000
2
1
40
60

Production overhead costs


Relating to machine activity
Relating to production run set-ups

$
209 000
25 000

Relating to handling of orders

51 000
285 000

a. What is the amount of production overhead to be absorbed by one unit of product M using a
traditional absorption costing approach, with a direct labour hour rate to absorb overheads?
A
B
C
D

$15.00
$17.50
$22.00
$30.00

b. What is the amount of production overhead to be absorbed by one unit of product M using an
activity based costing approach, with suitable cost drivers to trace overheads to products?
A
B
C
D

$12.95
$18.19
$32.57
$37.57
(The answers are at the end of the chapter)

4 MARGINAL COSTING VERSUS ABC


Section overview
The main criticism of using marginal costing to provide decision making information is that
marginal costing analyses cost behaviour patterns according to the volume of production.
However, although certain costs may be fixed in relation to the volume of production, they
may in fact be variable in relation to some other cost driver.

OVERHEAD COSTING ACTIVITY BASED COSTING | 181

The problem with marginal costing is that it analyses cost behaviour patterns according to the volume
of production. However, although certain costs may be fixed in relation to the volume of
production, they may in fact be variable in relation to some other cost driver. A failure to allocate
such costs to individual products could result in incorrect decisions concerning the future
management of the products.
The advantage of ABC is that it spreads costs across products according to a number of different
bases. For example, an ABC analysis may show that one particular activity which is carried out
primarily for one or two products is expensive. A correct allocation of the costs of this activity may
reveal that these particular products are not profitable. If these costs are fixed in relation to the
volume of production then they would be treated as period costs in a marginal costing system and
written off against the marginal costing contribution for the period.
The marginal costing system would therefore make no attempt to allocate these 'fixed' costs to
individual products and a false impression would be given of the long run average cost of the
products.
Therefore, marginal costing may provide incorrect decision making information, particularly in a
situation where 'fixed' costs are vary large compared with 'variable' costs.

5 INTRODUCING AN ABC SYSTEM INTO AN


ORGANISATION
Section overview
ABC should only be introduced if the additional information it provides will result in action
that will increase the organisation's overall profitability.
ABC identifies four levels of activities: product level, batch level, product-sustaining level
and facility-sustaining level.

5.1 WHEN SHOULD ABC BE INTRODUCED?


ABC should only be introduced if the additional information it provides will result in action that will
increase the organisation's overall profitability. This is most likely to occur in situations such as the
following, when the ABC analysis differs significantly from the traditional absorption costing analysis:
Production overheads are high in relation to direct costs, especially direct labour.
Overhead resource consumption is not just driven by production volume.
There is wide variety in the product range.
The overhead resource input varies significantly across the product range.

5.2 ANALYSIS OF ACTIVITIES


ABC attempts to relate the incidence of costs to the level of activities undertaken. A hierarchy of four
levels of activity has been suggested.
Definition
The hierarchy of activities is a classification of activities by level of organisation, for example, unit,
batch, product-sustaining and facility-sustaining.

CHAPTER 6

One view is that only marginal costing provides suitable information for decision making but this is not
true. Marginal costing provides a crude method of differentiating between different types of cost
behaviour by splitting costs into their variable and fixed elements. However, such an analysis can be
used only for short-term decisions and usually even these have longer-term implications which ought
to be considered.

182 | MANAGEMENT ACCOUNTING

TYPE OF ACTIVITIES

COSTS ARE DEPENDENT ON .

EXAMPLES

Product level

Volume of production

Machine power

Batch level

Number of batches

Set-up costs

Product-sustaining

Existence of a product group/line

Product management

Facility-sustaining

Organisation simply being in business

Rent and rates

Definitions
Product-sustaining activities are activities undertaken to develop or sustain a product or service.
Product sustaining costs are linked to the number of products or services, not to the number of units
produced.
Facility-sustaining activities are activities undertaken to support the organisation as a whole, and
which cannot be logically linked to individual units of output.

The difference between a unit product cost determined using traditional absorption costing and one
determined using ABC will depend on the proportion of overhead cost which falls into each of the
categories above.
a. If most overheads are related to unit level and facility level activities, the unit product costs
generated by each method will be similar.
b. If the overheads tend to be associated with batch or product level activities the unit product cost
generated by ABC will be significantly different from traditional absorption costing.
Consider the following example.
Worked Example: Batch level activity
XYZ produces a number of products including product D and product E and produces 500 units of
each of products D and E every period at a rate of ten of each every hour. The overhead cost is $500
000 and a total of 40 000 direct labour hours are worked on all products. A traditional overhead
absorption rate would be $12.50 per direct labour hour and the overhead cost per product would be
$1.25.
Production of D requires five production runs per period, while production of E requires 20. An
investigation has revealed that the overhead costs relate mainly to 'batch-level' activities associated
with setting-up machinery and handling materials for production runs.
There are 1,000 production runs per period and so overheads could be attributed to XYZ's products at
a rate of $500 per run.
Overhead cost per D = ($500 5 runs)/500 = $5
Overhead cost per E = ($500 20 runs)/500 = $20
These overhead costs are activity based and recognise that overhead costs are incurred due to batch
level activities. The fact that E has to be made in frequent small batches, perhaps because it is
perishable, means that it uses more resources than D. This is recognised by the ABC overhead costs,
not the traditional absorption costing overhead costs.
In the modern manufacturing environment, production often takes place in short, discontinuous
production runs and a high proportion of product costs are incurred at the design stage. An
increasing proportion of overhead costs are therefore incurred at batch or product level.
Such an analysis of costs gives management an indication of the decision level at which costs can
be influenced. For example, a decision to reduce production costs will not simply depend on making
a general reduction in output volumes: production may need to be organised to reduce batch
volumes; a process may need to be modified or eliminated; product lines may need to be merged or
cut out; facility capacity may need to be altered.

OVERHEAD COSTING ACTIVITY BASED COSTING | 183

5.3 ABC IN SERVICE AND RETAIL ORGANISATIONS

ACTIVITIES

EXAMPLES

POSSIBLE COST DRIVER

Unit level

Accept cash
Processing of cash by bank

Number of transactions
Number of transactions

Batch level

Cash desk closed by clerk (close out) and


reviewed by supervisor
Deposits
Review and transfer of funds

Number of 'close outs'


Number of deposits
Number of accounts

Product level

Maintenance charges for bank accounts


Reconciling bank accounts

Number of accounts
Number of accounts

An important aspect of ABC in non-manufacturing operations is to identify the items for which the
costing system is intended to provide cost information. In the case of cash processing above, ABCrelated costs can be established for customer accounts and also for cash processing transactions.
Costs can also be established for 'close outs' and fund transfers.
Having identified the items for which unit costs are needed, at a unit, batch or product level, activity
costs should be assigned to each cost item on the basis of their 'use' of each activity.
Question 3: ABC and retail organisations
List five activities that might be identified in a department store and state one possible cost driver for
each of the activities you have identified.
(The answer is at the end of the chapter)

6 ADVANTAGES AND DISADVANTAGES OF ABC


Section overview
ABC has a range of uses and has many advantages over more traditional costing methods.
However, the system does have its critics and it does not solve all costing problems.

6.1 ADVANTAGES OF ABC


Once the necessary information has been obtained ABC is similar to traditional absorption costing.
This simplicity is part of its appeal. Further merits of ABC are as follows:
a. The complexity of manufacturing has increased, with wider product ranges, shorter product life
cycles and more complex production processes. ABC recognises this complexity with its multiple
cost drivers.
b. In a more competitive environment, companies must be able to assess product profitability
realistically. ABC facilitates a good understanding of what drives overhead costs.
c. In modern manufacturing systems, overhead functions include a lot of non-factory-floor activities
such as product design, quality control, production planning and customer services. ABC is
concerned with all overhead costs and so it takes management accounting beyond its
'traditional' factory floor boundaries.
d. By facilitating and enabling the control of the incidence of the cost driver, the level of the cost can
be controlled.

CHAPTER 6

ABC was first introduced in manufacturing organisations but it can equally well be used in other types
of organisation. For example, the management of the Post Office in the US introduced ABC. They
analysed the activities associated with cash processing as follows:

184 | MANAGEMENT ACCOUNTING

e. The costs of activities not included in the costs of the products an organisation makes or the
services it provides can be considered to be not contributing to the value of the
product/service. The following questions can then be asked:
What is the purpose of this activity?
How does the organisation benefit from this activity?
Could the number of staff involved in the activity be reduced?
f. ABC can help with cost management. For example, suppose there is a fall in the number of orders
placed by a purchasing department. This fall would not impact on the amount of overhead
absorbed in a traditional absorption costing system as the cost of ordering would be part of the
general overhead absorption rate. The reduction in the workload of the purchasing department
might therefore go unnoticed and the same level of resources would continue to be provided,
despite the drop in number of orders. In an ABC system, however, this drop would be immediately
apparent because the cost driver rate would be applied to fewer orders.
g. Many costs are driven by customers, delivery costs, discounts, after-sales service and so on, but
traditional absorption costing systems do not account for this. Organisations may be trading with
certain customers at a loss but may not realise it because costs are not analysed in a way that
reveals the true situation. ABC can be used in conjunction with customer profitability analysis to
determine more accurately the profit earned by servicing particular customers.
Definition
Customer profitability analysis is the analysis of the revenue streams and service costs associated
with specific customers or customer groups.

h. Many service businesses have characteristics similar to those required for the successful
application of ABC:
A highly competitive market.
Diversity of products, processes and customers.
Significant overhead costs not easily assigned to individual 'products'.
Demands placed on overhead resources by individual 'products' and customers, which are not
proportional to volume.
If ABC were to be used in a hotel, for example, attempts could be made to identify the activities
required to support each guest by category and the cost drivers of these activities. The cost of a onenight stay midweek by a businessman could then be distinguished from the cost of a one-night stay by
a teenager at the weekend. Such information could prove invaluable for Customer profitability
analysis.

6.2 DISADVANTAGES OF ABC


It has been suggested by critics that activity based costing has some serious flaws.
a. Some measure of (arbitrary) cost apportionment may still be required at the cost pooling stage for
items like rent, rates and building depreciation.
b. Can a single cost driver explain the cost behaviour of all items in its associated pool?
c. On the other hand, the number of cost pools and cost drivers cannot be excessive otherwise an
ABC system would be too complex and too expensive.
d. Unless costs are caused by an activity that is measurable in quantitative terms and which can be
related to production output, cost drivers will not be usable. What drives the cost of the annual
external audit, for example?
e. ABC is sometimes introduced because it is fashionable, not because it will be used by
management to provide meaningful product costs or extra information. If management is not
going to use ABC information, an absorption costing system may be simpler to operate.
f. The costs of ABC may outweigh the benefits.

OVERHEAD COSTING ACTIVITY BASED COSTING | 185

6.3 OTHER USES OF ABC


The information provided by analysing activities can support the management functions of planning,
control and decision making, provided it is used carefully and with full appreciation of its implications.

Before an ABC system can be implemented, management must analyse the organisation's activities,
determine the extent of their occurrence and establish the relationships between activities,
products/services and their cost.
The information database produced from such an exercise can then be used as a basis for forward
planning and budgeting. For example, once an organisation has set its budgeted production level,
the database can be used to determine the number of times that activities will need to be carried out,
thereby establishing necessary departmental staffing and machine levels. Financial budgets can then
be drawn up by multiplying the budgeted activity levels by cost per activity.
This activity based approach may not produce the final budget figures but it can provide the basis for
different possible planning scenarios.

6.3.2 CONTROL
The information database also provides an insight into the way in which costs are structured and
incurred in service and support departments. Traditionally it has been difficult to control the costs of
such departments because of the lack of relationship between departmental output levels and
departmental cost. With ABC, however, it is possible to control or manage the costs by managing
the activities which underlie them by monitoring cost driver usage.

6.3.3 DECISION MAKING


Many of ABC's supporters claim that it can assist with decision making in a number of ways:
Provides accurate and reliable cost information
Establishes a long-run product cost
Provides data which can be used to evaluate different ways of delivering business
It is therefore particularly suited to the following types of decision:
Pricing
Promoting or discontinuing products or parts of the business
Redesigning products and developing new products or new ways to do business
Note, however, that an ABC cost is not a true cost, it is simply a long run average cost because some
costs such as depreciation are still arbitrarily allocated to products. An ABC cost is therefore not a
relevant cost for all decisions. For example, even if a product/service ceases altogether, some costs
allocated to that product/service using an activity based approach, such as building occupancy costs
or depreciation, would not disappear just because the product/service had disappeared.
Management would need to bear this in mind when making product deletion decisions.

6.4 ACTIVITY BASED MANAGEMENT (ABM)


Although the terms are sometimes used interchangeably, ABM is a broader concept than ABC, being
likely to incorporate ABC and activity based budgeting (ABB).
Activity based budgeting is where resources are allocated to individual activities depending on their
inter-relationships. A detailed knowledge of this is not required in this unit.
Definitions
Optimal ABM are actions, based on activity driver analysis, that increase efficiency, lower costs and/or
improve asset utilisation.
Strategic ABM are actions, based on activity based cost analysis, that claim to change the demand for
activities so as to improve profitability.

CHAPTER 6

6.3.1 PLANNING: ACTIVITY BASED BUDGETING (ABB)

186 | MANAGEMENT ACCOUNTING

KEY CHAPTER POINTS


Traditional costing systems assume that all products consume all resources in proportion to their
production volumes. The use of a predetermined overhead absorption rate tends to allocate too
great a proportion of overheads to high volume products, which use fewer support services and
too small a proportion of overheads to low volume products, which use more support services.
Activity based costing (ABC) attempts to overcome this problem by identifying core activities
involved in the production of a product and charging overheads on the basis of each product's
consumption of those activities/support services, rather than based on volume of production.
Activity based costing (ABC) is an alternative to the traditional method of accounting for costs absorption costing. ABC divides production into core activities which drive the need for resources,
assigns costs to those activities based on the resources they use, and then allocates those costs to
products based on their consumption of the activities.
A resource driver is an activity that causes an organisation to consume resources and incur costs.
An activity cost pool is a grouping of costs relating to a particular activity in an activity based
costing system.
A cost driver is a factor influencing the level of cost.
Activity based management (ABM) uses the information provided by an activity based cost analysis
to identify ways to improve an organisation's profitability through performing certain activities
more efficiently or eliminating activities that do not add value. ABM attempts to ensure customer
needs are satisfied whilst reducing the demand on an organisation's resources.
ABC involves the identification of the factors (cost drivers) which cause the costs of an
organisation's major activities. Support overheads are charged to products on the basis of their
usage of an activity.
When using ABC, for costs that vary with production levels in the short term, the cost driver will be
volume related (labour or machine hours). Overheads that vary with some other activity, and not
volume of production, should be traced to products using transaction-based cost drivers such as
production runs or number of orders received.
The principle difference between absorption costing and activity based costing is the way in which
overheads are absorbed into products. Absorption costing commonly uses either a labour hour or
machine hour basis to charge overheads to products. ABC attempts to absorb the costs of the
various activities involved in the production of a product according to that product's demand
for/usage of each activity.
The main criticism of using marginal costing to provide decision making information is that
marginal costing analyses cost behaviour patterns according to the volume of production.
However, although certain costs may be fixed in relation to the volume of production, they may in
fact be variable in relation to some other cost driver.
ABC should only be introduced if the additional information it provides will result in action that will
increase the organisation's overall profitability.
ABC identifies four levels of activities: product level, batch level, product sustaining level and
facility sustaining level.
ABC has a range of uses and has many advantages over more traditional costing methods.
However, the system does have its critics and it does not solve all costing problems.

OVERHEAD COSTING ACTIVITY BASED COSTING | 187

QUICK REVISION QUESTIONS


A ABC can be used for customer profitability analysis.
B A single cost driver may not explain the level of expenditure on an activity.
C In manufacturing, ABC is more appropriate than traditional absorption costing when the
consumption of resources on overhead activities is not related to production volumes.
D Traditional costing systems tend to allocate too small a proportion of overheads to high volume
products and too great a proportion of overheads to low volume products.
2 For which of the following costs might the number of machine hours worked be a cost driver?
A
B
C
D

Set-up costs
Product development costs
Short-run variable overhead costs
Materials handling and despatch costs

3 Which of the following is most likely to be the cost driver for production scheduling costs?
A
B
C
D

Volume of output
Number of orders
Number of production runs
Volume of materials handled

4 In ABC, brand management might be an example of a


A
B
C
D

batch level activity.


product level activity.
facility-sustaining activity.
product-sustaining activity.

5 In ABC, general factory administration costs might be an example of a


A
B
C
D

batch level activity.


product level activity.
facility-sustaining activity.
product-sustaining activity.

6 Which one of the following statements is incorrect?


A ABC may be used for cost and management accounting by service organisations.
B In ABC, direct labour hours or direct machine hours may be used to trace costs to products.
C The cost driver for quality inspection is likely to be number of hours worked on the product.
D In ABC, activity costs are absorbed into product costs using an activity cost per unit of cost
driver as the absorption rate.

CHAPTER 6

1 Which one of the following statements is incorrect?

188 | MANAGEMENT ACCOUNTING

ANSWERS TO QUICK REVISION QUESTIONS


1 D Traditional costing systems tend to allocate too great a proportion of overheads to high volume
products and too small a proportion of overheads to low volume products. Note that a
weakness of the ABC method is that for some activities, there may be several cost drivers for
cost.
2 C Short-run variable costs (such as repairs costs) are generally driven by production activity
(machine hours or direct labour hours).
3 C Production scheduling costs are likely to be driven by the number of production runs. Set-up
costs may be included in the general activity: 'production scheduling'.
4 D In ABC, activities are identified at different levels. At a product-sustaining level, activities are
generally related to product or brand management,
5 C General factory administration costs are incurred to keep the factory in operation, and so would
be classified as a facility-sustaining activity
6 C The cost driver for quality inspection is likely to be number of inspections carried out. In ABC,
direct labour hours or direct machine hours may be used to trace some costs to products
typically short-run variable costs. ABC can be applied to any operations where resources are
consumed by activities, including service organisations.

OVERHEAD COSTING ACTIVITY BASED COSTING | 189

ANSWERS TO CHAPTER QUESTIONS

2 (a) D
Traditional absorption costing approach
Direct
labour
hours
5 000

Product L = 5 000 units 1 hour

14 000

Product M = 7 000 units 2 hours

19 000

Therefore Overhead absorption rate =

$285 000
= $15 per hour
19 000

Overhead absorbed by one unit of product M would be as follows:


Product M

2 hours $15

$30 per unit

(b) B
ABC approach

Product L

= 5 000 units 3 hours

Machine
hours
15 000

Product M

= 7 000 units 1 hour

7 000
22 000

Using ABC the overhead costs are absorbed according to the cost drivers.
Machine-hour driven costs
Set-up driven costs
Order driven costs

209 000 22 000 m/c hours


25 000 50 set-ups
51 000 75 orders

$
= $9.50 per m/c hour
= $500 per set-up
= $680 per order

Overhead costs are therefore as follows:


Product M
$
66 500

Machine-driven costs

(7 000 hrs $9.50)

Set-up costs

(40 $500)

20 000

Order handling costs

(60 $680)

40 800
127 300

Units produced
Overhead cost per unit of Product M

7 000
$18.19

These figures suggest that product M absorbs an excessive amount of overhead using a direct
labour hour basis. Overhead absorption should be based on the activities which drive the costs,
in this case machine hours, the number of production run set-ups and the number of orders
handled for each product. Most overhead costs are driven by machine activity, but Product M
requires much less machine time than Product L.

CHAPTER 6

1 D A cost driver is best described as any factor which causes a change in the cost of an activity.

190 | MANAGEMENT ACCOUNTING

3
ACTIVITIES

POSSIBLE COST DRIVER

Quoting prices (curtains, carpets etc)

Number of requests for quotations

Purchasing and receiving goods

Number of orders

Returned goods

Number of returns

Operating a department

Number of departments/floor space

Check-out activity

Number of customers/check-outs

Home deliveries

Number of orders (or possibly the distance


travelled to deliver)

191

CHAPTER 7
PROCESS AND JOB
COSTING
Learning objectives

Reference

Process and job costing

LO7

Explain the differences between job and process costing techniques

LO7.1

Apply costing principles to job costing and process costing organisations

LO7.2

Topic list

1
2
3
4
5
6
7
8

The distinguishing features of process costing


The basics of process costing
Dealing with losses in process
Accounting for scrap
Valuing closing work in process
Valuing opening work in process
Joint products and by-products
Job costing

192 | MANAGEMENT ACCOUNTING

INTRODUCTION
This chapter looks at costing systems. Costing systems are used to cost goods or services. The
method used depends on the way in which the goods or services are produced.
The chapter begins by considering process costing. Process costing is applied when output consists of
a continuous stream of identical units. We will begin with the basics and look at how to account for the
most simple of processes. We will then move on to how to account for any losses which might occur,
as well as what to do with any scrapped units which are sold. Next we will consider how to deal with
closing work in process before examining situations involving closing work in process and losses. We
will then go on to have a look at situations involving opening work in process and how to deal with
situations where we have both opening and closing work in process and losses. This is followed with
an outline discussion of joint products and by-products.
This chapter will conclude by covering job costing.
The chapter content is summarised in the diagram below.

Process and
job costing

Process
costing

Basics

Accounting
for scrap

Work in
process

Joint products
and by-products

Job
costing

PROCESS AND JOB COSTING | 193

BEFORE YOU BEGIN


If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.

1 When is process costing used?

(Section 1)

2 Define process costing.

(Section 1)

3 What is on the left hand side of the process account?

(Section 2.1)

4 What is on the right hand side of the process account?

(Section 2.1)

5 What are the four key steps involved in process costing?

(Section 2.2)

6 Define normal loss, abnormal loss and abnormal gain.

(Section 3.1)

7 How is normal loss valued?

(Section 3.1)

8 How is work in process valued?

(Sections 5, 6)

9 What is a joint product? Give examples.

(Section 7.1)

10 What is a by-product ? Give examples.

(Section 7.2)

11 Define job costing.

(Section 8)

CHAPTER 7

There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.

194 | MANAGEMENT ACCOUNTING

1 THE DISTINGUISHING FEATURES OF PROCESS


COSTING
Section overview
Process costing is a costing method used when it is not possible to identify separate units
of production, or jobs, usually because of the continuous nature of the production
processes involved.
LO
7.1
7.2

Process costing is used where there is a continuous flow of identical units and it is common to
identify it with continuous production such as the following:
Oil refining
The manufacture of soap
Paint manufacture
Food and drink manufacture
Concrete/cement production
Magazine printing
Definition
Process costing is a cost accounting system used where products or services are mass produced in a
continuous flow of production. Process costs are attributed to the number of units produced. This may
involve estimating the number of equivalent units in stock at the start and end of the period under
consideration.

We will discuss 'equivalent units' later in this chapter.


The features of process costing which make it different from other methods of costing such as job or
batch costing are as follows:
a. The continuous nature of production in many processes means that there will usually be closing
work in process which must be valued. In process costing it is not possible to build up cost
records of the cost of each individual unit of output because production in progress is an
indistinguishable homogeneous mass.
b. There is often a loss in process due to spoilage, wastage, evaporation and so on.
c. The output of one process becomes the input to the next until the finished product is made in the
final process.
d. Output from production may be a single product, but there may also be a by-product (or byproducts) and/or joint products.
e. Costs are accumulated by department instead of by job with average cost per unit calculated
by total costs divided by number of units produced.

2 THE BASICS OF PROCESS COSTING

LO
7.2

Section overview
Costs incurred in processes are recorded in what are known as process accounts. A process
account has two sides, and on each side there are two columns, one for quantities (of raw
materials, work-in-process and finished goods) and one for costs.
There is a four step approach for dealing with process costing questions.

PROCESS AND JOB COSTING | 195

2.1 PROCESS ACCOUNTS


A process account has two sides (Debit and Credit), and on each side there are two columns one
for quantities (of raw materials, work in process and finished goods) and one for costs.
a. On the left hand side of the process account we record the inputs to the process and the cost of
these inputs. So we might show the quantity of material input to a process during the period and
its cost, the cost of labour and the cost of overheads.
b. On the right hand side of the process account we record what happens to the inputs by the end
of the period.
i. Some of the input might be converted into finished goods, so we show the units of finished
goods and the cost of these units.
ii. Some of the material input might evaporate or get spilled or damaged, so there would be
losses. So we record the loss units and the cost of the loss.

The quantity columns on each side of the account should total to the same amount. Why? For
instance if we put 100 kgs of material in to a process, which we record on the left hand side of the
account, we should know what has happened to those 100 kgs. Some would be losses maybe, some
would be WIP, some would be finished units, but the total should be 100 kgs.
Likewise the cost of the inputs to the process during a period (i.e. the total of the costs recorded on
the left hand side of the account) is the cost of the outputs of the process. If we have recorded
material, labour and overhead costs totalling $1 000 and at the end of the process we have 100
finished units (and no losses or WIP), then that output cost $1 000.
Here's a simple example of a process account:
PROCESS ACCOUNT
Material
Labour

Units
1 000

Overhead
1 000

$
11 000
4 000

Closing WIP
Finished goods
inventory

3 000
18 000

Units
200
800

$
2 000
16 000

1 000

18 000

As you can see, the quantity columns on each side balance (i.e. they are the same), as do the
monetary columns. Don't worry at this stage about how the costs are split between WIP and finished
units.
Worked Example: Basics of process costing
Suppose that Purr and Miaow Co make squeaky toys for cats. Production of the toys involves two
processes, shaping and colouring. During the year to 31 March 20X3, 1 000 000 units of material worth
$500 000 were input to the first process, shaping. Direct labour costs of $200 000 and production
overhead costs of $200 000 were also incurred in connection with the shaping process. There were no
opening or closing inventories in the shaping department. The process account for shaping for the
year ended 31 March 20X3 is as follows:
PROCESS 1 (SHAPING) ACCOUNT
Direct materials
Direct labour
Production overheads

Units
1 000 000

1 000 000

$
500 000
200 000
200 000
900 000

Output to Process 2

Units
1 000 000

$
900 000

1 000 000

900 000

When preparing process accounts, balance off the quantity columns (i.e. ensure they total to the same
amount on both sides) before attempting to complete the monetary value columns since they will
help you to check that you have not missed something. This becomes increasingly important as more
complications are introduced into questions.

CHAPTER 7

iii. At the end of a period, some units of input might be in the process of being turned into finished
units so would be work in process (WIP). We record the units of WIP and the cost of these units.

196 | MANAGEMENT ACCOUNTING

When using process costing, if a series of separate processes is needed to manufacture the finished
product, the output of one process becomes the input to the next until the final output is made in
the final process. In our example, all output from shaping was transferred to the second process,
colouring, during the year to 31 March 20X3. An additional 500 000 units of material, costing $300 000,
were input to the colouring process. Direct labour costs of $150 000 and production overhead costs of
$150 000 were also incurred. There were no opening or closing inventories in the colouring
department.
The process account for colouring for the year ended 31 March 20X3 is as follows:
PROCESS 2 (COLOURING) ACCOUNT
Materials from process 1
Added materials
Direct labour
Production overhead

Units
1 000 000
500 000

1 500 000

$
900 000 Output to finished
300 000 goods
150 000
150 000
1 500 000

Units

1 500 000

1 500 000

1 500 000

1 500 000

In some cases, the figures for direct labour and production overhead may not be given separately in
an assessment question, but instead grouped together as one figure and called 'conversion cost'.
Added materials, labour and overhead in process 2 are usually added gradually throughout the
process. Materials from process 1, in contrast, will often be introduced in full at the start of the second
process.

2.2 FRAMEWORK FOR DEALING WITH PROCESS COSTING


There is a suggested four-step approach when dealing with process costing questions.
The exact work done at each step will depend on the circumstances of the question, but the approach
can always be used.

Step 1

Determine output and losses.


Determine expected output.
Calculate loss or gain.
Calculate equivalent units if there is closing work in process.

Step 2

Calculate cost per unit of output, losses and WIP.


Calculate cost per unit or cost per equivalent unit.

Step 3

Calculate total cost of output, losses and WIP.


In some examples this will be straightforward. In cases where there is work in process, a
statement of evaluation will have to be prepared. This will be covered later in the
chapter.

Step 4

Complete accounts.
Complete the process account and any other accounts required.

3 DEALING WITH LOSSES IN PROCESS

LO
7.2

Section overview
Losses may occur in a process. If a certain level of loss is expected, this is known as normal
loss. If losses are greater than expected, the extra loss is abnormal loss. If losses are less
than expected, the difference is known as abnormal gain.

PROCESS AND JOB COSTING | 197

3.1 LOSSES
During a production process, a loss may occur.
Definitions
The normal loss is expected loss, allowed for in the budget, and normally calculated as a percentage
of the good output, from a process during a period of time. Normal losses are generally either valued
at zero or at their disposal values.
Abnormal loss is any loss in excess of the normal loss budgeted.
Abnormal gain is the outcome from improvements associated with production activity.

Losses may occur due to wastage, spoilage, evaporation, and so on.

Units associated with abnormal loss and gain are valued at the same unit rate as 'good' units.
Abnormal events do not therefore affect the cost of good production. Their costs are analysed
separately in an abnormal loss or abnormal gain account.

3.1.1 ACCOUNTING FOR ABNORMAL GAINS AND LOSSES


a. In an abnormal loss account, the debit entry shows the units (and their value) from the process
account. The credit entry shows the impact on the statement of comprehensive income.
b. In an abnormal gain account, the debit entry shows the effect on the statement of comprehensive
income, while the credit entry shows the units (and their value) from the process account.
Worked Example: Abnormal losses and gains
Assume that input to a process is 1 000 units at a cost of $4 500. Normal loss is 10% and there are no
opening or closing inventories. Determine the accounting entries for the cost of output and the cost
of the loss if actual output were as follows:
(a) 860 units (so that actual loss is 140 units)
(b) 920 units (so that actual loss is 80 units)
Solution
Before we demonstrate the use of the 'four-step framework' we will summarise the way that the losses
are dealt with:
a. Normal loss is given no share of cost.
b. The cost of output is therefore based on the expected units of output, which in our example
amount to 90% of 1 000 = 900 units.
c. Abnormal loss is given a cost, which is written off to the statement of comprehensive income via an
abnormal loss/gain account.
d. Abnormal gain is treated in the same way, except that being a gain rather than a loss, it appears as
a debit entry in the process account (as it is a type of input, being additional unexpected units),
whereas a loss appears as a credit entry in this account (as it is a type of output).
(a) Output is 860 units.

Step 1

Determine output and losses.


If actual output is 860 units and the actual loss is 140 units:
Actual loss
Normal loss (10% of 1 000)
Abnormal loss

Units
140
100
40

CHAPTER 7

Since normal loss is not given a cost, the cost of producing these units is borne by the 'good' units of
output.

198 | MANAGEMENT ACCOUNTING

Step 2

Calculate cost per unit of output and losses.


The cost per unit of output and the cost per unit of abnormal loss are based on expected
output.

Costs incurred
$4 500
=
= $5 per unit
Expected output
900 units

Step 3

Calculate total cost of output and losses.


Normal loss is not assigned any cost.
$
4 300
0
200
4 500

Cost of output (860 $5)


Normal loss
Abnormal loss (40 $5)

Step 4

Complete accounts.
PROCESS ACCOUNT
Cost incurred

Units
1 000

1 000

$
4 500

Normal loss
Output (finished
goods a/c)
Abnormal loss

4 500

Units
100
860
40
1 000

ABNORMAL LOSS ACCOUNT


Process a/c

Units
40

$
200

Statement of
comprehensive
income

Units
40

$
0

( $5)
( $5)

4 300
200
4 500

$
200

(b) Output is 920 units.

Step 1

Determine output and losses.


If actual output is 920 units and the actual loss is 80 units:
Actual loss
Normal loss (10% of 1 000)
Abnormal gain

Step 2

Units
80
100
20

Calculate cost per unit of output and losses.


The cost per unit of output and the cost per unit of abnormal gain are based on
expected output.
Costs incurred
$4 500
=
= $5 per unit
Expected output
900 units
Whether there is abnormal loss or gain does not affect the valuation of units of output.
The figure of $5 per unit is exactly the same as in the previous paragraph, when there
were 40 units of abnormal loss.

Step 3

Calculate total cost of output and losses.


Cost of output (920 $5)
Normal loss
Abnormal gain (20 $5)

$
4 600
0
(100)
4 500

PROCESS AND JOB COSTING | 199

Step 4

Complete accounts.
PROCESS ACCOUNT
Cost incurred
Abnormal gain a/c
( $5)

Units
1 000
20

$
4 500
100

1 020

4 600

Normal loss
Output
(Finished goods a/c)
( $5)

Units
100
920

$
0
4 600

1 020

4 600

ABNORMAL GAIN
Statement of
comprehensive
income

Units
20

$
100

Process a/c

Units
20

$
100

During a four-week period, period 3, costs of input to a process were $29 070. Input was 1 000 units,
output was 850 units and normal loss is 10%.
During the next period, period 4, costs of input were again $29 070. Input was again 1 000 units, but
output was 950 units.
There were no units of opening or closing inventory.
Prepare the process account and abnormal loss or gain account for each period.
Solution

Step 1

Determine output and losses.


Period 3
Actual output
Normal loss (10% 1 000)
Abnormal loss
Input

Units
850
100
50
1 000

Period 4
Actual output
Normal loss (10% 1 000)
Abnormal gain
Input

Step 2

Calculate cost per unit of output and losses.


For each period the cost per unit is based on expected output.
Cost of input
$29 070
=
= $32.30 per unit
Expected units of output
900

Units
950
100
(50)
1 000

CHAPTER 7

Worked Example: Abnormal losses and gains

200 | MANAGEMENT ACCOUNTING

Step 3

Step 4

Calculate total cost of output and losses.


Period 3
Cost of output (850 $32.30)
Normal loss
Abnormal loss (50 $32.30)

$
27 455
0
1 615
29 070

Period 4
Cost of output (950 $32.30)
Normal loss
Abnormal gain (50 $32.30)

$
30 685
0
(1 615)
29 070

Complete accounts.
PROCESS ACCOUNT
Units
Period 3
Cost of input

Period 4
Cost of input
Abnormal gain a/c
( $32.30)

1 000

$
29 070

1 000

29 070

1 000
50

29 070
1 615

1 050

30 685

Normal loss
Finished goods a/c
( $32.30)
Abnormal loss a/c
( $32.30)

Normal loss
Finished goods a/c
( $32.30)

Units

100
850

0
27 455

50

1 615

1 000

29 070

100
950

0
30 685

1 050

30 685

ABNORMAL LOSS OR GAIN ACCOUNT


$
Period 3
Abnormal loss in process a/c

1 615

$
Period 4
Abnormal gain in process a/c

1 615

There is a zero balance on this account at the end of period 4.

Question 1: Full cost

Charlton Co manufactures a product in a single process operation. Normal loss is 10% of input. Loss
occurs at the end of the process. Data for June are as follows:
Opening and closing inventories of work in process
Cost of input materials (3 300 units)
Direct labour and production overhead
Output to finished goods
The full cost of finished output in June was
A $74 250.
B $81 000.
C $82 500.
D $89 100.
(The answer is at the end of the chapter)

Nil
$59 100
$30 000
2 750 units

PROCESS AND JOB COSTING | 201

Question 2: Abnormal gain

Zed Co makes product Emm which goes through several processes. The following information is
available for the month of June:
Opening WIP
Closing WIP
Input
Normal loss
Transferred to finished goods

kg
5 200
3 500
58 300
400
59 900

What was the abnormal gain in June?

4 ACCOUNTING FOR SCRAP


LO
7.2

Section overview
The valuation of normal loss is either at scrap value or nil. It is conventional for the scrap
value of normal loss to be deducted from the cost of materials before a cost per equivalent
unit is calculated.
Definition

Scrap is discarded material having some value.

4.1 BASIC RULES FOR ACCOUNTING FOR SCRAP


a. Revenue from scrap is treated, not as an addition to sales revenue, but as a reduction in costs. The
valuation of normal loss is either at scrap value or nil. It is conventional for the scrap value of
normal loss to be deducted from the cost of materials before a cost per equivalent unit is
calculated.
b. The scrap value of normal loss is therefore used to reduce the material costs of the process
with the scrap value of the normal loss.
DEBIT
CREDIT

Scrap account
Process account

Abnormal losses and gains never affect the cost of good units of production. The scrap value of
abnormal losses is not credited to the process account, and the abnormal loss and gain units
carry the same full cost as a good unit of production.
c. The scrap value of abnormal loss is used to reduce the cost of abnormal loss with the scrap
value of abnormal loss, which therefore reduces the write-off of cost to the statement of
comprehensive income.
DEBIT
CREDIT

Scrap account
Abnormal loss account

CHAPTER 7

A 260 kgs
B 300 kgs
C 400 kgs
D 560 kgs
(The answer is at the end of the chapter)

202 | MANAGEMENT ACCOUNTING

d. The scrap value of abnormal gain arises because the actual units sold as scrap will be less than
the scrap value of normal loss. Because there are fewer units of scrap than expected, there will be
less revenue from scrap as a direct consequence of the abnormal gain. The abnormal gain account
should therefore be debited with the scrap value of the abnormal gain.
DEBIT
CREDIT

Abnormal gain account


Scrap account

e. The scrap account is completed by recording the actual cash received from the sale of scrap with
the amount received from the sale of the actual scrap.
DEBIT
CREDIT

Cash at bank/Receivables
Scrap account

The same basic principle therefore applies that only normal losses should affect the cost of the good
output. The scrap value of normal loss only is credited to the process account. The scrap values of
abnormal losses and gains are analysed separately in the abnormal loss or gain account.
Worked Example: Scrap and abnormal loss or gain

A factory has two production processes. Normal loss in each process is 10% and scrapped units sell for
$0.50 each from process 1 and $3 each from process 2. Relevant information for costing purposes
relating to period 5 is as follows:
Direct materials added:
Units
Cost
Direct labour
Production overhead
Output to process 2/finished goods
Actual production overhead

Process 1
2 000
$8 100
$4 000
150% of direct labour cost
1 750 units
$17 800

Process 2
1 250
$1 900
$10 000
120% of direct labour cost
2 800 units

Prepare the accounts for process 1, process 2, scrap and abnormal loss or gain.
Solution

Step 1

Determine output and losses.

Output
Normal loss (10% of input)
Abnormal loss
Abnormal gain

Process 1
Units
1 750
200
50

2 000

Process 2
Units
2 800
300

(100)
3 000*

* 1 750 units from process 1 + 1 250 units added.

Step 2

Calculate cost per unit of output and losses.


Process 1
$
Cost of input
material
from process 1
labour
overhead

(150% $4 000)

Less: scrap value of


normal loss

(200 $0.50)

Expected output
90% of 2 000
90% of 3 000
Cost per unit
$18 000 1 800
$40 500 2 700

Process 2
$

8 100

4 000
6 000
18 100

(1 750 $10)

(100)
18 000

(300 $3)

(120% $10 000)

1 900
17 500
10 000
12 000
41 400
(900)
40 500

1 800
2 700
$10
$15

PROCESS AND JOB COSTING | 203

Note. Calculate the cost per unit of output for process 1 prior to attempting to calculate the cost of
process 2.

Step 3

Calculate total cost of output and losses.


Process 1
$
17 500
100
500
18 100

18 100

Output (1 750 $10)


Normal loss (200 $0.50)*
Abnormal loss (50 $10)
Abnormal gain

Process 2
$
42 000
900

42 900
(1 500)
41 400

(2 800 $15)
(300 $3)*

(100 $15)

* Remember that normal loss is valued at scrap value only.


Complete accounts.
PROCESS 1 ACCOUNT
Direct materials
Direct labour
Production
overhead a/c

Units
2 000

$
8 100
4 000

Scrap a/c (normal loss)


Process 2 a/c
Abnormal loss a/c

6 000
18 100

2 000

Units
200
1 750
50

$
100
17 500
500

2 000

18 100

PROCESS 2 ACCOUNT
Units
Direct materials
From process 1
Added materials
Direct labour
Production overhead

1 750
1 250

17 500
1 900
10 000
12 000
41 400
1 500
42 900

3 000
100
3 100

Abnormal gain

Units
Scrap a/c (normal loss)
Finished goods a/c

300
2 800

900
42 000

3 100

42 900

ABNORMAL LOSS ACCOUNT


$
500

Process 1 (50 units)

$
Scrap a/c: sale of scrap of
extra loss (50 units)
Statement of comprehensive
income

500

25
475
500

ABNORMAL GAIN ACCOUNT


$
Scrap a/c (loss of scrap
Revenue due to abnormal
gain, 100 units $3)
Statement of
comprehensive income

$
Process 2 abnormal gain
(100 units)

1 500

300
1 200
1 500

1 500

SCRAP ACCOUNT
$
Scrap value of normal loss
Process 1 (200 units)
Process 2 (300 units)
Abnormal loss a/c (process 1)

100
900
25
1 025

$
Cash at bank/Receivables
Loss in process 1 (250 units)
Loss in process 2 (200 units)
Abnormal gain a/c (process 2)

125
600
300
1 025

CHAPTER 7

Step 4

204 | MANAGEMENT ACCOUNTING

Question 3: Process accounts

Parks Co operates a processing operation involving two stages, the output of process 1 being passed
to process 2. The process costs for period 3 were as follows:
Process 1

Material
Labour

3 000 kg at $0.25 per kg


$120

Process 2

Material
Labour

2 000 kg at $0.40 per kg


$84

General overhead for period 3 amounted to $357 and is absorbed into process costs at a rate of 375%
of direct labour costs in process 1 and 496% of direct labour costs in process 2.
The normal output of process 1 is 80% of input and of process 2, 90% of input. Waste from process 1 is
sold for $0.20 per kg and that from process 2 for $0.30 per kg.
The output for period 3 was as follows:
Process 1
Process 2

2 300 kgs
4 000 kgs

There was no inventory of work in process at either the beginning or the end of the period and it may
be assumed that all available waste had been sold at the prices indicated.
Show how the above would be recorded in process, scrap and abnormal loss/gain accounts by
completing the proformas below. (Hint. Not all boxes require entries.)
PROCESS 1 ACCOUNT
Kg

kg

Material

Normal loss to scrap a/c

Labour

Production transferred to
process 2

General overhead

Abnormal loss a/c

Abnormal gain account

PROCESS 2 ACCOUNT
Kg

Transferred from process 1

Normal loss to scrap a/c

Material added

Production transferred to

Labour

finished inventory

General overhead

Abnormal loss

kg

kg

Abnormal gain

SCRAP ACCOUNT
kg

Normal loss (process 1)

Abnormal gain (process 1)

Normal loss (process 2)

Abnormal gain (process 2)

Abnormal loss (process 1)

Cash

Abnormal loss (process 2)

PROCESS AND JOB COSTING | 205

ABNORMAL LOSS AND GAIN ACCOUNT


kg

kg

Process 1 (loss)

Scrap value of abnormal

Process 2 (loss)

loss

Scrap value of abnormal gain

Process 1 (gain)

Statement of comprehensive
income

Process 2 (gain)

(The answer is at the end of the chapter)

5 VALUING CLOSING WORK IN PROCESS


Section overview
When units are partly completed at the end of a period, i.e. when there is closing work in
process, it is necessary to calculate the equivalent units of production in order to determine
the cost of a completed unit.

In the examples we have looked at so far we have assumed that opening and closing inventories of
work in process have been nil. We must now look at more realistic examples and consider how to
allocate the costs incurred in a period between completed output, i.e. finished units, and partly
completed closing inventory.
Some examples will help to illustrate the problem, and the techniques used to share out (apportion)
costs between finished output and closing work in process.
Worked Example: Valuation of closing inventory

Trotter Co is a manufacturer of processed goods. In March 20X3, in one process, there was no
opening inventory, but 5,000 units of input were introduced to the process during the month, at the
following cost:
Direct materials
Direct labour
Production overhead

$
16 560
7 360
5 520
29 440

Of the 5 000 units introduced, 4 000 were completely finished during the month and transferred to the
next process. Closing inventory of 1 000 units was only 60% complete with respect to materials and
conversion costs.
Solution

a. The problem in this example is to divide the costs of production ($29 440) between the finished
output of 4 000 units and the closing inventory of 1 000 units. It is argued, with good reason, that a
division of costs in proportion to the number of units of each (4 000:1 000) would not be 'fair'
because closing inventory has not been completed, and has not yet 'received' its full amount of
materials and conversion costs, but only 60% of the full amount. The 1 000 units of closing
inventory, being only 60% complete, are the equivalent of 600 fully worked units.
b. To apportion costs fairly and proportionately, units of production must be converted into the
equivalent of completed units, i.e. into equivalent units of production.

CHAPTER 7

LO
7.2

206 | MANAGEMENT ACCOUNTING

Definition

Equivalent units are the notional number of whole units that could have been fully produced in the
period. They represent the sum of the proportion of incomplete units that have been completed.
Equivalent units are used to apportion costs between work in process and completed output.

Step 1

Determine output.
For this step in our framework we need to prepare a statement of equivalent units.
STATEMENT OF EQUIVALENT UNITS
Total
units
4 000
1 000
5 000

Fully worked units


Closing inventory

Step 2

Completion
100%
60%

Equivalent
units
4 000
600
4 600

Calculate cost per unit of output, and WIP.


For this step in our framework we need to prepare a statement of costs per equivalent
unit because equivalent units are the basis for apportioning costs.
STATEMENT OF COSTS PER EQUIVALENT UNIT
Total costs
$29 440
=
Equivalent units
4 600
Cost per equivalent unit $6.40

Step 3

Calculate total cost of output and WIP.


For this step in our framework a statement of evaluation may now be prepared, to show
how the costs should be apportioned between finished output and closing inventory.
STATEMENT OF EVALUATION
Equivalent
units

Item
Fully worked units
Closing inventory

Step 4

Cost per equivalent


unit

4 000
600
4 600

Valuation
$
25 600
3 840
29 440

$6.40
$6.40

Complete accounts.
The process account would be shown as follows:
PROCESS ACCOUNT
Direct materials
Direct labour
Production o'hd

Units
5 000

5 000

$
16 560
7 360
5 520
29 440

Output to next process


Closing inventory c/f

Units
4 000
1 000

$
25 600
3 840

5 000

29 440

5.1 A FEW HINTS ON PREPARING ACCOUNTS


When preparing a process account, it might help to make the entries as follows:
a. Enter the units first. The units columns are simply memorandum columns, but they help you to
make sure that there are no units unaccounted for, for example, as loss.
b. Enter the costs of materials, labour and overheads next. These should be given to you.
c. Enter your valuation of finished output and closing inventory next. The value of the credit
entries should, of course, equal the value of the debit entries.

PROCESS AND JOB COSTING | 207

5.2 DIFFERENT RATES OF INPUT


In many industries, materials, labour and overhead may be added at different rates during the course
of production.
a. Output from a previous process, for example, the output from process 1 to process 2, may be
introduced into the subsequent process all at once, so that closing inventory is 100% complete in
respect of these materials.
b. Further materials may be added gradually during the process, so that closing inventory is only
partially complete in respect of these added materials.
c. Labour and overhead may be 'added' at yet another different rate. When production overhead is
absorbed on a labour hour basis, however, we should expect the degree of completion on
overhead to be the same as the degree of completion on labour.
When this situation occurs, equivalent units, and a cost per equivalent unit, should be calculated
separately for each type of material, and also for conversion costs.

Suppose that Shaker Co is a manufacturer of processed goods, and that results in process 2 for April
20X3 were as follows:
Opening inventory
Material input from process 1
Costs of input:

nil
4 000 units
$
6 000
1 080
1 720

Material from process 1


Added materials in process 2
Conversion costs (direct labour and manufacturing overhead)

Output is transferred into the next process, process 3.


Closing work in process amounted to 800 units, complete as follows:
%
100
50
30

Process 1 material
Added materials
Conversion costs

Required

Prepare the account for process 2 for April 20X3.


Solution

Step 1

Determine output and losses.


STATEMENT OF EQUIVALENT UNITS (OF PRODUCTION IN THE PERIOD)

Input
Units
4 000

4 000

Output
Completed
production
Closing inventory

Total
Units
3 200
800
4 000

* 800 50% ** 800 30%

Equivalent units of production


Process 1
Added
Conversion
material
materials
costs
Units
%
Units
%
Units
%
3 200
100
3 200
100
3 200
100
800
4 000

100

400*
3 600

50

240**
3 440

30

CHAPTER 7

Worked Example: Equivalent units and different degrees of completion

208 | MANAGEMENT ACCOUNTING

Step 2

Calculate cost per unit of output, losses and WIP.


STATEMENT OF COST (PER EQUIVALENT UNIT)
Input

Cost
$
6 000
1 080
1 720
8 800

Process 1 material
Added materials
Conversion costs

Step 3

Equivalent production
in units

Cost per
unit
$
1.50
0.30
0.50
2.30

4 000
3 600
3 440

Calculate total cost of output, losses and WIP.


STATEMENT OF EVALUATION (OF FINISHED WORK AND CLOSING INVENTORIES)

Production
Completed production
Closing inventory:

Cost element

process 1 material
added material
Conversion cots

Number of
equivalent
units
3 200
800
400
240

Cost per
equivalent
unit
$
2.30
1.50
0.30
0.50

Total
$

Cost
$
7 360

1 200
120
120
1 440
8 800

Step 4

Complete accounts.
PROCESS ACCOUNT
Process 1 material
Added material
Conversion costs

Units
4 000

4 000

$
6 000
1 080
1 720
8 800

Process 3 a/c
(finished output)
Closing inventory c/f

Units
3 200

$
7 360

800
4 000

1 440
8 800

5.3 CLOSING WORK IN PROCESS AND LOSSES


The previous sections have dealt separately with the following:
a. The treatment of loss and scrap.
b. The use of equivalent units as a basis for apportioning costs between units of output and units of
closing inventory.
We must now look at a situation where both problems occur together. We shall begin with an
example where loss has no scrap value.
The conventions are as follows:
a. Costs should be divided between finished output, closing inventory and abnormal loss/gain using
equivalent units as a basis of apportionment.
b. Units of abnormal loss/gain are often taken to be one full equivalent unit each, and are valued
on this basis, i.e. they carry their full 'share' of the process costs.
c. Abnormal loss units are an addition to the total equivalent units produced but abnormal gain
units are subtracted in arriving at the total number of equivalent units produced.
d. Units of normal loss are valued at zero equivalent units, i.e. they do not carry any of the process
costs.

PROCESS AND JOB COSTING | 209

Worked Example: Changes in inventory level and losses

The following data have been collected for a process:


Opening inventory
Input units
Cost of input
Normal loss

none
2 800 units
$16 695
10%; nil scrap value

Output to finished goods 2 000 units


Closing inventory
450 units, 70% complete
Total loss
350 units

Prepare the process account for the period.


Solution

Step 1

Determine output and losses.

Total units
2 000

Completely worked units

( 100%)

Equivalent units
of work
done this
period
2 000

Closing inventory

450

( 70%)

315

Normal loss (10% 2800)


Abnormal loss (350 280)

280
70

( 100%)

0
70

2 800

Step 2

2 385

Calculate cost per unit of output, losses and WIP.


STATEMENT OF COST (PER EQUIVALENT UNIT)
Costs incurred
$16 695
=
Equivalent units of work done
2 385
Cost per equivalent unit = $7

Step 3

Calculate total cost of output, losses and WIP.


STATEMENT OF EVALUATION
Equivalent
units
2 000
315
70
2 385

Completely worked units


Closing inventory
Abnormal loss

Step 4

$
14 000
2 205
490
16 ,695

Complete accounts.
PROCESS ACCOUNT
Units
Opening inventory
Input costs

2 800

16 695

2 800

16 695

Normal loss
Finished goods a/c
Abnormal loss a/c
Closing inventory c/f

Units
280
2 000
70
450
2 800

$
0
14 000
490
2 205
16 695

5.4 CLOSING WORK IN PROCESS, LOSS AND SCRAP


When loss has a scrap value, the accounting procedures are the same as those previously described.
However, if the equivalent units are a different percentage (of the total units) for materials, labour and
overhead, it is a convention that the scrap value of normal loss is deducted from the cost of
materials before a cost per equivalent unit is calculated.

CHAPTER 7

STATEMENT OF EQUIVALENT UNITS

210 | MANAGEMENT ACCOUNTING

Question 4: Closing work in process

Complete the process account below from the following information. (Hint. Not all boxes require
entries.)
Opening inventory

Nil

Input units

10 000

Input costs
Material
Labour

$5 150
$2 700

Normal loss

5% of input

Total loss

1 000 units

Scrap value of units of loss

$1 per unit

Output to finished goods

8 000 units

Closing inventory

1 000 units

Completion of closing inventory

80% for material


50% for labour
PROCESS ACCOUNT

Units

Units

Material

Completed production

Labour

Closing inventory

Abnormal gain

Normal loss

Abnormal loss

(The answer is at the end of the chapter)

6 VALUING OPENING WORK IN PROCESS


LO
7.2

Section overview
The weighted average cost method of valuing opening WIP makes no distinction between
units of opening WIP and new units introduced to the process during the current period.

6.1 WEIGHTED AVERAGE COST METHOD


The weighted average cost method of inventory valuation is an inventory valuation method that
calculates a weighted average cost of units produced from both opening inventory and units
introduced in the current period.
With the weighted average cost method no distinction is made between units of opening WIP and
new units introduced to the process during the current period. The cost of opening WIP is added to
costs incurred during the period, and completed units of opening WIP are each given a value of one
full equivalent unit of production.

PROCESS AND JOB COSTING | 211

Worked Example: Weighted average cost method

Magpie Co produces an item which is manufactured in two consecutive processes. Information


relating to Process 2 during September 20X3 is as follows:
Opening inventory 800 units
Degree of completion:
Process 1 materials
Added materials
Conversion costs (direct labour and manufacturing overhead)

%
100
40
30

$
4 700
600
1 000
6 300

During September 20X3, 3,000 units were transferred from process 1 at a valuation of $18 100. Added
materials cost $9,600 and conversion costs were $11 800.
Closing inventory at 30 September 20X3 amounted to 1,000 units which were 100% complete with
respect to process 1 materials and 60% complete with respect to added materials. Conversion cost
work was 40% complete.

CHAPTER 7

Magpie Co uses a weighted average cost system for the valuation of output and closing inventory.
Prepare the process 2 account for September 20X3.
Solution

Step 1

Determine output and losses.


Opening inventory units count as a full equivalent unit of production when the weighted
average cost system is applied. Closing inventory units are assessed in the usual way.
STATEMENT OF EQUIVALENT UNITS
Total

Output to finished goods*


Closing inventory

Process 1

units
2 800
1 000
3 800

(100%)
(100%)

material
2 800
1 000
3 800

(60%)

Equivalent units
Added
Conversio
n
material
costs
2 800
2 800
600 (40%)
400
3 400
3 200

* 3 000 units from process 1 minus closing inventory of 1 000 units plus opening inventory
of 800 units.

Step 2

Calculate cost per unit of output and WIP.


The cost of opening inventory is added to costs incurred in September 20X3, and a cost
per equivalent unit is then calculated.
STATEMENT OF COSTS PER EQUIVALENT UNIT

Opening inventory
Added in September 20X3
Total cost

Process 1
material
$
4 700
18 100
22 800

Equivalent units
Cost per equivalent unit

Step 3

Added
materials
$
600
9 600
10 200

3 800 units
$6

3 400 units
$3

Conversion
costs
$
1 000
11 800
12 800
3 200 units
$4

Calculate total cost of output and WIP.


STATEMENT OF EVALUATION
Process 1
Material
$
Output to finished goods
(2 800 units)
Closing inventory

16 800
6 000

Added
materials
$
8 400
1 800

Conversion
costs
$

Total
cost
$

11 200
1 600

36 400
9 400
45 800

212 | MANAGEMENT ACCOUNTING

Step 4

Complete accounts
PROCESS 2 ACCOUNT
Opening inventory b/f
Process 1 a/c
Added materials
Conversion costs

Units
800
3 000

3 800

$
6 300
18 100
9 600
11 800
45 800

Finished goods a/c

Closing inventory c/f

Units
2 800

$
36 400

1 000
3 800

9 400
45 800

6.2 A FINAL QUESTION


The following question involves the following process costing situations:
Normal loss with and without sale of scrap.
Abnormal loss.
Abnormal gain.
Opening work in process.
Closing work in process.

Take some time to work through this question carefully and to check your workings against the answer
given below. This question should help consolidate all of the process costing knowledge that you
have acquired while studying this chapter.
Question 5: Watkins Ltd

Watkins Ltd has a financial year which ends on 30 April 20X0. It operates in a processing industry in
which a single product is produced by passing inputs through two sequential processes. A normal loss
of 10% of input is expected in each process. Total loss for process 1 was 1 200 units.
The following account balances have been extracted from its ledger at 31 March 20X0:

Process 1 (Materials $4 400; Conversion costs $3 744)


Process 2 (Process 1 $4 431; Conversion costs $5 250)
Abnormal loss
Abnormal gain
Overhead control account
Sales
Cost of sales
Finished goods inventory

Debit
$
8 144
9 681
1 400

Credit
$

300
250
585 000
442 500
65 000

Watkins Ltd uses the weighted average method of accounting for work in process.
During April 20X0 the following transactions occurred:
Process 1

Process 2

Materials input (kg $)


Labour cost
Transfer to process 2

Transfer from process 1


Labour cost
Transfer to finished goods
Overhead costs incurred amounted to
Sales to customer were

4 000 kg

$22 000
$12 000

2 400 kg
2 400 kg
$15 000
2 500 kg
$54 000
$52 000

Overhead costs are absorbed into process costs on the basis of 150% of labour cost.
The losses which arise in process 1 have no scrap value: those arising in process 2 can be sold for $2 per
kg.

PROCESS AND JOB COSTING | 213

Details of opening and closing work in process for the month of April 20X0 are as follows:
Process 1
Process 2

Opening
3 000 kg
2 250 kg

Closing
3 400 kg
2 600 kg

In both processes closing work in process is fully complete as to material cost and 40% complete as to
conversion cost.
Inventories of finished goods at 30 April 20X0 were valued at cost of $60 000.
You are required to fill in the blank boxes.
a. In an account for process 1, the monetary and quantity values for:
kgs at $

transfers to process 2 are

ii normal loss are

kgs at $

iii. abnormal loss are

kgs at $

iv. abnormal gain are

kgs at $

v. WIP materials are

kgs at $
kgs at $

vi. WIP conversion costs are

b. In an account for process 2, the monetary and quantity values for:


i. finished goods are
kgs at $
ii. normal loss are

kgs at $

iii. WIP from process 1 are

kgs at $

iv. WIP from process 2 are

kgs at $

(The answer is at the end of the chapter)

7 JOINT PRODUCTS AND BY-PRODUCTS

LO
7.2

Section overview
Joint products are two or more products produced by the same process and separated in
processing, each having a sufficiently high saleable value to merit recognition as a main
product.
A by-product is an incidental product from a process which has an insignificant value
compared to the main product(s).

7.1 JOINT PRODUCTS


Joint products
are produced in the same process.
are indistinguishable from each other until the separation point.
have a substantial sales value after further processing, if necessary.
may require further processing after the separation point.

For example, in the oil refining industry the following joint products all arise from the same process:
Diesel fuel
Petrol
Paraffin
Lubricants

CHAPTER 7

214 | MANAGEMENT ACCOUNTING

7.2 BY-PRODUCTS
A by-product is an incidental product from a process which has an insignificant value compared to
the main product(s).
Definition

A by-product is output of some insignificant value produced incidentally while manufacturing the
main product. By products are not separately identifiable as individual products until separation point.
A by-product is a product which is similarly produced at the same time and from the same common
process as the 'main product' or joint products. The distinguishing feature of a by-product is its
relatively low sales value in comparison to the main product. In the timber industry, for example, byproducts include sawdust, small off cuts and bark.

7.3 DISTINGUISHING JOINT PRODUCTS FROM BY-PRODUCTS


The answer lies in management attitudes to their products, which in turn is reflected in the cost
accounting system.
a. A joint product is regarded as an important saleable item, and so it should be separately costed.
The profitability of each joint product should be assessed in the cost accounts.
b. A by-product is not important as a saleable item, and whatever revenue it earns is a 'bonus' for the
organisation. It is not worth costing by-products separately, because of their relative
insignificance. It is therefore equally irrelevant to consider a by-product's profitability. The only
question is how to account for the 'bonus' net revenue that a by-product earns.

7.4 ACCOUNTING FOR JOINT AND BY-PRODUCTS


The point at which joint and by-products become separately identifiable is known as the split-off
point or separation point. Costs incurred up to this point are called common costs or joint costs.
Common or joint costs need to be allocated (apportioned) in some manner to each of the joint
products. In the example below there are two different split-off points.
(1) Split-off point

Input
raw materials

A
roduct
Joint p
Joint p
roduc
tB

Process 1

(2) Split-off point

roduct

Process 2

Joint p
Joint

By-product X

produ

ct D

By-product Y

Example of two split-off points

7.5 APPORTIONING COMMON COSTS


Reasons for apportioning common costs to individual joint products are as follows:
a. To put a value to closing inventories of each joint product.
b. To record the costs and therefore the profit from each joint product. This is of limited value
however, because the costs and therefore profit from one joint product are influenced by the share
of costs assigned to the other joint products. Management decisions should not be based on the
apparent relative profitability of the products which has arisen due to the arbitrary apportionment
of the joint costs.
c. Perhaps to assist in pricing decisions.
Here are some examples of common costing problems.

PROCESS AND JOB COSTING | 215

a. How to spread the common costs of oil refining between the joint products made petrol,
naphtha, kerosene and so on.
b. How to spread the common costs of running the telephone network between telephone calls in peak
rate times and cheap rate times, or between local calls and long-distance calls.

7.5.1 METHODS OF APPORTIONING COMMON COSTS


The main methods that might be used to establish a basis for apportioning or allocating common
costs to each product are as follows:
Physical measurement, e.g. weight of output.
Relative sales value apportionment method 1; sales value at split-off point.
Relative sales value apportionment method 2; sales value of end product less further processing
costs after split-off point, i.e. the net realisable value of each product at the split-off point.

Despite the fact that the by-product has a small value relative to that of the main product, it does have
some commercial value and its accounting treatment usually consists of one of the following:
a. Income (minus any post-separation further processing or selling costs) from the sale of the byproduct may be added to sales of the main product, thereby increasing sales revenue for the
period.
b. The sales of the by-product may be treated as a separate, incidental source of income against
which are offset only post-separation costs (if any) of the by-product. The revenue would be
recorded in the statement of comprehensive income as 'other income'.
c. The sales income of the by-product may be deducted from the cost of production or cost of sales
of the main product.
d. The net realisable value of the by-product may be deducted from the cost of production of the
main product. The net realisable value is the final saleable value of the by-product minus any
post-separation costs.
The choice of method will be influenced by the circumstances of production and ease of calculation,
as much as by conceptual correctness. The most common method is method (d). Notice that this
method is the same as the accounting treatment of a normal loss which is sold for scrap.
Question 6: Split off point

Butter
Milk

Cream
Yoghurt

Mark the split-off point on the diagram above.


(The answer is at the end of the chapter)

8 JOB COSTING
Section overview
Job costing is the costing method used where work is undertaken to customers' special
requirements and each order is of comparatively short duration.
The usual method of fixing prices within a company involved in contracting is cost plus
pricing.

CHAPTER 7

7.6 ACCOUNTING FOR BY-PRODUCTS

216 | MANAGEMENT ACCOUNTING

LO
7.2
7.2

The work relating to a job is usually carried out within a factory or workshop and moves through
processes and operations as a continuously identifiable unit.
Definitions

A job is a customer order or task of relatively short duration. It can be an individual product, a small
unique batch of products, a project, a case or even a client project.
Job costing is a form of specific order costing where costs are attributed to individual jobs.

8.1 PROCEDURE FOR THE PERFORMANCE OF JOBS


The normal procedure which is adopted in companies involved in contract work involves the following:
a. Customer and supplier discuss and agree parameters and scope of job, for example, the quantity,
quality, size and colour of the goods, the date of delivery and any special requirements.
b. The estimating department of the organisation then prepares an estimate for the job. This will
include the cost of the materials to be used, the wages expected to be paid, the appropriate
amount for factory, administration, selling and distribution overhead, the cost where appropriate of
additional equipment needed specially for the job, and finally the supplier's profit margin. The
total of these items will represent the quoted selling price.
c. At the appropriate time, the job will be 'loaded' on to the factory floor. This means that as soon as
all materials, labour and equipment are available and subject to the scheduling of other orders, the
job will be started. In an efficient organisation, the start of the job will be timed to ensure that it will
be ready for the customer by the promised date of delivery. The job should not be loaded too
early, otherwise storage space will have to be found for the product until the date it is required by
the customer.

8.2 RECORDING JOB COSTS


A separate record must be maintained to show the details of individual jobs. In manual systems, these
are known as job cost cards or job cost sheets. In computerised systems, job costs will be collected
in job accounts.

8.2.1 JOB ACCOUNTS


Job accounts are very much like the process accounts we encountered in Section 1. Inputs to a job are
recorded on the left-hand side of the account, outputs on the right-hand side.

8.2.2 COLLECTING JOB COSTS


Key points on the process of collecting job costs are as follows:
a. Some labour costs, such as an overtime premium, might be charged either directly to a job or else
as an overhead cost, depending on the circumstances in which the costs have arisen.
b. The relevant costs of materials issued, direct labour performed and direct expenses incurred are
charged to a job account in the work in process ledger, the work in process ledger recording the
cost of all WIP.
c. The job account is allocated with the job's share of the factory overhead, based on the absorption
rate(s) in operation. If the job is incomplete at the end of an accounting period, it is valued at
factory cost in the closing statement of financial position, where a system of absorption costing is
in operation.
d. On completion of the job, the job account is charged with the appropriate administration, selling
and distribution overhead, after which the total cost of the job can be ascertained. The job is then
transferred to finished goods.
e. The difference between the agreed selling price and the total actual cost will be the supplier's
profit (or loss).
f. When delivery is made to the customer, the costs become a cost of sale.

PROCESS AND JOB COSTING | 217

Question 7: Job costing

Twist and Tern Co is a company that carries out contracting work. One of the jobs carried out in
February was job 1357, to which the following information relates:
Direct material Y: 400 kilos were issued from stores at a cost of $5 per kilo.
Direct material Z: 800 kilos were issued from stores at a cost of $6 per kilo.
60 kilos were returned.
Department P:

320 labour hours were worked, of which 100 hours were done as overtime.

Department Q:

200 labour hours were worked, of which 100 hours were done as overtime.

Overtime work is not normal in department P, where basic pay is $8 per hour plus an overtime
premium of $2 per hour. Overtime work was done in department Q in February because of a request
by the customer of another job to complete that job quickly. Basic pay in department Q is $10 per
hour and the overtime premium is $3 per hour.
Overhead is absorbed at the rate of $3 per direct labour hour in both departments.
a. The direct materials cost of job 1357 is $

c. The full production cost of job 1357 is $

.
.

(The answer is at the end of the chapter)

8.3 COST PLUS PRICING


The usual method of setting prices within a company involved in contract work is cost plus pricing.
Cost plus pricing is where a desired profit margin is added to total costs to arrive at the selling price.
The disadvantages of cost plus pricing are as follows:
a. There are no incentives to control costs as a profit is guaranteed.
b. There is no motive to tackle inefficiencies or waste.
c. It does not take into account any significant differences in actual and estimated volumes of activity.
Since the overhead absorption rate is based upon estimated volumes, there may be under-/overabsorbed overheads not taken into account.
d. Because overheads are apportioned in an arbitrary way, this may lead to under and over pricing.
The cost plus system is often adopted where one-off jobs are carried out to customers' specifications.
Advantages are:
a. It is relatively simple to determine the appropriate price once overheads have been allocated.
b. For a one-off contract it ensures that the contractor's costs will be covered and a profit realised,
hence reducing the risk of losses on the contract.
c. It may help the supplier justify the price to the customer e.g. if supplier can point to an increase in
the cost of raw materials as a reason for the price increase.
d. It may help promote price stability because it limits the ability of the sales department to adopt a
discretionary approach to pricing.
In a competitive market however the margin added to cost would need to take into account
competitor prices or the company may price itself out of the market.

CHAPTER 7

b. The direct labour cost of job 1357 is $

218 | MANAGEMENT ACCOUNTING

Question 8: Selling prices

The total cost of job 259 is $4 200.


a. When profit is calculated as 25 per cent of sales, the correct selling price for the job is $

b. When profit is calculated as 25 per cent of cost, the correct selling price for the job is $

(The answer is at the end of the chapter)

Worked Example: Job costing example

An example may help to illustrate the principles of job costing.


FM Co is a contract company. On 1 June 20X2, there was one uncompleted job in the factory. The job
card for this work is summarised as follows:
Job card, job no 6832
Costs to date
Direct materials
Direct labour (120 hours)
Factory overhead ($2 per direct labour hour)
Factory cost to date

$
630
840
240
1 710

During June, three new jobs were started in the factory, and costs of production were as follows:
Direct materials
Issued to:
Job 6832
Job 6833
Job 6834
Job 6835

$
2 390
1 680
3 950
4 420

Material transfers
Job 6832 to Job 6834
Job 6834 to Job 6833

$
620
250

Materials returned to store


From Job 6832
From Job 6835

$
870
170

Direct labour hours recorded


Job 6832
Job 6833
Job 6834
Job 6835

Hours
430
650
280
410

The cost of labour hours during June 20X2 was $8 per hour, and production overhead is absorbed at
the rate of $2 per direct labour hour. Completed jobs were delivered to customers as soon as they
were completed, and the invoiced amounts were as follows:
Job 6832
Job 6834
Job 6835

$8 500
$9 000
$9 500

Administration and marketing overheads are added to the cost of sales at the rate of 20% of factory
cost.
Required

a. Prepare the job accounts for each individual job during June 20X2. (Remember inputs to the job go
on the left-hand side of the account, outputs on the right-hand side.)
b. Prepare the summarised job cost cards for each job, and calculate the profit on each completed
job.

PROCESS AND JOB COSTING | 219

Solution

a. Job accounts
JOB 6832
Balance b/f
Materials (stores a/c)
Labour (wages a/c)
Production overhead (o'hd a/c)

$
1 710
2 390
3 440
860
8 400

$
620

Job 6834 a/c


(materials transfer)
To stores (materials returned)
Cost of sales (balance)

870
6 910
8 400

JOB 6833
$
1 680
5 200
1 300
250
8 430

$
8 430

Balance c/f

8 430

JOB 6834
Materials (stores a/c)
Labour (wages a/c)
Production overhead (o'hd a/c)
Job 6832 a/c (materials transfer)

$
3 950
2 240
560
620
7 370

$
250

Job 6833 a/c (materials transfer)


Cost of sales (balance)

7 120
7 370

JOB 6835
Materials (stores a/c)
Labour (wages a/c)
Production overhead (o'hd a/c)

$
4 420
3 280
820
8 520

$
170

To stores (materials returned)


Cost of sales (balance)

8 350
8 520

Note that the accounts to which the double entry is made are shown in brackets.
b. Job cards, summarised

Materials
Labour
Production overhead
Factory cost
Admin & marketing o'hd (20%)
Cost of sale
Invoice value
Profit/(loss) on job

Job 6832
$
1 530*
4 280
1 100
6 910
1 382
8 292
8 500
208

Job 6833
$
1 930
5 200
1 300
(c/f) 8 430

* $(630 + 2 390 620 870) ** $(3 950 + 620 250)

Job 6834
$
4 320**
2 240
560
7 120
1 424
8 544
9 000
456

Job 6835
$
4 250
3 280
820
8 350
1 670
10 020
9 500
(520)

CHAPTER 7

Materials (stores a/c)


Labour (wages a/c)
Production overhead (o'hd a/c)
Job 6834 a/c (materials transfer)

220 | MANAGEMENT ACCOUNTING

KEY CHAPTER POINTS


Process costing is a costing method used where it is not possible to identify separate units of
production, or jobs, usually because of the continuous nature of the production processes
involved.
Costs incurred in processes are recorded in what are known as process accounts.
A process account has two sides, and on each side there are two columns one for quantities (of
raw materials, work in process and finished goods) and one for costs.
A suggested four-step approach when dealing with process costing questions is:

Step 1
Step 2
Step 3
Step 4

Determine output and losses


Calculate cost per unit of output, losses and WIP
Calculate total cost of output, losses and WIP
Complete accounts

Losses may occur in a process. If a certain level of loss is expected, this is known as normal loss. If
losses are greater than expected, the extra loss is abnormal loss. If losses are less than expected,
the difference is known as abnormal gain.
The valuation of normal loss is either at scrap value or nil. It is conventional for the scrap value of
normal loss to be deducted from the cost of materials before a cost per equivalent unit is
calculated.
Abnormal losses and gains never affect the cost of good units of production. The scrap value of
abnormal losses is not credited to the process account, and the abnormal loss and gain units carry
the same full cost as a good unit of production.
When units are partly completed at the end of a period, i.e. when there is closing work in process,
it is necessary to calculate the equivalent units of production in order to determine the cost of a
completed unit.
The weighted average cost method of valuing opening WIP makes no distinction between units of
opening WIP and new units introduced to the process during the current period.
Joint products are two or more products separated in a process, each of which has a significant
value.
A by-product is an incidental product from a process which has an insignificant value compared to
the main products(s).
Job costing is the costing method used where work is undertaken to customers' special
requirements and each order is of comparatively short duration.
The usual method of fixing prices within a company involved in contract work is cost plus pricing.

PROCESS AND JOB COSTING | 221

QUICK REVISION QUESTIONS


THE FOLLOWING INFORMATION RELATES TO QUESTIONS 1 AND 2

A company manufactures chemical X in a single process. At the start of the month there was no workin-process. During the month 300 litres of raw material were input into the process at a total cost of
$6 000. Conversion costs during the month amounted to $4 500. At the end of the month 250 litres of
chemical X were transferred to finished goods inventory. The remaining work-in-process was 100%
complete with respect to materials and 50% complete with respect to conversion costs. There were no
losses in the process.

A
B
C
D

Material
25 litres
25 litres
50 litres
50 litres

Conversion costs
25 litres
50 litres
25 litres
50 litres

2 If there had been a normal process loss of 10% of input during the month the value of this loss
would have been
A nil.
B $450.
C $600.
D $1 050.

3 In a process account, abnormal losses are valued


A at zero.
B at their scrap value.
C at the cost of raw materials.
D the same as good production.
4 A company needs to produce 340 litres of chemical Y. There is a normal loss of 10% of the material
input into the process. During a given month the company did produce 340 litres of good
production, although there was an abnormal loss of 5% of the material input into the process.
How many litres of material were input into the process during the month?
A
B
C
D

357 litres
374 litres
391 litres
400 litres

CHAPTER 7

1 The equivalent units for closing work-in-process at the end of the month would have been

222 | MANAGEMENT ACCOUNTING

THE FOLLOWING INFORMATION RELATES TO QUESTIONS 5 AND 6

A company produces a certain food item in a manufacturing process. On 1 November, there was no
opening inventory of work in process. During November, 500 units of material were input to the
process, with a cost of $9 000. Direct labour costs in November were $3 840. Production overhead is
absorbed at the rate of 200% of direct labour costs. Closing inventory on 30 November consisted of
100 units which were 100% complete as to materials and 80% complete as to labour and overhead.
There was no loss in process.
5 The full production cost of completed units during November was
A $10 400.
B $16 416.
C $16 800.
D $20 520.
6 The value of the closing work in process on 30 November is
A $2 440.
B $3 720.
C $4 104.
D $20 520.

THE FOLLOWING INFORMATION RELATES TO QUESTIONS 7 AND 8

A company makes a product in two processes. The following data is available for the latest period, for
process 1.
Opening work in process of 200 units was valued as follows:
Material
Labour
Overhead

$2 400
$1 200
$400

No losses occur in the process.


Units added and costs incurred during the period:
Material
Labour
Overhead

$6 000 (500 units)


$3 350
$1 490

Closing work in process of 100 units had reached the following degrees of completion:
Material
Labour
Overhead

100%
50%
30%

The company uses the weighted average method of inventory valuation.


7 How many equivalent units are used when calculating the cost per unit in relation to overhead?
A 500
B 600
C 630
D 700
8 The value of the units transferred to process 2 was
A $7 200.
B $13 200.
C $14 840.
D $15 400.

PROCESS AND JOB COSTING | 223

9 A company manufactures two joint products, P and R, in a common process. Data for June are as
follows:
$
1 000
10 000
12 000
3 000

Opening inventory
Direct materials added
Conversion costs
Closing inventory
Production
Units
4 000
6 000

P
R

Sales
Units
5 000
5 000

Sales price
$ per unit
5
10

A
B
C
D

$1.25
$2.22
$2.50
$2.75

10 How is revenue from scrap treated?


A As a bonus to all employees
B As an addition to sales revenue
C As a reduction in costs of processing
D As a bonus to production employees

CHAPTER 7

If costs are apportioned between joint products on a sales value basis, what was the cost per unit
of product R in June?

224 | MANAGEMENT ACCOUNTING

ANSWERS TO QUICK REVISION QUESTIONS


1 C Work in progress = 300 litres input 250 litres to finished goods
= 50 litres
Equivalent litres for each cost element are as follows:
Material
Equiv.
litres
100
50

Conversion costs
%
Equiv.
litres
50
25

50 litres in progress

Option A is incorrect because it assumes that the units in progress are only 50 per cent
complete with respect to materials.
Option B has transposed the information concerning the two cost elements.
If you selected option D you calculated the correct number of litres in progress but you did not
take account of their degree of completion.
2 A There is no mention of a scrap value available for any losses therefore the normal loss would
have a zero value. The normal loss does not carry any of the process costs therefore options B,
C and D are all incorrect.
3 D Abnormal losses are valued at the same unit rate as good production, so that their occurrence
does not affect the cost of good production. They are not valued at zero, so option A is
incorrect.
The scrap value of the abnormal loss (option B) is credited to a separate abnormal loss account;
it does not appear in the process account.
Option C is incorrect because abnormal losses also absorb some conversion costs.
4 D The total loss was 15% of the material input. The 340 litres of good output therefore represents
85% of the total material input.
Therefore, material input =

340
= 400 litres
0.85

Options A and B are incorrect because they represent a further five per cent and ten per cent
respectively, added to the units of good production.
If you selected option C you simply added 15 per cent to the 340 litres of good production.
However, the losses are stated as a percentage of input, not as a percentage of output.
5 C

Step 1

Determine output and losses.


Input
Units
500
500

Step 2

Output
Finished units (balance)
Closing inventory

Total
Units
400
100
500

Equivalent units
Materials
Labour and overhead
Units
%
Units
%
400
100
400
100
100
100
80
80
500
480

Calculate the cost per equivalent unit.

Input
Materials
Labour and overhead

Cost
$
9 000
11 520

Equivalent
production
in units
500
480

Cost per
unit
$
18
24
42

PROCESS AND JOB COSTING | 225

Step 3

Calculate total cost of output.


Cost of completed units = $42 400 units = $16 800
If you selected option A you omitted the absorption of overhead at the rate of 200
per cent of direct labour.
If you selected option B you did not allow for the fact that the work in progress
was incomplete.
Option D is the total process cost for the period, some of which must be allocated
to the work in progress.

6 B Using the data from answer 5 above, extend step 3 to calculate the value of the work in
progress.

Work in progress:

Number of
equivalent units

Materials
Labour & overhead

100
80

Cost per
equivalent unit
$
18
24

Total
$
1 800
1 920
3 720

If you selected option A you omitted the absorption of overhead into the process costs. If you
selected option C you did not allow for the fact that the work in progress was incomplete.
Option D is the total process cost for the period, some of which must be allocated to the
completed output.
7 C STATEMENT OF EQUIVALENT UNITS

Output to process 2*
Closing WIP

Total
Units
600
100
700

Equivalent units
Labour

Materials

(100%)

600
100
700

(50%)

600
50
650

Overheads
600
30
630

(30%)

*500 units input + opening WIP 200 units closing WIP 100 units.
Option A is incorrect because it is the number of units input to the process, taking no account
of opening and closing work in progress.
Option B is the completed output, taking no account of the work done on the closing
inventory. Option D is the total number of units worked on during the period, but they are not
all complete in respect of overhead cost.
8 B STATEMENT OF COSTS PER EQUIVALENT UNIT

Opening stock
Added during period
Total cost
Equivalent units
Cost per equivalent unit

Materials
$
2 400
6 000
8 400
700
$12

Labour
$
1 200
3 350
4 550
650
$7

Overheads
$
400
1 490
1 890
630
$3

Total

$22

Value of units transferred to process 2 = 600 units $22 = $13 200


Option A is incorrect because it represents only the material cost of the units transferred.
Option C is all of the costs incurred in the process during the period, but some of these costs
must be allocated to the closing work in progress.
Option D is the value of 700 completed units: but only 600 units were transferred to the next
process.

CHAPTER 7

Cost
element

226 | MANAGEMENT ACCOUNTING

9 C Total production inventory


$
1 000
10 000
12 000
23 000
3 000
20 000

Opening inventory
Direct materials added
Conversion costs
Less closing inventory
Total production cost

P
R

Production
Units
4 000
6 000

( $5)
( $10)

Sales value
$
20 000
60 000
80 000

($20 000 20/80)


($20 000 60/80)

Apportioned
cost
$
5 000
15 000
20 000

Product R cost per unit = $15 000/6 000 = $2.50 per unit.
Option A is the cost per unit for product P, and if you selected option B you apportioned the
production costs on the basis of units sold. If you selected option D you made no adjustment
for inventories when calculating the total costs.
10 C Revenue from scrap is treated as a reduction in costs of processing.

PROCESS AND JOB COSTING | 227

ANSWERS TO CHAPTER QUESTIONS


1 C

Step 1

Determine output and losses.


Units
2 750
330
220
3 300

Actual output
Normal loss (10% 3 300)
Abnormal loss

Step 2

Calculate cost per unit of output and losses.


= Cost per expected unit of output

Step 3

Calculate total cost of output and losses.


$
82 500
0
6 600
89 100

Cost of output (2 750 $30)


Normal loss
Abnormal loss (220 $30)

Hence cost of 2 750 finished units output is $82 500


Option A is incorrect because it results from allocating a full unit cost to the normal loss:
remember that normal loss does not carry any of the process cost.
Option B is incorrect because it results from calculating a 10% normal loss based on output of 2
750 units (275 units normal loss), rather than on input of 3 300 units.
Option D is simply the total input cost, with no attempt to apportion some of the cost to the
abnormal loss.
2 B
DR
Opening WIP
Input

PROCESS ACCOUNT
CR
5 200
Output
58 300
Normal loss

59 900
400

Closing WIP

3 500

Abnormal gain

63 800

63 800

The abnormal gain is the balancing figure: 63 800 5 200 58 300 = 300
3

Step 1

Determine output and losses.

Output
Normal loss (20% of 3 000 kgs)
Abnormal loss
Abnormal gain

Process 1
kgs
2 300
600
100

3 000

* From process 1 (2 300 kgs) + 2 000 kgs added

(10% of 4 300)

Process 2
kgs
4 000
430

(130)
4 300*

CHAPTER 7

Cost of input
$89 100
=
= $30 per unit
Expected units of output
3 300 330

228 | MANAGEMENT ACCOUNTING

Step 2

Calculate cost per unit of output and losses.


Process 1
$
750

120
450

Material (3 000 $0.25)


From process 1
Labour
Overhead (375% $120)
Less: scrap value of normal loss
(600 $0.20)
Expected output
3 000 80%
Cost per unit $ $1320 $120
3 000 600

Step 3

(2 000 $0.40)
(2 300 $0.50)
(496% $84)

(120)
1 200

(430 $0.3)

(129)
2 322

2 400
$0.50

4 300 90%

3 870
$0.60

$2 451 $129

4 300 430

Calculate total cost of output and losses.


Process 1
$
1 150

Output (2 300 $0.50)


Normal loss (scrap)
(600 $0.20)
Abnormal loss (100 $0.50)

120
50
1 320

1 320

Abnormal gain

Step 4

Process 2
$
800
1 150
84
417

Process 2
$
2 400

(4 000 $0.60)
(430 $0.30)

129

2 529
(78)
2 451

(130 $0.60)

Complete accounts.
PROCESS 1 ACCOUNT

Material
Labour
General overhead

kg
3 000

3 000

$
750
120
450

kg
Normal loss to scrap a/c
(20%)
Production transferred to
process 2
Abnormal loss a/c

1 320

600

120

2 300
100
3 000

1 150
50
1 320

kg

PROCESS 2 ACCOUNT
kg
Transferred from
process 1
Material added
Labour
General overhead
Abnormal gain

2 300
2 000

4 300
130
4 430

$
1 150
800
84
417
2 451
78
2 529

Normal loss to scrap a/c


(10%)
Production transferred to
finished inventory

430

129

4 000

2 400

4 430

2 529

kg
130
1 000

$
39
230

1 130

269

SCRAP ACCOUNT
Normal loss (process 1)
Normal loss (process 2)
Abnormal loss
(process 1)

kg
600
430

$
120
129

100
1 130

20
269

Abnormal gain (process 2)


Cash/Receivables

PROCESS AND JOB COSTING | 229

ABNORMAL LOSS AND GAIN ACCOUNT


Process 1 (loss)
Scrap value of abnormal
Gain
Statement of
comprehensive income

kg

100

50

130

39
9

230

98

Scrap value of
abnormal loss
Process 2 (gain)

kg

100
130

20
78

230

98

(Note. In this answer, a single account has been prepared for abnormal loss/gain. It is also possible
to separate this single account into two separate accounts, one for abnormal gain and one for
abnormal loss.)

Step 1 Determine output and losses.


STATEMENT OF EQUIVALENT UNITS
Total
Units
8 000
1 000
500
500
10 000

Completed production
Closing inventory
Normal loss
Abnormal loss

Equivalent units
Material
Labour
%
Units
%
Units
100
8 000
100
8 000
80
800
50
500

100

500
9 300

100

500
9 000

Step 2 Calculate cost per unit of output, losses and WIP.


STATEMENT OF COST PER EQUIVALENT UNIT
Equivalent
units

Cost
$
4 650
2 700
7 350

Material ($(5 150 500))*


Labour

9 300
9 000

Cost per
equivalent
unit
$
0.50
0.30
0.80

* The scrap value of the normal loss is used to reduce the material costs of the process.
Step 3 Calculate total cost of output, losses and WIP.
STATEMENT OF EVALUATION
Equivalent
units

Completed production
Closing inventory: material
Labour

8 000
800
500

Abnormal loss

500

Cost per
equivalent
unit
$
0.80
0.50
0.30

Total

$
6 400

400
150
550
400
7 350

0.80

Step 4 Complete accounts.


PROCESS ACCOUNT
Material
Labour

Units
10 000

$
5 150
2 700

10 000

7 850

Completed production
Closing inventory
Normal loss
Abnormal loss

Units
8 000
1 000
500
500
10 000

$
6 400
550
500
400
7 850

CHAPTER 7

230 | MANAGEMENT ACCOUNTING

5 (a) Process 1
STATEMENT OF EQUIVALENT UNITS
Equivalent units
Conversion
Material costs
costs
2 400
2 400
(100%) 3 400
(40%) 1 360
0
0
800
800
6 600
4 560

Total units
2 400
3 400
400
800
7 000

Transfers to process 2
Closing WIP
Normal loss (10% 4 000)
Abnormal loss

STATEMENT OF COSTS PER EQUIVALENT UNIT


Costs incurred
= Cost per equivalent unit
Equivalent units
Therefore Materials cost per equivalent unit =

$4 400 $22 000


$26 400
=
= $4
6 600
6 600

therefore Conversion costs per equivalent unit

$3 744 $12 000 $18 000


$33 744
=
=
4 560
4 560

$7.40
STATEMENT OF EVALUATION
Materials
$
9 600
3 200
13 600
26 400

Transfers to process 2
Abnormal loss
Closing WIP

Conversion costs
$
17 760
5 920
10 064
33 744

Total
$
27 360
9 120
23 664
60 144

PROCESS 1 ACCOUNT
WIP materials
(opening)
WIP conversion costs
Materials
Labour
Overhead

Kg
3 000

$
4 400

4 000

7 000

3 744
22 000
12 000
18 000
60 144

Process 2
Normal loss
Abnormal loss
WIP materials (closing)
WIP conversion costs

The monetary and quantity values for:


(i) transfer to process 2 are
(ii) normal loss are

2 400

kgs at $ 27 360

kgs at $

400

(iii) abnormal loss are

800

kgs at $

9 120

(iv) abnormal gain are

kgs at $

(v) WIP materials are

3 400

(vi) WIP conversion costs are

kgs at $ 13 600
0

kgs at $ 10 064

Kg
2 400

$
27 360

400
800
3 400

7 000

9 120
13 600
10 064
60 144

PROCESS AND JOB COSTING | 231

(b) Process 2
STATEMENT OF EQUIVALENT UNITS
Total units
2 500
240 *
(690) *
2 600*
4 650

Finished goods
Normal loss
Abnormal gain
Closing WIP

* Total input units

Process 1
2 500
0
(690)
2 600
4 410

Conversion costs
2 500
0
(690)
1 040**
2 850

= opening WIP + input = 2 250 + 2 400 = 4 650

Normal loss = 2 400 * 10% = 240


Expected transfer to finished goods = total input 4 650 normal loss 240 closing WIP 2 600 =
1 810.
Actual transfer to finished goods = 2 500, hence abnormal gain = 2 500 1 810 = 690
= finished goods + closing WIP + normal loss abnormal gain
= 2 500 + 2 600 + 240 690
= 4 650

CHAPTER 7

Total output units

** 2 600 40% = 1 040


STATEMENT OF COSTS PER EQUIVALENT UNIT
Process 1 =

$4 431 27 360 480


= $7.10
4 410

Conversion costs =

$5 250 $15 000 $22 500


= $15.00
2 850

STATEMENT OF EVALUATION
Process 1
$
17 750
4 899
18 460
41 109

Finished goods
Abnormal gain
Closing WIP

Conversion
costs
$
37 500
10 350
15 600
63 450

Total
$
55 250
15 249
34 060
104 559

PROCESS 2 ACCOUNT
Kg
2 250

2 400

690
5 340

WIP Process 1
WIP conversion costs
Process 1
Labour
Overhead
Abnormal gain

$
4 431
5 250
27 360
15 000
22 500
15 249
89 790

Finished goods
Normal loss
WIP process 1
WIP conversion costs

The monetary and quantity values for:


(i) finished goods are
(ii) normal loss are

kgs at $ 55 250

2 500
240

kgs at $

480

(iii) WIP from process 1 are

2 600

kgs at $ 18 460

(iv) WIP from process 2 are

kgs at $ 15 600

Kg
2 500
240
2 600

$
55 250
480
18 460
15 600

5 340

89 790

232 | MANAGEMENT ACCOUNTING

6
Butter
Milk

Cream
Yoghurt
Split off point

7 (a) The direct materials cost is $

6 440

Workings
$
2 000

Direct material Y (400 kilos $5)


Direct material Z (800 60 kilos $6)
Total direct material cost

(b) The direct labour cost is $

4 440
6 440

4 560

Workings
$
2 560

Department P (320 hours $8)

2 000

Department Q (200 hours $10)


Total direct labour cost

4 560

In department P, overtime premium will be charged to overhead. In department Q, overtime


premium will be charged to the job of the customer who asked for overtime to be worked.
(c) The full production cost is $ 12 560
Workings
Direct material cost
Direct labour cost
Production overhead (520 hours $3)

$
6 440
4 560
1 560
12 560

8 If you have difficulty working out the correct amount, simply jot down the cost and selling price
structures as percentages in each case.
(a) The correct selling price is $ 5 600 .
Workings

Profit is calculated as a percentage of sales, so selling price must be written as 100%.


%
75
25
100

Cost
Profit
Selling price

Selling price = $4 200 100/75 = $5 600


(b) The correct selling price is $

5 250

Workings

Profit is calculated as a percentage of cost, so cost must be written as 100%.


Cost
Profit
Selling price

Selling price = $4 200 125/100 = $5 250

%
100
25
125

233

CHAPTER 8
STANDARD COSTING
Learning objectives

Reference

Standard costing

LO8

Explain how standard costing can be used to assist in cost control and efficient resource
allocation

LO8.1

Topic list

1 What is standard costing?


2 Setting standards

234 | MANAGEMENT ACCOUNTING

INTRODUCTION
Just as there are standards for most things in our daily lives (cleanliness in restaurants, educational
achievement of students, number of trains running on time), there are standards for the costs of
products and services. Also, just as the standards in our daily lives are not always met, the standards
for the costs of products and services are not always met. We will be looking at standards for costs,
what they are used for and how they are set.
In the next chapter we will see how standard costing forms the basis of a process called variance
analysis, a vital management control tool.
The chapter content is summarised in the diagram below.

Standard
costing

What is it?

Setting
standards

STANDARD COSTING | 235

BEFORE YOU BEGIN


If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What is a standard cost?

(Section 1)

2 State two principal uses of standard costing.

(Section 1.2)

3 What is the difference between actual and standard costs called?

(Section 1.3)

4 What are the four types of performance standards?

(Section 2.1)

CHAPTER 8

5 Which element of Direct material standards are the purchasing department most likely to estimate
and what knowledge will they use to do this?
(Section 2.3)

236 | MANAGEMENT ACCOUNTING

1 WHAT IS STANDARD COSTING


Section overview
A standard cost is a predetermined estimated unit cost, used for inventory valuation and
control.
The standard cost of a product is a detailed list of the expected costs required to produce
a completed unit of that product. Differences between actual and standard costs are called
variances.

1.1 STANDARD COST


Definition
A standard cost system is a cost accounting system that uses standard cost of input and standard
quantities to measure the final cost of a product or service.

LO
8.1

The standard cost of a product provides a detailed breakdown of all the expected costs required to
produce a completed unit of that product
The standard cost of product 1234 is set out below:
STANDARD COST PRODUCT 1234
$
Direct materials
Material X 3 kg at $4 per kg
Material Y 9 litres at $2 per litre

12
18
30

Direct labour
Grade A 6 hours at $1.50 per hour
Grade B 8 hours at $2 per hour
Standard direct cost
Variable production overhead 14 hours at $0.50 per hour
Standard variable cost of production
Fixed production overhead 14 hours at $4.50 per hour
Standard full production cost
Administration and marketing overhead
Standard cost of sale
Standard profit
Standard sales price

9
16
25
55
7
62
63
125
15
140
20
160

Notice how the total standard cost is built up from standards for each cost element: standard
quantities of materials at standard prices, standard quantities of labour time at standard rates and so
on. It is therefore determined by management's estimates of the following:
The expected prices of materials, labour and expenses.
Efficiency levels in the use of materials and labour.
Budgeted overhead costs and budgeted volumes of activity.
We will see how management arrives at these estimates below.
But why should management want to prepare standard costs? Obviously to assist with standard
costing, but what is the point of standard costing?

STANDARD COSTING | 237

1.2 THE USES OF STANDARD COSTING


Standard costing has a variety of uses but its two principal ones are as follows:
To value inventories and measure the cost of production for cost accounting purposes.
To act as a control device by establishing standards (planned costs), highlighting (via variance
analysis which we will cover in the next chapter) activities that are not conforming to plan and
therefore alerting management to areas which may be out of control and in need of corrective
action.
Worked Example: Standard cost
Bloggs makes one product, the joe. Two types of labour are involved in the preparation of a joe,
skilled and semi-skilled. Skilled labour is paid $10 per hour and semi-skilled $5 per hour. Twice as
many skilled labour hours as semi-skilled labour hours are needed to produce a joe, four semi-skilled
labour hours being needed.
A joe is made up of three different direct materials. Seven kilograms of direct material A, four litres of
direct material B and three metres of direct material C are needed. Direct material A costs $1 per
kilogram, direct material B $2 per litre and direct material C $3 per metre.
Variable production overheads are incurred at Bloggs at the rate of $2.50 per direct labour (skilled)
hour.
A system of absorption costing is in operation at Bloggs. The basis of absorption is direct labour
(skilled) hours. For the forthcoming accounting period, budgeted fixed production overheads are $250
000 and budgeted production of the joe is 5 000 units.
Administration, selling and distribution overheads are added to products at the rate of $10 per unit.
Using the above information calculate a standard cost for the joe.
Solution
STANDARD COST PRODUCT JOE
$
7
8
9

Direct materials
A 7 kgs $1
B 4 litres $2
C 3 m $3

24
Direct labour
Skilled 8 $10
Semi-skilled 4 $5

80
20

Standard direct cost


Variable production overhead 8 $2.50
Standard variable cost of production
Fixed production overhead 8 $6.25 (W)
Standard full production cost
Administration, selling and distribution overhead
Standard cost of sale
Standard profit (25% 204)
Standard sales price

Working
Overhead absorption rate =

$250 000
= $6.25 per skilled labour hour
5 000 8

100
124
20
144
50
194
10
204
51
255

CHAPTER 8

A mark-up of 25% is made on the joe.

238 | MANAGEMENT ACCOUNTING

Worked Example: Marginal costing system

What would a standard cost for product joe show under a marginal system?
Solution

STANDARD COST PRODUCT JOE


Direct materials
Direct labour
Standard direct cost
Variable production overhead
Standard variable production cost
Standard sales price
Standard contribution

$
24
100
124
20
144
255
111

Although the use of standard costs to simplify the keeping of cost accounting records should not be
overlooked, we will be concentrating on the control and variance analysis aspect of standard costing.
Standard costing is a control technique which compares standard costs with actual results to obtain
variances which are used to improve performance.
Notice that the above definition highlights the control aspects of standard costing.

1.3 STANDARD COSTING AS A CONTROL TECHNIQUE


Differences between actual and standard costs are called variances.
Standard costing involves:
The establishment of predetermined estimates of the costs of products or services
The collection of actual costs
The comparison of the actual costs with the predetermined estimates
The predetermined costs are known as standard costs and the difference between standard and
actual cost is known as a variance. The process by which the total difference between standard and
actual results is analysed is known as variance analysis.
Standard costing can be used in a variety of costing situations:
Batch and mass production
Process manufacture
Job production where there is standardisation of parts
Service industries if a realistic cost unit can be established
However, the greatest benefit from its use can be gained if there is a degree of repetition in the
production process. It is therefore most suited to mass production and repetitive assembly work.

2 SETTING STANDARDS
Section overview
The standard cost of a product, or service, is made up of a number of different standards,
one for each cost element, each of which has to be set by management.

Performance standards are used to set efficiency targets. There are four types: ideal,
attainable, current and basic. We have divided this section into two: the first part looks at
setting the monetary part of each standard, whereas the second part looks at setting the
resources requirement part of each standard.

STANDARD COSTING | 239

LO
8.1

Standard costs may be used in both absorption costing and in marginal costing systems. We shall,
however, confine our description to standard costs in absorption costing systems.

2.1 TYPES OF PERFORMANCE STANDARD


Performance standards are used to set efficiency targets. There are four types: ideal, attainable,
current and basic.

TYPE OF STANDARD

DESCRIPTION

Ideal

These are based on perfect operating conditions: no wastage, no spoilage, no


inefficiencies, no idle time, no breakdowns. Variances from ideal standards are
useful for pinpointing areas where a close examination may result in large savings
in order to maximise efficiency and minimise waste. However ideal standards are
likely to have an unfavourable motivational impact because reported variances
will always be adverse. Employees may feel unmotivated by the perception of
having unattainable targets.

Attainable

These are based on the hope that a standard amount of work will be carried out
efficiently, machines properly operated or materials properly used. Some
allowance is made for wastage and inefficiencies. If well set they provide a useful
psychological incentive by giving employees a realistic, but challenging target of
efficiency. The consent and co operation of employees involved in improving the
standard are required. Also sometimes called 'practical standards' or 'target
standards'.

Current

These are based on current working conditions (current wastage, current


inefficiencies). The disadvantage of current standards is that they do not attempt
to improve on current levels of efficiency.

Basic

T These are kept unaltered over a long period of time, and may be out of date
because of changes within the organisation or changes in the environment in
which the organisation operates. They are used as a 'benchmark standard'
against which to measure changes in efficiency or performance over a long
period of time. Basic standards are perhaps the least useful and least common
type of standard in use.

Ideal standards, attainable standards and current standards each have their supporters and it is by no
means clear which of them is preferable.
Question 1: Performance standards

Which of the following statements is not correct?


A Basic standards may provide an incentive to greater efficiency even though the standard cannot be
achieved.
B Variances from ideal standards are useful for pinpointing areas where a close examination might
result in large cost savings.
C Current standards or attainable standards are a better basis for budgeting, because they represent
the level of productivity which management will wish to plan for.
D Ideal standards cannot be achieved and so there will always be adverse variances. If the standards
are used for budgeting, an allowance will have to be included for these 'inefficiencies'.
(The answer is at the end of the chapter)

CHAPTER 8

The setting of standards raises the problem of how demanding the standard should be. Should the
standard represent a perfect performance or an easily attainable performance? The type of
performance standard used can have behavioural implications. There are four types of standard.

240 | MANAGEMENT ACCOUNTING

2.2 METHODS OF STANDARD SETTING


Standards for each resource required to produce the product need to be set in terms of both the
physical quantity of that resource (e.g. labour hours) and its cost (e.g. wage rate per hour).
The standard can be derived using historic data, although this may result in past inefficiencies being
incorporated. Methods of estimating costs from past information were considered in Chapter 3,
Section 7.
If new methods of working are being introduced, standards based on historical data may not be
appropriate. In this case, new standards will need to be calculated based on an analysis of working
practices, using methods such as engineering studies.

2.3 DIRECT MATERIAL STANDARDS


The standard cost of direct material for a unit of product =
standard price per unit of material x standard quantity of the material
Direct material price standards will be estimated by the purchasing department from their knowledge
of the following:
Purchase contracts already agreed.
Pricing discussions with regular suppliers.
The forecast movement of prices in the market.
The availability of bulk purchase discounts.
Price inflation can cause difficulties in setting realistic standard prices. Suppose that a material costs
$10 per kilogram at the moment and during the course of the next twelve months it is expected to go
up in price by 20% to $12 per kilogram. What standard price should be selected?
The current price of $10 per kilogram
The average expected price for the year, say $11 per kilogram
Either would be possible, but neither would be entirely satisfactory.
a. If the current price were used in the standard, the reported price variance will become adverse as
soon as prices go up, which might be very early in the year. If prices go up gradually rather than in
one big jump, it would be difficult to select an appropriate time for revising the standard.
b. If an estimated mid-year price were used, price variances should be favourable in the first half of
the year and adverse in the second half of the year, again assuming that prices go up gradually
throughout the year. Management could only really check that in any month, the price variance did
not become excessively adverse / favourable and that the price variance switched from being
favourable to adverse around month six or seven.
To estimate the materials required to make each product (material usage), technical specifications
must be prepared for each product by production experts in the production department. The
'standard product specification' for materials must list the quantities required per unit of each
material in the product. These standard input quantities must be made known to the operators in the
production department so that control action by management to deal with excess material wastage
will be understood by them.

2.4 DIRECT LABOUR STANDARDS


The standard cost of direct labour for a unit of product = standard labour rate per hour x standard
quantity of hours required by that particular labour type
Direct labour rates per hour will be set by discussion with the personnel department and by reference
to the payroll and to any agreements on pay rises with trade union representatives of the employees.
a. A separate hourly rate or weekly wage will be set for each different labour grade/type of employee.
b. An average hourly rate will be applied for each grade, even though individual rates of pay may vary
according to age and experience.

STANDARD COSTING | 241

Similar problems when dealing with inflation to those described for direct material standards can be
encountered when setting labour standards.
To estimate the labour hours required (labour efficiency), technical specifications must be prepared
for each product by production experts in the production department. The 'standard operation
sheet' for labour will specify the expected hours required by each grade of labour in each department
to make one unit of product. These standard times must be carefully set and must be understood by
the labour force. Where necessary, standard procedures or operating methods should be stated.

2.5 OVERHEAD ABSORPTION RATES


When standard costs are fully absorbed costs, the absorption rate of fixed production overheads will
be predetermined, usually each year when the budget is prepared, and based in the usual manner on
budgeted fixed production overhead expenditure and budgeted production.
For selling and distribution costs, standard costs might be absorbed as a percentage of the standard
selling price.

CHAPTER 8

Standard costs under marginal costing will, of course, not include any element of absorbed
overheads.

242 | MANAGEMENT ACCOUNTING

KEY CHAPTER POINTS


A standard cost is a predetermined estimated unit cost, used for inventory valuation and control.
The standard cost of a product shows full details of the expected costs required to produce a
completed unit of that product.
Differences between actual and standard cost are called variances.
Performance standards are used to set efficiency targets. There are four types: ideal, attainable,
current and basic.

STANDARD COSTING | 243

QUICK REVISION QUESTIONS


1 Which of the following would not be directly relevant to the determination of direct labour
standards per unit of output?
A Skills of the work force
B the type of performance standard to be used
C the volume of output from the production budget
D technical specifications of the proposed production methods
2 What is an attainable standard?
A A standard which is kept unchanged, to show the trend in costs.
B A standard which is based on currently attainable operating conditions.
C A standard which includes no allowance for losses, waste and inefficiencies. It represents the
level of performance which is attainable under perfect operating conditions.
D A standard which includes some allowance for losses, waste and inefficiencies. It represents the
level of performance which is attainable under efficient operating conditions.
3 A control technique which compares standard costs and revenues with actual results to obtain
variances, which are used to stimulate improved performance, is known as
A budgeting.
B standard costing.
C variance analysis.
D budgetary control.

A Printing
B Fashion design
C Postal services
D Mobile phone manufacture

CHAPTER 8

4 For which one of the following is standard costing most likely to be appropriate?

244 | MANAGEMENT ACCOUNTING

ANSWERS TO QUICK REVISION QUESTIONS


1 C The volume of output would influence the total number of labour hours required, but it would
not be directly relevant to the standard labour time per unit.
The type of performance standard (option B) would be relevant. For example, if an ideal
standard is used there would be no extra time allowed for inefficiencies.
Option D would be relevant because it would provide information about the tasks to be
performed and the time that those tasks should take.
Similarly Option A would be relevant because the skills of the workforce will affect the way the
task is performed and the time that the task should take.
2 D An attainable standard assumes efficient levels of operation, but includes allowances for normal
loss, waste and machine downtime.
Option A describes a basic standard.
Option B describes a current standard.
Option C describes an ideal standard.
3 B Standard costing is a control technique comparing standard costs with actual costs. When the
differences between standard costs and actual costs are analysed, this is known as variance
analysis.
4 D Standard costing may be suitable when an organisation produces a large quantity of standard
products, or provides standard services. This applies to mobile phone manufacture. It does not
apply to postal services, since delivery costs vary with size and distance. It does not apply to
fashion design, which by its nature is non-standard work. It does not apply to printing, which is a
type of jobbing industry where each printing 'job' may be different.

STANDARD COSTING | 245

ANSWERS TO CHAPTER QUESTIONS

CHAPTER 8

1 A Statement A is describing ideal standards, not basic standards.

246 | MANAGEMENT ACCOUNTING

247

CHAPTER 9
VARIANCE ANALYSIS
Learning objectives

Reference

Variance analysis

LO9

Define and describe a variance

LO9.1

Explain the causes of variances and associated corrective actions

LO9.2

Calculate a variance

LO9.3

Topic list

1
2
3
4
5
6
7
8
9

Variances
Direct material cost variances
Direct labour cost variances
Variable production overhead variances
Fixed production overhead variances
The reasons for cost variances
The significance of cost variances
Sales variances
Operating statements

248 | MANAGEMENT ACCOUNTING

INTRODUCTION
The actual results achieved by an organisation during a reporting period (week, month, quarter, year)
will, more than likely, be different from the expected results. The expected results are the standard
costs and revenues which we looked at in the previous chapter. Such differences may occur between
individual items, such as the cost of labour or the volume of sales, and between the total expected
profit and the total actual profit.
Management will have spent considerable time and trouble setting standards. When actual results
differ from the standards, the reasons for the differences need to be considered and the results used
to assist in attempts to attain the standards. The wise manager will use variance analysis as a method
of control.
This chapter examines variance analysis and sets out the method of calculating the variances.
We will then go on to look at the reasons for, and significance of, cost variances.
The chapter concludes by building on the basics set down in this chapter by introducing sales
variances and operating statements.
The chapter content is summarised in the diagram below.

Variance
analysis

Cost
variances

Sales
variances

Direct material
cost variances

Operating
statements

Direct labour
cost variances

Variable production
overhead variances

Fixed production
overhead variances

Reasons for
cost variances

Significance of
cost variances

VARIANCE ANALYSIS | 249

BEFORE YOU BEGIN


If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What is a variance?

(Section 1)

2 What is a direct material total variance?

(Section 2)

3 What effect do opening and closing inventories have on material variances?

(Section 2.2)

4 The direct labour total variance can be subdivided into which two variances?

(Section 3)

5 The variable production overhead total variance can be subdivided into which two variances?
(Section 4)
6 In an absorption costing system, the fixed production overhead total variance can be subdivided
into which two variances?
(Section 5)
7 State reasons for cost variances arising.

(Section 6)

8 Explain the relevance of materiality and controllability when deciding whether or not a variance
should be investigated.
(Section 7)
9 How is selling price variance calculated?

(Section 8.1)

10 How is sales volume profit variance calculated?

(Section 8.2)
(Section 9)

CHAPTER 9

11 Draw a proforma operating statement reconciling budgeted profit and actual profit.

250 | MANAGEMENT ACCOUNTING

1 VARIANCES
Section overview
A variance is the difference between a planned, budgeted, or standard cost and the actual
cost incurred. The same comparisons may be made for revenues. The process by which the
total difference between standard and actual results is analysed is known as variance
analysis.
LO
9.1

When actual results are better than expected results, we have a favourable variance (F). If, on the
other hand, actual results are worse than expected results, we have an unfavourable variance (U).
Variances can be divided into three main groups:
Variable cost variances
Sales variances
Fixed production overhead variances

2 DIRECT MATERIAL COST VARIANCES


2.1 INTRODUCTION
Section overview
The direct material total variance can be subdivided into the direct material price variance
and the direct material usage variance.
Direct material price variances are usually extracted at the time of the receipt of the
materials, rather than at the time of usage.
LO
9.1

The direct material total variance The direct material total variance is the difference between what
the output actually cost and what it should have cost, in terms of material. is the difference between
what the output actually cost and what it should have cost, in terms of material.

2.1.1 THE DIRECT MATERIAL PRICE VARIANCE


This is the difference between the standard cost and the actual cost for the actual quantity of material
used or purchased. In other words, it is the difference between what the material did cost and what it
should have cost.

2.1.2 THE DIRECT MATERIAL USAGE VARIANCE


This is the difference between the standard quantity of materials that should have been used for the
number of units actually produced, and the actual quantity of materials used, valued at the standard
price per unit of material. It is the difference between how much material should have been used and
how much material was used, valued at standard price.
Worked Example: Example name
Product X has a standard direct material cost as follows:
LO
9.3

10 kilograms of material Y at $10 per kilogram = $100 per unit of X.


During period 4, 1 000 units of X were manufactured, using 11 700 kilograms of material Y which cost
$98 600.

VARIANCE ANALYSIS | 251

Calculate the following variances:


a. The direct material total variance
b. The direct material price variance
c. The direct material usage variance
Solution
a. The direct material total variance
This is the difference between what 1 000 units should have cost and what they did cost.
1 000 units should have cost ( $100)
but did cost
Direct material total variance

$
100 000
98 600
1 400 (F)

The variance is favourable because the units cost less than they should have cost.
Now we can break down the direct material total variance into its two constituent parts: the direct
material price variance and the direct material usage variance.
b. The direct material price variance
This is the difference between what 11 700 kgs should have cost and what 11 700 kgs did cost.
11 700 kgs of Y should have cost ( $10)
but did cost
Material Y price variance

$
117 000
98 600
18 400 (F)

The variance is favourable because the material cost less than expected.
c. The direct material usage variance
This is the difference between how many kilograms of Y should have been used to produce 1 000
units of X and how many kilograms were used, valued at the standard cost per kilogram.
1 000 units should have used ( 10 kgs)
but did use
Usage variance in kgs
standard price per kilogram
Usage variance in $

10 000 kgs
11 700 kgs
1 700 kgs (U)
$10
$17 000 (U)

The variance is unfavourable because more material than the standard quantity was used.

Price variance
Usage variance
Total variance

$
18 400 (F)
17 000 (U)
1 400 (F)

2.2 MATERIALS VARIANCES AND OPENING AND CLOSING INVENTORY


Direct material price variances are usually extracted at the time of the receipt of the materials rather
than at the time of usage. .
Suppose that a company uses raw material P in production, and that this raw material has a standard
price of $3 per metre. During one month 6 000 metres are bought for $18 600, and 5 000 metres are
used in production. At the end of the month, inventory will have been increased by 1 000 metres. In
variance analysis, the problem is to decide the material price variance. Should it be calculated on the
basis of materials purchased (6 000 metres) or on the basis of materials used (5 000 metres)?
The answer to this problem depends on how closing inventories of the raw materials will be valued.
a. If they are valued at standard cost, (1 000 units at $3 per unit) the price variance is calculated on
material purchases in the period.

CHAPTER 9

d. Summary

252 | MANAGEMENT ACCOUNTING

b. If they are valued at actual cost (FIFO) (1 000 units at $3.10 per unit) the price variance is calculated
on materials used in production in the period.
A full standard costing system is usually in operation and therefore the price variance is usually
calculated on purchases in the period. The variance on the full 6 000 metres will be written off to the
costing income statement, even though only 5 000 metres are included in the cost of production.
There are two main advantages in extracting the material price variance at the time of receipt.
a. If variances are extracted at the time of receipt they will be brought to the attention of managers
earlier than if they are extracted as the material is used. If it is necessary to correct any variances
then management action can be more timely.
b. Since variances are extracted at the time of receipt, all inventories will be valued at standard
price. This is administratively easier and it means that all issues from inventory can be made at
standard price. If inventories are held at actual cost it is necessary to calculate a separate price
variance on each batch as it is issued. Since issues are usually made in a number of small batches
this can be a time-consuming task, especially with a manual system.
The price variance would be calculated as follows:
6 000 metres of material P purchased should cost ( $3)
but did cost
Price variance

$
18 000
18 600
600 (U)

3 DIRECT LABOUR COST VARIANCES


Section overview
The direct labour total variance can be subdivided into the direct labour rate variance and
the direct labour efficiency variance.
If idle time arises, it is usual to calculate a separate idle time variance, and to base the
calculation of the efficiency variance on active hours, when labour actually worked, only. It is
always an unfavourable variance.
LO
9.1

The direct labour total variance is the difference between what the output should have cost and
what it did cost, in terms of labour.
The direct labour rate variance. This is similar to the direct material price variance. It is the difference
between the standard rate and the actual rate for the actual number of hours paid for.
It is the difference between what the labour did cost and what it should have cost.
The direct labour efficiency variance is similar to the direct material usage variance. It is the
difference between the hours that should have been worked for the number of units actually
produced, and the actual number of hours worked, valued at the standard rate per hour.
It is the difference between how many hours should have been worked and how many hours were
worked, valued at the standard rate per hour.
The calculation of direct labour variances is very similar to the calculation of direct material variances.

VARIANCE ANALYSIS | 253

Worked Example: Direct labour variances


The standard direct labour cost of product X is as follows:
LO
9.3

2 hours of grade Z labour at $5 per hour = $10 per unit of product X.


During period 4, 1 000 units of product X were made, and the direct labour cost of grade Z labour was
$8 900 for 2 300 hours of work.
Calculate the following variances:
a. The direct labour total variance.
b. The direct labour rate variance.
c. The direct labour efficiency (productivity) variance.
Solution
a. The direct labour total variance
This is the difference between what 1 000 units should have cost and what they did cost.
1 000 units should have cost ( $10)
but did cost
Direct labour total variance

$
10 000
8 900
1 100 (F)

The variance is favourable because the units cost less than they should have done.
Again we can analyse this total variance into its two constituent parts.
b. The direct labour rate variance
This is the difference between what 2 300 hours should have cost and what 2 300 hours did cost.
2 300 hours of work should have cost ( $5 per hr)
but did cost
Direct labour rate variance

$
11 500
8 900
2 600 (F)

The variance is favourable because the labour rate was less than the standard rate.
c. The direct labour efficiency variance
1 000 units of X should have taken ( 2 hrs)
but did take
Efficiency variance in hours
standard rate per hour
Efficiency variance in $

2 000 hrs
2 300 hrs
300 hrs (U)
$5
$1 500 (U)

d. Summary
Rate variance
Efficiency variance
Total variance

$
2 600 (F)
1 500 (U)
1 100 (F)

4 VARIABLE PRODUCTION OVERHEAD VARIANCES


Section overview
The variable production overhead total variance can be subdivided into the variable
production overhead expenditure variance and the variable production overhead efficiency
variance (based on actual hours).

CHAPTER 9

The variance is unfavourable because more hours were worked than should have been worked.

254 | MANAGEMENT ACCOUNTING

Worked Example: Variable production overhead variances


Suppose that the variable production overhead cost of product X is as follows:
2 hours at $1.50 = $3 per unit
LO
9.3

During period 6, 400 units of product X were made. The labour force worked 820 hours, of which
60 hours were recorded as idle time. The variable overhead cost was $1 230.
Calculate the following variances:
a. The variable overhead total variance..
b. The variable production overhead expenditure variance.
c. The variable production overhead efficiency variance.
Solution
Since this example relates to variable production costs, the total variance is based on actual units of
production. (If the overhead had been a variable selling cost, the variance would be based on sales
volumes.)
400 units of product X should cost ( $3)
but did cost
Variable production overhead total variance

$
1 200
1 230
30 (U)

In many variance reporting systems, the variance analysis goes no further, and expenditure and
efficiency variances are not calculated. However, the unfavourable variance of $30 may be explained
as the sum of two factors:
a. The hourly rate of spending on variable production overheads was higher than it should have been,
that is there is an expenditure variance.
b. The labour force worked inefficiently, and took longer to make the output than it should have
done. This means that spending on variable production overhead was higher than it should have
been, in other words there is an efficiency (productivity) variance. The variable production
overhead efficiency variance is exactly the same, in hours, as the direct labour efficiency variance,
and occurs for the same reasons.
It is usually assumed that variable overheads are incurred during active working hours, but are not
incurred during idle time (for example, the machines are not running, therefore power is not being
consumed, and no indirect materials are being used). This means in our example that although the
labour force was paid for 820 hours, they were actively working for only 760 of those hours and so
variable production overhead spending occurred during 760 hours.
The variable production overhead expenditure variance is the difference between the amount of
variable production overhead that should have been incurred in the actual hours actively worked, and
the actual amount of variable production overhead incurred.
a.
760 hours of variable production overhead should cost ( $1.50)
but did cost
Variable production overhead expenditure variance

$
1 140
1 230
90 (U)

The variable production overhead efficiency variance. If you already know the direct labour
efficiency variance, the variable production overhead efficiency variance is exactly the same in
hours, but priced at the variable production

VARIANCE ANALYSIS | 255

b. In our example, the efficiency variance would be as follows


400 units of product X should take ( 2hrs)
but did take (active hours)
Variable production overhead efficiency variance in hours
standard rate per hour
Variable production overhead efficiency variance in $

800 hrs
760 hrs
40 hrs (F)
$1.50
$60 (F)

c. Summary
Variable production overhead expenditure variance
Variable production overhead efficiency variance
Variable production overhead total variance

$
90 (U)
60 (F))
30 (U)

5 FIXED PRODUCTION OVERHEAD VARIANCES


Section overview
The fixed production overhead total variance can be subdivided into an expenditure
variance and a volume variance. The fixed production overhead volume variance can be
further subdivided into an efficiency and capacity variance.

LO
9.1

You may have noticed that the method of calculating cost variances for variable cost items is
essentially the same for labour, materials and variable overheads. Fixed production overhead
variances are very different. In an absorption costing system, they are an attempt to explain the
under- or over-absorption of fixed production overheads in production costs.
The fixed production overhead total variance (i.e. the under- or over-absorbed fixed production
overhead) may be broken down into two parts as usual:
An expenditure variance.
A volume variance.
You will find it easier to calculate and understand fixed overhead variances, if you keep in mind the
whole time that you are trying to 'explain' (put a name and value to) any under- or over-absorbed
overhead.

5.1 UNDER OR OVER-ABSORPTION


Overhead absorption rate =

Budgeted fixed overhead


Budgeted activity level

The budgeted fixed overhead is the planned or expected fixed overhead and the budgeted activity
level is the planned or expected activity level.
If either of the following budget estimates are incorrect, then we will have an under- or overabsorption of overhead.
The numerator (number on top) = Budgeted fixed overhead.
The denominator (number on bottom) = Budgeted activity level.

CHAPTER 9

The absorption rate is calculated as follows:

256 | MANAGEMENT ACCOUNTING

5.2 THE FIXED OVERHEAD EXPENDITURE VARIANCE


The fixed overhead expenditure variance occurs if the numerator is incorrect. It measures the underor over-absorbed overhead caused by the actual total expenditure on fixed overhead being different
from the budgeted total expenditure on fixed overhead.
Therefore
Fixed overhead expenditure variance = Budgeted (planned) expenditure Actual Expenditure.

5.3 THE FIXED OVERHEAD VOLUME VARIANCE


The fixed overhead volume variance arises if the denominator (i.e. the budgeted activity level or
volume) is incorrect.
The fixed overhead volume variance measures the under- or over-absorbed overhead caused by the
actual activity level being different from the budgeted activity level used in calculating the
absorption rate.
There are two reasons why the actual activity level may be different from the budgeted activity level
used in calculating the absorption rate.
a. The workforce may have worked more or less efficiently than the standard set.
b. The hours worked by the workforce could have been different to the budgeted hours, regardless of
the level of efficiency of the workforce, because of overtime, strikes and so on.

5.4 HOW TO CALCULATE THE VARIANCES


LO
9.3

In order to clarify the overhead variances which we have encountered in this section, consider the
following definitions which are expressed in terms of how each overhead variance should be
calculated.
Definition

Fixed overhead total variance is the difference between fixed overhead incurred and fixed overhead
absorbed.
Fixed overhead expenditure variance is the difference between budgeted fixed overhead
expenditure and actual fixed overhead expenditure.
Fixed overhead volume variance is the difference between actual and budgeted (planned) volume
multiplied by the standard absorption rate per unit.

You should now be ready to work through an example to demonstrate all of the fixed overhead
variances.
Worked Example: Fixed overhead variance

Suppose that a company plans to produce 1 000 units of product E during August 20X3. The expected
time to produce a unit of E is five hours, and the budgeted fixed overhead is $20 000. The standard
fixed overhead cost per unit of product E will therefore be as follows:
5 hours at $4 per hour = $20 per unit
Actual fixed overhead expenditure in August 20X3 turns out to be $20 450. The labour force manages
to produce 1 100 units of product E in the month.

VARIANCE ANALYSIS | 257

Calculate the following variances:


a. The fixed overhead total variance.
b. The fixed overhead expenditure variance.
c. The fixed overhead volume variance.
Solution

All of the variances help to assess the under- or over absorption of fixed overheads.
a. Fixed overhead total variance
Fixed overhead incurred
Fixed overhead absorbed (1 100 units $20 per unit)
Fixed overhead total variance
(= under-/over-absorbed overhead)

$
20 450
22 000
1 550 (F)

The variance is favourable because more overheads were absorbed than budgeted.
b. Fixed overhead expenditure variance
Budgeted fixed overhead expenditure
Actual fixed overhead expenditure
Fixed overhead expenditure variance

$
20 000
20 450
450 (U)

The variance is unfavourable because actual expenditure was greater than budgeted expenditure.
c. Fixed overhead volume variance
The production volume achieved was greater than expected. The fixed overhead volume variance
measures the difference at the standard rate.
$
Actual production at standard rate (1 100 $20 per unit)
Budgeted production at standard rate (1 000 $20 per unit)
Fixed overhead volume variance

22 000
20 000
2 000 (F)

The variance is favourable because output was greater than expected.


i. The labour force may have worked efficiently, and produced output at a faster rate than
expected. Since overheads are absorbed at the rate of $20 per unit, more will be absorbed if
units are produced more quickly.
ii. The labour force may have worked longer hours than budgeted, and therefore produced more
output.

Expenditure variance
Volume variance
Over-absorbed overhead (total variance)

$
450 (U)
2 000 (F)
$1 550 (F)

In general, a favourable cost variance will arise if actual results are less than expected results. Be
aware, however, of the fixed overhead volume variance which gives rise to favourable and
unfavourable variances in the following situations:
A favourable fixed overhead volume variance occurs when actual production is greater than
budgeted (planned) production.
An unfavourable fixed overhead volume variance occurs when actual production is less than
budgeted (planned) production.

Do not worry if you find fixed production overhead variances more difficult to grasp than the other
variances we have covered. Most students do. Read over this section again and then try the following
practice questions.

CHAPTER 9

The variances may be summarised as follows:

258 | MANAGEMENT ACCOUNTING

Question 1, 2 and 3: Common information

The following information relates to the questions shown below.


Barbados has prepared the following standard cost information for one unit of Product Zeta.
Direct materials
Direct labour
Fixed overheads

4kg @ $10/kg
2 hours @ $4/hour
3 hours @ $2.50

$40.00
$8.00
$7.50

The fixed overheads are based on a budgeted expenditure of $75 000 and budgeted activity of 30 000
hours.
Actual results for the period were recorded as follows:
Production
Materials 33 600 kg
Labour 16 500 hours
Fixed overheads

9 000 units
$336 000
$68 500
$70 000

Question 1: Material variances Question here

The direct material price and usage variances are:

A
B
C
D

Material price
$

24 000 (F)
24 000 (U)

Material usage
$
24 000 (F)
24 000 (U)

(The answer is at the end of the chapter)

Question 2: Labour variances

The direct labour rate and efficiency variances are:

A
B
C
D

Labour rate
$
2 500 (U)
2 500 (F)
6 000 (U)
6 000 (F)

Labour efficiency
$
6 000 (F)
6 000 (U)
2 500 (F)
2 500 (U)

(The answer is at the end of the chapter)

Question 3: Overhead variances

The total fixed production overhead variance is


A $2 500 (U).
B $2 500 (F).
C $5 000 (U).
D $5 000 (F).
(The answer is at the end of the chapter)

VARIANCE ANALYSIS | 259

6 THE REASONS FOR COST VARIANCES


Section overview
There are many possible reasons for cost variances arising, including changes in the price
or use of material, the availability of labour and the efficiency of machinery.
LO
9.2

VARIANCE

FAVOURABLE

UNFAVOURABLE

Material price

Unforeseen discounts received

Price increase

Discounts obtained in purchasing

Careless purchasing

Change in material standard

Change in material standard

Change in supply and demand of raw


materials (supply exceeds demand)

Change in supply and demand of raw


materials (demand exceeds supply)

Material used of higher quality than


standard

Defective material

More effective use made of material

Theft

Errors in allocating material to jobs

Stricter quality control

Material usage

Excessive waste

Errors in allocating material to jobs


Labour rate

Use of apprentices or other workers at a


rate of pay lower than standard.

Idle time

Wage rate increase.


Use of higher grade labour.
Machine breakdown
Non availability of material
Illness or injury to worker
Under-utilisation of assets

Labour efficiency

Output produced more quickly than


expected because of work motivation,
better quality of equipment or materials,
or improved processes.
Errors in allocating time to jobs.
Higher asset utilisation than planned.

Lost time in excess of standard


allowed.
Output lower than standard set
because of deliberate restriction, lack
of training, or sub standard material
used.
Errors in allocating time to jobs.

Overhead expenditure

Savings in costs incurred

Increase in cost of services used.

More economical use of services.

Excessive use of services.

Labour force working more efficiently


(favourable labour efficiency variance).
Labour force working overtime.

Labour force working less efficiently


(unfavourable labour efficiency
variance).
Machine breakdown, strikes, labour
shortages.

This is not an exhaustive list and in a question you should review the information given in order to
analyse possible reasons for variances.

7 THE SIGNIFICANCE OF COST VARIANCES


Section overview
Materiality, controllability, the type of standard being used, the interdependence of
variances and the cost of an investigation should be taken into account when deciding
whether to investigate reported variances.

CHAPTER 9

Change in type of services used.


Overhead volume

260 | MANAGEMENT ACCOUNTING

LO
9.2

Once variances have been calculated, management have to decide whether or not to investigate their
causes. It would be extremely time consuming and expensive to investigate every variance, therefore
managers have to decide which variances are worthy of investigation.
There are a number of factors which can be taken into account when deciding whether or not a
variance should be investigated.
a. Materiality. A standard cost is an average expected cost and is not a rigid specification. Small
variations either side of this average are therefore bound to occur. The problem is to decide
whether a variation from standard should be considered significant and worthy of investigation.
Tolerance limits can be set and only variances which exceed such limits would require
investigating.
b. Controllability. Some types of variance may not be controllable even once their cause is
discovered. For example, if there is a general worldwide increase in the price of a raw material
there are limited actions that can be taken to mitigate the impact on costs. If a central decision is
made to award all employees a 10% increase in salary, staff costs in division A will increase by this
amount and the variance is not controllable by division A's manager. Uncontrollable variances call
for a change in the plan, not an investigation into the past.
c. The type of standard being used.
i. The efficiency variance reported in any control period, whether for materials or labour, will
depend on the efficiency level set. If, for example, an ideal standard is used, variances will
always be unfavourable.
ii. A similar problem arises if average price levels are used as standards. If inflation exists,
favourable price variances are likely to be reported at the beginning of a period, to be offset by
unfavourable price variances later in the period as inflation pushes prices up.
d. Interdependence between variances. Individual variances should not be looked at in isolation.
One variance might be inter-related with another, and much of it might have occurred only
because the other, inter-related, variance occurred too. We will investigate this issue further in a
moment.
e. Costs of investigation. The costs of an investigation should be weighed against the benefits of
correcting the cause of a variance.
The investigation of variances and the need for control action is discussed further in Chapter 12.

7.1 INTERDEPENDENCE BETWEEN VARIANCES


When two variances are interdependent (interrelated) one will often be unfavourable and the other
one favourable.

7.2 INTERDEPENDENCE MATERIALS PRICE AND USAGE VARIANCES


It may be decided to purchase cheaper materials for a job in order to obtain a favourable price
variance. This may lead to higher materials wastage than expected and therefore, unfavourable usage
variances occur. If the cheaper materials are more difficult to handle, there might be some
unfavourable labour efficiency variance too.
If a decision is made to purchase more expensive materials, which perhaps have a longer service life,
the price variance will be unfavourable but the usage variance might be favourable.

7.3 INTERDEPENDENCE LABOUR RATE AND EFFICIENCY VARIANCES


If employees in a workforce are paid higher rates for experience and skill, using a highly skilled team
should incur an unfavourable rate variance at the same time as a favourable efficiency variance. In
contrast, a favourable rate variance might indicate a high proportion of inexperienced workers in the
workforce, which could result in an unfavourable labour efficiency variance and possibly an
unfavourable materials usage variance, due to high rates of rejects.

VARIANCE ANALYSIS | 261

Question 4: Causes of variance

A large unfavourable direct labour efficiency variance has been reported. Which TWO of the following
might be causes of the variance?
I

Using expensive skilled labour

II Using poor quality direct materials


III Using a target standard cost for the labour efficiency standard
IV Working overtime
A I and III only
B I and IV only
C II and III only
D II and IV only
(The answer is at the end of the chapter)

Question 5: Investigation of variances

List the factors which should be taken into account when deciding whether or not a variance should be
investigated.
(The answer is at the end of the chapter)

8 SALES VARIANCES
Section overview
The selling price variance is a measure of the effect on expected profit of a different selling
price to standard selling price. The sales volume profit variance is the difference between
the actual units sold and the budgeted (planned) quantity, valued at the standard profit per
unit.

8.1 SELLING PRICE VARIANCE

LOs
9.1
9.3

The selling price variance is a measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have
been for the actual quantity sold, and what it was.

Suppose that the standard selling price of product X is $15. Actual sales in 20X3 were 2 000 units at
$15.30 per unit.
The selling price variance is calculated as follows:
Sales revenue from 2 000 units should have been ( $15)
but was ( $15.30)
Selling price variance

$
30 000
30 600

The variance calculated is favourable because the price was higher than expected.

600 (F)

CHAPTER 9

Definition

262 | MANAGEMENT ACCOUNTING

8.2 SALES VOLUME PROFIT VARIANCE


Definition

LOs
9.1
9.3

The sales volume profit variance is the difference between the actual units sold and the budgeted
(planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or
decrease in standard profit as a result of the sales volume being higher or lower than budgeted
(planned).

Suppose that a company budgets to sell 8,000 units of product J for $12 per unit. The standard full
cost per unit is $7. Actual sales were 7,700 units, at $12.50 per unit.
The sales volume profit variance is calculated as follows:
8 000 units
7 700 units
300 units (U)
$5

Budgeted sales volume


Actual sales volume
Sales volume variance in units
standard profit per unit ($(127))
Sales volume variance

$1 500 (U)

The variance calculated above is unfavourable because actual sales were less than budgeted
(planned).
Question 6: Selling price variance

Jasper Co has the following budget and actual figures for 20X4:
Budget
600
$30

Sales units
Selling price per unit

Actual
620
$29

Standard full cost of production = $28 per unit.


What are the selling price variance and the sales volume profit variances?

A
B
C
D

Sales price
$
600 (U)
600 (U)
620 (U)
620 (U)

Sales volume
$
20 (F)
40 (F)
20 (F)
40 (F)

(The answer is at the end of the chapter)

8.3 THE SIGNIFICANCE OF SALES VARIANCES


The following table suggests some possible causes for the existence of sales variances:
VARIANCE

FAVOURABLE

UNFAVOURABLE

Sales price

Price increase to cover unforeseen costs.

Price cut to stimulate demand due to


increase in competition.

Price increase following increased


demand.
Price increase to reflect increased
product/service quality
Sales volume

Increased sales resulting from a new


advertising campaign or a change in
perception of the product by the public.

Unexpected slump in the economy/demand


for the product.

VARIANCE ANALYSIS | 263

The possible interdependence between sales price and sales volume variances should be obvious to
you. A reduction in the sales price might stimulate bigger sales demand, so that an unfavourable sales
price variance might be counterbalanced by a favourable sales volume variance. Similarly, a price rise
would give a favourable price variance, but possibly at the cost of a fall in demand and an
unfavourable sales volume variance.
It is important in analysing an unfavourable sales variance that the overall consequence should be
considered, for example, has there been a counterbalancing favourable variance as a direct result of
the unfavourable one?

9 OPERATING STATEMENTS
Section overview
Operating statements show how the combination of variances reconcile budgeted profit
and actual profit.

So far, we have considered how variances are calculated without considering how they combine to
reconcile the difference between budgeted profit and actual profit during a period. This reconciliation
is usually presented as a report to senior management at the end of each control period. The report is
called an operating statement or statement of variances.
Definition

An operating statement is a regular report for management of actual costs and revenues, usually
showing variances from budget.

An extensive example will now be introduced, both to revise the variance calculations already
described, and also to show how to combine them into an operating statement.
Worked Example: Example name

Sydney manufactures one product, and the entire product is sold as soon as it is produced. There are
no opening or closing inventories and work in progress is negligible. The company operates a
standard costing system and analysis of variances is made every month. The standard cost card for the
product, a boomerang, is as follows:

Direct materials
Direct wages
Variable overheads
Fixed overhead
Standard cost
Standard profit
Standing selling price

0.5 kilos at $4 per kilo


2 hours at $2.00 per hour
2 hours at $0.30 per hour
2 hours at $3.70 per hour

$
2.00
4.00
0.60
7.40
14.00
6.00
20.00

Selling and administration expenses are not included in the standard cost, and are deducted from
profit as a period charge.

CHAPTER 9

STANDARD COST CARD BOOMERANG

264 | MANAGEMENT ACCOUNTING

Budgeted (planned) output for the month of June 20X7 was 5 100 units. Actual results for June 20X7
were as follows:
Production of 4 850 units was sold for $95 600.
Materials consumed in production amounted to 2 300 kgs at a total cost of $9 800.
Labour hours paid for amounted to 8 500 hours at a cost of $16 800.
Actual operating hours amounted to 8 000 hours.
Variable overheads amounted to $2 600.
Fixed overheads amounted to $42 300.
Selling and administration expenses amounted to $18 000.
Calculate all variances and prepare an operating statement for the month ended 30 June 20X7.
Solution
a.

b.

2 300 kg of material should cost ( $4)


but did cost
Material price variance
4 850 boomerangs should use ( 0.5 kgs)
but did use
Material usage variance in kgs
standard price per kg
Material usage variance in $

c.

d.

8 500 hours of labour should cost ( $2)


but did cost
Labour rate variance
4 850 boomerangs should take ( 2 hrs)
but did take (active hours)
Labour efficiency variance in hours
standard rate per hour
Labour efficiency variance in $

e.
f.

g.

Idle time variance 500 hours (U) $2


8 000 hours incurring variable o/hd expenditure should cost ( $0.30)
but did cost
Variable overhead expenditure variance
Variable overhead efficiency variance in hours is the same as the
labour efficiency variance:
1 700 hours (F) $0.30 per hour

h.

Budgeted fixed overhead (5 100 units 2 hrs $3.70)


Actual fixed overhead
Fixed overhead expenditure variance

i.

Actual production at standard rate (4 850 $3.70 2)


Budgeted production at standard rate (5 100 $3.70 2)
Fixed overhead volume variance in $

j.

Revenue from 4 850 boomerangs should be ( $20)


but was
Selling price variance
Budgeted sales volume
Actual sales volume
Sales volume profit variance in units

k.

standard profit per unit


Sales volume profit variance in $

$
9 200
9 800
600 (U)
2 425 kgs
2 300 kgs
125 kg (F)
$4
$ 500 (F)
$
17 000
16 800
200 (F)
$
9 700 hrs
8 000 hrs
1 700 hrs (F)
$2
$3 400 (F)
$1 000 (U)
$
2 400
2 600
200 (U)

$ 510 (F)
$
37 740
42 300
4 560 (U)
$
35 890
37 740
1 850 (U)
$
97 000
95 600
1 400 (U)
5 100 units
4 850 units
250 units
$6 (U)
$1 500 (U)

VARIANCE ANALYSIS | 265

There are several ways in which an operating statement may be presented. Perhaps the most
common format is one which reconciles budgeted profit to actual profit. In this example, sales and
administration costs will be introduced at the end of the statement, so that we shall begin with
'budgeted profit before sales and administration costs'.
Sales variances are reported first, and the total of the budgeted profit and the two sales variances
results in a figure for 'actual sales minus the standard cost of sales'. The cost variances are then
reported, and an actual profit before sales and administration costs calculated. Sales and
administration costs are then deducted to reach the actual profit for June 20X7.
SYDNEY OPERATING STATEMENT JUNE 20X7
$
Budgeted (planned) profit before sales and administration costs
Sales variances:
price
volume

1 400 (U)
1 500 (U)
2 900 (U)
27 700

Actual sales minus the standard cost of sales


(F)
$

(U)
$
600

500
200
3 400
1 000
200
510

4 610
Actual profit before sales and
administration costs
Sales and administration costs
Actual profit, June 20X7
Check:
Sales
Materials
Labour
Variable overheads
Fixed overhead
Sales and administration
Actual profit

4 560
1 850
8 210

3 600 (U)
24 100
18 000
6 100
95 600

9 800
16 800
2 600
42 300
18 000
89 500
6 100

CHAPTER 9

Cost variances
Material price
Material usage
Labour rate
Labour efficiency
Labour idle time
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Fixed overhead volume

$
30 600

266 | MANAGEMENT ACCOUNTING

KEY CHAPTER POINTS


A variance is the difference between a planned, budgeted, or standard cost and the actual cost
incurred. The same comparisons can be made for revenues. The process by which the total
difference between standard and actual results is analysed is known as variance analysis.
The direct material total variance can be subdivided into the direct material price variance and the
direct material usage variance.
Direct material price variances are usually extracted at the time of receipt of the materials, rather
than at the time of usage.
The direct labour total variance can be subdivided into the direct labour rate variance and the
direct labour efficiency variance.
If idle time arises, it is usual to calculate a separate idle time variance, and to base the calculation
of the efficiency variance on active hours, when labour actually worked, only. It is always an
unfavourable variance.
The variable production overhead total variance can be subdivided into the variable production
overhead expenditure variance and the variable production overhead efficiency variance, based on
active hours.
In an absorption costing system, the fixed production overhead total variance can be subdivided
into an expenditure variance and a volume variance.
There are many possible reasons for cost variances arising, including changes in the price or use of
material, the availability of labour and the efficiency of machinery.
Materiality, controllability, the type of standard being used, the interdependence of variances and
the cost of an investigation should be taken into account when deciding whether to investigate
reported variances.
The selling price variance is a measure of the effect on expected profit of a different selling price to
standard selling price.
The sales volume profit variance is the difference between the actual units sold and the budgeted
(planned) quantity, valued at the standard profit per unit. In other words, it measures the increase
or decrease in standard profit as a result of the sales volume being higher or lower than budgeted
(planned).
Operating statements show how the combination of variances reconciles budgeted profit and
actual profit.

VARIANCE ANALYSIS | 267

QUICK REVISION QUESTIONS


THE FOLLOWING INFORMATION RELATES TO QUESTIONS 1 TO 3

A company expected to produce 200 units of its product, the Bone, in 20X3. The actual number
produced was 260 units. The standard labour cost per unit was $70 (10 hours at a rate of $7 per hour).
The actual labour cost was $18 600 and the number of hours worked was 2 200 hours although 2 300
hours were paid.
1 What is the direct labour rate variance for the company in 20X3?
A $400 (U)
B $2 500 (F)
C $2 500 (U)
D $3 200 (U)
2 What is the direct labour efficiency variance for the company in 20X3?
A $400 (U)
B $2 100 (F)
C $2 800 (U)
D $2 800 (F)
3 What is the idle time variance?
A $700 (F)
B $700 (U)
C $809 (U)
D $809 (F)
4 A company has budgeted to make and sell 4 200 units of product X during a period.
The standard fixed overhead cost per unit is $4.
During the period covered by the budget, the actual results were as follows:
Production and sales
Fixed overhead incurred

5 000 units
$17 500

A
B
C
D

Fixed overhead
expenditure variance
$700 (F)
$700 (F)
$700 (U)
$700 (U)

Fixed overhead
volume variance
$3 200 (F)
$3 200 (U)
$3 200 (F)
$3 200 (U)

5 A company has a budgeted material cost of $125 000 for the production of 25 000 units per month.
Each unit is budgeted to use 2 kgs of material. The standard cost of material is $2.50 per kg.
Actual materials in the month cost $136 000 for 27 000 units and 53 000 kgs were purchased and
used.
What was the favourable material usage variance?
A $2 500
B $4 000
C $7 500
D $10 000

CHAPTER 9

The fixed overhead variances for the period were:

268 | MANAGEMENT ACCOUNTING

THE FOLLOWING INFORMATION RELATES TO QUESTIONS 6 AND 7

A company operating a standard costing system has the following direct labour standards per unit for
one of its products:
4 hours at $12.50 per hour
Last month when 2 195 units of the product were manufactured, the actual direct labour cost for the 9
200 hours worked was $110 750.
6 What was the direct labour rate variance for last month?
A $4 250 favourable
B $4 250 unfavourable
C $5 250 favourable
D $5 250 unfavourable
7 What was the direct labour efficiency variance for last month?
A $4 250 favourable
B $4 250 unfavourable
C $5 250 favourable
D $5 250 unfavourable
8 PQ Limited currently uses a standard absorption costing system. The fixed overhead variances
extracted from the operating statement for November are:
Fixed production overhead expenditure variance
Fixed production overhead volume variance

$
5 800 unfavourable
2 800 favourable

PQ Limited is considering using standard marginal costing as the basis for variance reporting in
future. What variance for fixed production overhead would be shown in a marginal costing
operating statement for November?
A No variance
B Volume variance: $2 800 favourable
C Total variance: $3 000 unfavourable
D Expenditure variance: $5 800 unfavourable

VARIANCE ANALYSIS | 269

ANSWERS TO QUICK REVISION QUESTIONS


1 C
$
16 100
18 600
2 500 (U)

2 300 hours should have cost ( $7)


but did cost
Rate variance

Option A is the total direct labour cost variance.


If you selected option B you calculated the correct dollar value of the variance but you
misinterpreted its direction.
If you selected option D you based your calculation on the 2 200 hours worked, but 2 300 hours
were paid for and these hours should be the basis for the calculation of the rate variance.
2 D
2 600 hrs
2 200 hrs
400 hrs (F)
$7
$2 800 (F)

260 units should have taken ( 10 hrs)


but took (active hours)
Efficiency variance in hours
standard rate per hour
Efficiency variance in $

Option A is the total direct labour cost variance. If you selected option B you based your
calculations on the 2,300 hours paid for; but efficiency measures should be based on the active
hours only, i.e. 2 200 hours.
If you selected option C you calculated the correct dollar value of the variance but you
misinterpreted its direction.
3 B Idle time hours (2 300 2 200) standard rate per hour

= 100 hrs $7
= $700 (U)

If you selected option A you calculated the correct dollar value of the variance but you
misinterpreted its direction. The idle time variance is always unfavourable.
If you selected options C or D you evaluated the idle time at the actual hourly rate instead of
the standard hourly rate.
4 C Fixed overhead expenditure variance
$
16 800
17 500
700 (U)

The variance is unfavourable because the actual expenditure was higher than the amount
budgeted.
Fixed overhead volume variance
Actual production at standard rate (5 000 $4 per unit)
Budgeted production at standard rate (4 200 $4 per unit)
Fixed overhead volume variance

$
20 000
16 800
3 200 (F)

The variance is favourable because the actual volume of output was greater than the budgeted
volume of output.
If you selected an incorrect option you misinterpreted the direction of one or both of the
variances.

CHAPTER 9

Budgeted fixed overhead expenditure (4 200 units $4 per unit)


Actual fixed overhead expenditure
Fixed overhead expenditure variance

270 | MANAGEMENT ACCOUNTING

5 A
27 000 units should use ( 2 kg)
but did use
standard price per kg
Material usage variance

$
54 000 kg
53 000 kg
1 000 kg (F)
2.5
2 500 (F)

6 A
9 200 hours should have cost ( $12.50)
but did cost
Direct labour rate variance

$
115 000
110 750
4 250 (F)

7 D
2 195 units should have taken ( 4 hours)
but did take
Direct labour efficiency variance (in hours)
standard rate pre hour

8 780 hours
9 200 hours
420 hours (U)
12.50
5 250 (U)

8 D The only fixed overhead variance in a marginal costing statement is the fixed overhead
expenditure variance. This is the difference between budgeted and actual overhead
expenditure, calculated in the same way as for an absorption costing system.
There is no volume variance with marginal costing, because under or over absorption due to
volume changes cannot arise.

VARIANCE ANALYSIS | 271

ANSWERS TO CHAPTER QUESTIONS


1 A Material price variance
33 600 kg should have cost ( $10/kg)
and did cost

$
336 000
336 000

Material usage variance


9 000 units should have used ( 4kg)
but did use
standard cost per kg

36 000 kg
33 600 kg
2 400 kg (F)
$10
24 000 (F)

2 A
Direct labour rate variance
16 500 hrs should have cost ( $4)
but did cost

$
66 000
68 500
2 500 (U)

Direct labour efficiency variance


9 000 units should have taken ( 2 hrs)
but did take
standard rate per hour ( $4)

18 000 hrs
16 500 hrs
1 500 (F)
$4
6 000 (F)

3 A
Fixed production overhead absorbed ($7.50 9 000)
Fixed production overhead incurred

$
67 500
70 000
2 500 (U)

Materiality, controllability, type of standard being used, interdependence between variances


and costs of investigation.

6 D
Sales revenue for 620 units should have been ( $30)
but was ( $29)
Selling price variance
Budgeted sales volume
Actual sales volume
Sales volume variance in units
standard profit per unit ($(30 28))
Sales volume profit variance

$18 600
$17 980
$620 (U)
600 units
620 units
20 units (F)
$2
$40 (F)

CHAPTER 9

4 C If a target standard rather than a current standard is used, unfavourable variances will occur until
the target is achieved. Poor quality materials may slow down work, and possibly increase
wastage/rejection rates. This will cause labour inefficiency. Using expensive skilled labour
should be expected to result in favourable efficiency variances. There should be no connection
between labour efficiency and whether work is done in normal time or overtime.

272 | MANAGEMENT ACCOUNTING

273

CHAPTER 10
CAPITAL EXPENDITURE
Learning objectives

Reference

Capital expenditure

LO10

Analyse capital expenditure decisions in organisations using relevant tools and


techniques

LO10.1

Apply capital expenditure analysis to project planning and managing uncertain


scenarios through scenario analysis

LO10.2

Decision making

LO2

Identify the quantitative and qualitative criteria involved in accepting a project

LO2.3

Analyse the challenges posed by differences between a project and an organisation's


risk profiles

LO2.4

Explain the impact of cash flows and risks on project decision making

LO2.5

Topic list

1
2
3
4
5

The process of investment decision making


Post-completion audit
The payback method
The accounting rate of return method
Risk and uncertainty in decision making

274 | MANAGEMENT ACCOUNTING

INTRODUCTION
This chapter is an introduction to the appraisal of projects which involve the outlay of capital.
Capital expenditure differs from day-to-day revenue expenditure for two reasons:
Capital expenditure often involves a bigger outlay of money.
The benefits from capital expenditure are likely to accrue over a long period of time, usually well
over one year and often much longer. In such circumstances the benefits cannot all be set against
costs in the current year's income statement.
For these reasons any proposed capital expenditure project should be properly appraised, and found
to be worthwhile, before the decision is taken to go ahead with the expenditure.
We begin the chapter with an overview of the investment decision-making process, before moving on
to examine two capital investment appraisal techniques, the straightforward payback method and the
slightly more involved accounting rate of return method.
We conclude by looking at uncertainty and risk. Decision making involves making decisions now about
what will happen in the future. Ideally, the decision maker would know with certainty what the future
consequences would be for each choice faced. But, in reality, decisions must be made in the
knowledge that their consequences, although perhaps probable, are rarely totally certain.
The chapter content is summarised in the diagram below.

Capital
expenditure

The process

Payback
method

Post audit

ARR method

Risk and
uncertainty

CAPITAL EXPENDITURE | 275

BEFORE YOU BEGIN


If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 A typical model for investment decision making has a number of distinct stages.

(Section 1.2)

What are they?


3 What is a post-completion audit?

(Section 1.5)
(Section 2)

4 Why perform a post-completion appraisal?

(Section 2.1)

5 Which projects should be audited?

(Section 2.2)

6 Who should perform a post-completion audit (PCA)?

(Section 2.4)

7 Define the payback method of investment appraisal.

(Section 3)

8 What are the disadvantages of the payback method?

(Section 3.2)

9 What are the advantages of the payback method?

(Section 3.3)

10 What are the formulae that can be used for ARR?

(Section 4)

11 What are the drawbacks and advantages to the ARR method of project appraisal?

(Section 4.2)

12 What are risk and uncertainty?

(Section 5.1)

CHAPTER 10

2 What are steps involved in the analysis stage of investment decision making?

276 | MANAGEMENT ACCOUNTING

1 THE PROCESS OF INVESTMENT DECISION


MAKING
Section overview
A typical model for investment decision making has a number of distinct stages:
Origination of proposals
Project screening
Analysis and acceptance
Monitoring and review
During the project's progress, project controls should be applied.

1.1 CREATION OF CAPITAL BUDGETS


LO
10.1

The capital budget will normally be prepared to cover a longer period than sales, production and
resource budgets, from three to five years, although it should be broken down into periods matching
those of other budgets. It should indicate the expenditure required to cover capital projects already
underway and those it is anticipated will start in the three to five year period of the capital budget.
The budget should therefore be based on the current production budget, future expected levels of
production and the long-term development of the organisation, and industry, as a whole.
Budget limits or constraints might be imposed internally (soft capital rationing) or externally (hard
capital rationing).
Projects can be classified in the budget into those that generally arise from top management policy
decisions or from sources such as mandatory government regulations (health, safety and welfare
capital expenditure) and those that tend to be appraised using the techniques covered in this chapter.
a. Cost reduction and replacement expenditure.
b. Expenditure on the expansion of existing product lines.
c. New product expenditure.
The administration of the capital budget is usually separate from that of the other budgets. Overall
responsibility for authorisation and monitoring of capital expenditure is, in most large organisations,
the responsibility of a committee.

1.2 THE INVESTMENT DECISION MAKING PROCESS


LO
2.3

Capital expenditure often involves the outlay of large sums of money, and expected benefits may
take a number of years to accrue. For these reasons it is vital that capital expenditure is subject to a
rigorous process of appraisal and control.
A typical model for investment decision making has a number of distinct stages:

Origination of proposals
Project screening
Analysis and acceptance
Monitoring and review

We will look at these stages in more detail below.

CAPITAL EXPENDITURE | 277

1.3 ORIGINATION OF PROPOSALS


Investment opportunities must be sought where appropriate to ensure an organisation either gains or
maintains competitive advantage. An organisation must set up processes to ensure that the
environment is scanned for potential opportunities and gives an early warning of future
problems. Such processes may include seeking external professional advice, carrying out scenario
planning and holding regular internal meetings where interested parties can bring suggestions. A
technological change that might result in a drop in sales might be picked up by this scanning process,
and steps should be taken immediately to respond to such a threat.
Ideas for investment might come from those working in technical positions. A factory manager, for
example, could be well placed to identify ways in which expanded capacity or new machinery could
increase output or the efficiency of the manufacturing process. Innovative ideas, such as new product
lines, are more likely to come from those in higher levels of management, given their strategic view of
the organisation's direction and their knowledge of the competitive environment.
The overriding feature of any proposal is that it should be consistent with the organisation's overall
strategy to achieve its objectives.

1.4 PROJECT SCREENING


Each proposal must be subject to detailed screening. A qualitative evaluation may occur, using
questions such as those below, before any financial analysis is undertaken. Only if the project passes
this initial screening will more detailed financial analysis begin.
a. What is the purpose of the project?
b. Does it 'fit' with the organisation's long-term objectives?
c. Is it a mandatory investment, for example, to conform with safety legislation?
d. What resources are required and are they available, e.g. money, capacity, labour?
e. Do we have the necessary management expertise to guide the project to completion?
f. Does the project expose the organisation to unnecessary risk?
g. How long will the project last and what factors are key to its success?
h. Have all possible alternatives been considered?

1.5 ANALYSIS AND ACCEPTANCE


Step 1

Complete and submit standard format financial information as a formal investment


proposal.

Step 2

Classify the project by type to separate projects into those that require more or less
rigorous financial appraisal, and those that must achieve a greater or lesser rate of return
in order to be deemed acceptable.

Step 3

Carry out financial analysis of the project. We look at this in more detail below.

Step 4

Compare the outcome of the financial analysis to predetermined acceptance criteria.

Step 5

Consider the project in the light of the capital budget for the current and future
operating periods.

Step 6

Make the decision accept/reject. This is considered in more detail below.

Step 7

Monitor the progress of the project (covered below).

The approval hierarchy for an investment will be dependent on the level of investment i.e. its
cost/value and complexity (see section 1.5.3).
Steps 1 to 6 above can be seen in the context of the decision-making process that was described in
chapter 1, section 3.7. After all, investing in capital projects involves a decision about whether to
spend, and how much to spend. Using the approach from chapter 1:

CHAPTER 10

The analysis stage can be broken down into a number of steps.

278 | MANAGEMENT ACCOUNTING

Step 1

Define the problem. The problem that leads to capital expenditure decisions may be
that existing assets are getting old and less reliable, and management want to decide
how to improve reliability and efficiency in production. The problem may be that the
organisation wants to expand the scale of its operations or diversify into a new line of
business, and to do this it needs to invest in new assets.

Step 2

Identify the decision-making criteria. There are several different ways of evaluating
investment options. As we shall see later, the decision-making criteria may be that any
new investment should earn a minimum return on capital invested, or should add value to
the business, or that any amount invested should be recovered within a given number of
years.

Step 3

Develop alternatives. With capital investment decisions, the alternatives may be


presented simply as 'Invest in a specific asset' or 'Do not invest'. However there may be
other options to consider, such as whether to buy Asset 1 or Asset 2 (which may be a
bigger and more expensive item). There may also be different options about when to
invest whether to invest now or whether to defer the spending until a later time. In the
exam, the options are likely to be either to invest or not to invest 'now'.

Step 4

Analyse the alternatives. Each of the alternatives should be analysed and evaluated,
using the chosen decision-making criterion. If the alternatives are simply either to invest
or not to invest, the analysis is carried out by evaluating the decision to invest.

Step 5

Select an alternative. If investing is worthwhile, the 'don't invest' option is rejected. If


investing seems worthwhile, the 'don't invest' option is rejected.

1.5.1 FINANCIAL ANALYSIS


The financial analysis will involve the application of the organisation's preferred investment
appraisal techniques. In many projects some of the financial implications will be extremely difficult to
quantify, but every effort must be made to do so, to have a formal basis for planning and controlling
the project.
Here are examples of the type of question that will be addressed at this stage:
a. What cash flows/profits will arise from the project and when?
b. Has inflation been considered in the determination of the cash flows?
c. What are the results of the financial appraisal?
d. Has any allowance been made for risk, and if so, what was the outcome?
Some types of project, for example, a marketing investment decision, may give rise to cash inflows
and returns which are so intangible and difficult to quantify that a full financial appraisal may not be
possible. In this case more weight may be given to a consideration of the qualitative issues.

1.5.2 QUALITATIVE ISSUES


Financial analysis of capital projects is obviously vital because of the amount of money involved and
the length of time for which it is tied up. A consideration of qualitative issues is also relevant to the
decision i.e. factors which are difficult or impossible to quantify. We have already seen that qualitative
issues would be considered in the initial screening stage, for example, in reviewing the project's 'fit'
with the organisation's overall objectives and whether it is a mandatory investment. There is a very
wide range of other qualitative issues that may be relevant to a particular project.
a. What are the implications of not undertaking the investment, e.g. adverse effect on staff morale,
loss of market share?
b. Will acceptance of this project lead to the need for further investment activity in future?
c. What will be the effect on the company's image?
d. Will the organisation be more flexible as a result of the investment, and better able to respond to
market and technology changes?

CAPITAL EXPENDITURE | 279

1.5.3 APPROVAL HIERARCHY


'Invest' or 'Don't invest' decisions on projects may be made at different levels within the
organisational hierarchy, depending on three factors:
a. The type of investment.
b. Its perceived riskiness.
c. The amount of expenditure required.
For example, a divisional manager may be authorised to make decisions up to $25 000, an area
manager up to $150 000 and a group manager up to $300 000, with board approval for greater
amounts.
Once the 'Invest' or 'Don't invest' decision, or accept/reject, decision has been made, the
organisation is committed to the project, and the decision maker must accept that the project's
success or failure reflects on his or her ability to make sound decisions.

1.6 MONITORING THE PROGRESS OF THE PROJECT


During the project's progress, project controls should be applied to ensure the following:
Capital spending does not exceed the amount authorised
The implementation of the project is not delayed
The anticipated benefits are eventually obtained
The first two items are easier to control than the third, because the controls can normally be applied
soon after the capital expenditure has been authorised, whereas monitoring the benefits will span a
longer period of time.

1.6.1 CONTROLS OVER EXCESS SPENDING


There are a number of controls which organisations can implement to ensure that capital spending
does not exceed the amount authorised.
a. The authority to make capital expenditure decisions must be formally assigned.
b. Capital expenditure decisions should be documented. Approval of the project should specify the
manager authorised to carry out the expenditure, and hence responsible for the successful
implementation of the project, the amount of expenditure authorised and the period of time in
which the expenditure should take place.
c. Some overspending above the amount authorised by 5% or 10% might be allowed. If the
required expenditure exceeds the amount authorised by more than this amount, a fresh
submission for reauthorisation of the project should be required.
d. A total capital budget monitors total spending. Any additional capital expenditure in excess of the
original budget would require approval via a structured capital expenditure approach.

1.6.2 CONTROL OVER DELAYS


If there is a delay in carrying out the project and the capital expenditure has not taken place before
the stated deadline is reached, the project should be resubmitted for fresh authorisation, and the
proposer should be asked to explain the reasons for the delay.

1.6.3 CONTROL OVER THE ANTICIPATED BENEFITS

A difficulty with control measurements of capital projects is that most projects are 'unique' with no
standard or yardstick to judge them against other than their own appraisal data. Therefore if actual
costs were to exceed the estimated costs, it might be impossible to tell just how much of the variance
is due to bad estimating and how much is due to inefficiencies and poor cost control.

CHAPTER 10

Further control can be exercised over capital projects by ensuring that the anticipated benefits do
actually materialise, the benefits are as big as anticipated and running costs do not exceed
expectation.

280 | MANAGEMENT ACCOUNTING

In the same way, if benefits are below expectation, is this because the original estimates were
optimistic, or because management has been inefficient and failed to get the benefits they should
have done?
Many capital projects such as the purchase of replacement assets and marketing investment decisions
do not have clearly identifiable costs and benefits. The incremental benefits and costs of such
schemes can be estimated, but it would need a very sophisticated management accounting system to
be able to identify and measure the actual benefits and many of the costs. Even so, some degree of
monitoring and control can still be exercised by means of a post-completion appraisal or audit
review.

2 POST-COMPLETION AUDIT
Section overview
A post-completion audit cannot reverse the decision to incur the capital expenditure,
because the expenditure has already taken place but it can assist with the implementation
and control of future investments.
Definition
A post-completion audit (PCA) is an objective independent assessment of the success of a capital
project in relation to plan. It covers the whole life of the project and provides feedback to managers to
aid the implementation and control of future projects. A post-completion audit is often referred to as
post-implementation audit in some countries.

The PCA is therefore is therefore a forward-looking rather than a backward-looking technique. It


seeks to identify general lessons to be learned from a project.

2.1 WHY PERFORM A POST-COMPLETION APPRAISAL (PCA) OR AUDIT?


a. The possibility of the PCA can motivate managers to work to achieve the promised benefits from
the project.
b. If the audit takes place before the project life ends, and if it finds that the benefits have been less
than expected because of management inefficiency, steps can be taken to improve efficiency.
Alternatively, it will highlight those projects which should be discontinued.
c. PCA may be incorporated into individual performance reviews for the project manager.
d. It might identify weaknesses in the forecasting and estimating techniques used to evaluate
projects, and so should help to improve the discipline and quality of forecasting for future
investment decisions.
e. Areas where improvements can be made in methods which should help to achieve better results
in general from capital investments might be revealed.
f. The original estimates may be more realistic if managers are aware that they will be monitored,
but post-completion audits should not be unfairly critical.
Research by Neale and Homes (1990) found that managers see the following advantages to PCAs:
a. They improve the quality of decision making.
b. They improve organisational performance.
c. They improve control and guidance.
d. They encourage a more realistic approach to new investment project decision making.
e. They help to identify critical success factors.
f. They enable changes to be made more quickly to projects that are not doing very well.
g. They encourage (when relevant) project termination.

CAPITAL EXPENDITURE | 281

2.2 WHICH PROJECTS SHOULD BE AUDITED?


A reasonable guideline might be to audit all projects above a certain size, and a random selection
of smaller projects.
A PCA does not need to focus on all aspects of an investment, but should concentrate on those
aspects which have been identified as particularly sensitive or critical to the success of a project. The
most important thing to remember is that post-completion audits are time-consuming and costly, so
careful consideration should be given to the cost-benefit trade-off arising from the post-completion
audit results.

2.3 WHEN SHOULD PROJECTS BE AUDITED?


If the audit is carried out too soon, the information may not be complete. On the other hand, if the
audit is too late then management action will be delayed and the usefulness of the information is
greatly reduced.
There is no correct answer to the question of when to audit, although research suggests that in
practice most companies perform the PCA approximately one year after the completion of the
project.

2.4 WHO PERFORMS A PCA?


Because it can be very difficult to evaluate an investment decision completely objectively, it is
generally appropriate to separate responsibility for the investment decision from that for the PCA.
Line management involved in the investment decision should therefore not carry out the PCA. To
avoid conflicts of interest, outside experts could be used.

2.5 PROBLEMS WITH PCA


a. There are many uncontrollable factors which are outside management control in long-term
investments, such as environmental changes.
b. It may not be possible to identify separately the costs and benefits of any particular project.
c. PCA can be a costly and time-consuming exercise, although 'contrary to what is often thought,
conducting a PCA does not appear to be an expensive business' reported Brantjes, von Eije,
Eusman and Prins in Management Accounting (Post-completion auditing with Heineken) in April
1999.
d. Applied punitively, post-completion audit exercises may lead to managers becoming over
cautious and unnecessarily risk averse.
e. The strategic effects of a capital investment project may take years to materialise and it may in
fact, never be possible to identify or quantify them effectively.
Despite the growth in popularity of post-completion audits, you should bear in mind the possible
alternative control processes:
a. Teams could manage a project from beginning to end, control being used before the project is
started and during its life, rather than at the end of its life.
b. More time could be spent choosing projects rather than checking completed projects.

A 1999 Management Accounting article looked at post completion auditing at Heineken (the Dutch
beer producer) and how it was applied to a project to replace a 20-year old bottling line. The
following table shows the planned objectives of the investment and the actual situation at the time a
PCA was carried out on the investment. (Guilders were the Dutch currency prior to the euro.) This
should give you an idea of the type of objectives that can be monitored with a PCA.

CHAPTER 10

Case study

282 | MANAGEMENT ACCOUNTING

OBJECTIVES

PLAN

ACTUAL

Efficiency

Increase from 65% to 80%

No increase yet

Staff savings

From 13 to 7 per shift

Achieved

Forklift savings

1 vehicle less

1 and possibly 2 vehicles less

Savings on overhaul of
old bottling line

1.3 million guilders of savings

Savings achieved, but as a result of


reusing part of the old bottling line
another 1.8 million guilders was spent in
additional overhaul costs

Savings on
maintenance

Savings of 0.4 million guilders annually

Savings estimated at 0.3 million guilders


annually

Quality

50% reduction in damage

Achieved

Working conditions

Level of noise

All much improved, but not quantified

Accessibility
Safety
Attainability

Now that we have discussed all the stages involved in the capital budgeting process, we will return to
study in detail the stage that many managers consider to be the most important: the financial
appraisal. A decision about whether to invest is often made on financial considerations, and the
decision criterion is related to financial return. We will begin with what is probably the most
straightforward appraisal technique: the payback method.

3 THE PAYBACK METHOD


Section overview
The payback method looks at how long it takes for a project's net cash inflows to equal the
initial investment. It is often used as a first screening method because it helps focus
attention on liquidity.
Definition
Payback is the time required for the cash inflows from a capital investment project to equal the cash
outflows, so that the returns from the investment pay back the initial outlay.

Payback is often used as a 'first screening method' because it helps focus attention on liquidity. By
this, we mean that when a capital investment project is being subjected to financial appraisal, the first
question to ask is: 'How long will it take to pay back its cost?' The organisation might have a target
payback, and so it would reject a capital project unless its payback period were less than a target
maximum number of years.
When deciding between two or more competing projects, management may prefer the one with the
shortest payback.
If payback were the only method of evaluation used, the decision criterion would be to recover the
initial capital outlay as quickly as possible.
However, a project should not be evaluated on the basis of payback alone. If a project gets through
the payback test, it ought then to be evaluated with a more sophisticated project appraisal technique.
Payback is a cash based measure. Ideally it is based on the project's cash inflows versus its cash
outflows. It does not consider profit. In the absence of cash flow information however, profits before
depreciation can be used as a very rough approximation of annual cash flows.

CAPITAL EXPENDITURE | 283

With some methods of capital expenditure appraisal, it is commonly assumed that cash flows in each
period occur on the last day of the period. However with the payback method, either of two different
assumptions may be used:
a. that the cash flows in each period do occur at the end of the period: this means that capital
expenditure at the beginning of the first year are assumed to occur in 'Year 0', which is the year
that has just ended. When this assumption is used, payback will occur at the end of a particular
year.
b. that the cash flows occur at an even rate throughout each time period. When this assumption is
used, payback will normally occur at some time during a particular year, not at the end of a year.
When it is assumed that cash flows occur at an even rate throughout the year (with the exception of
any cash from the disposal of a capital asset, which happens at the very end of the project), the
payback period is calculated as follows.
a. Calculate the cumulative cash flows at the end of each year. The initial capital outlay is a cash
outflow, so the cumulate cash flow will remain negative until payback is achieved.
b. Payback is achieved during the year that the cumulative cash flows change from negative to
positive.
c. The time in the payback year that payback occurs is found by calculating the proportion:
(Extra cash inflow needed for payback at the start of the year/Cash flow during the year)
d. Multiply this proportion by 12 months to get the payback month in the year.
For example, suppose that the cumulative cash flow for a project at the end of Year 3 is - $15 000 and
the cash flow in Year 4 is $36 000. The payback period will be 3 years + [(15 000/36 000) 12 months]
= 3 years 5 months.

3.1 WHY IS PAYBACK ALONE AN INADEQUATE PROJECT APPRAISAL


TECHNIQUE?
Look at the figures below for two mutually exclusive projects (this means that only one of them can be
undertaken).
Capital cost of asset
Profits before depreciation
Year 1
Year 2
Year 3
Year 4
Year 5

Project P
$60 000
$20 000
$30 000
$40 000
$50 000
$60 000

Project Q
$60 000
$50 000
$20 000
$5 000
$5 000
$5 000

Project P pays back in year 3. If we assume that cash flows occur at the end of the year, payback occurs
at the end of year 3. If we assume that cash flows occur at an even rate throughout each year, Project P
will pay back one quarter of the way through year 3 (after 2 years 3 months).

Using payback alone to judge projects, project Q would be preferred. But the returns from project P
over its life are much higher than the returns from project Q. Project P will earn total profits before
depreciation of $200 000 on an investment of $60 000, whereas project Q will earn total profits before
depreciation of only $85 000 on an investment of $60 000. Making the choice between the projects on
payback alone would be inappropriate: total return must also be considered.

CHAPTER 10

Project Q pays back in year 2. If we assume that cash flows occur at the end of the year, payback
occurs at the end of year 2. If we assume that cash flows occur at an even rate throughout each year,
Project Q will pay back half way through year 2 (after 1 year 6 months).

284 | MANAGEMENT ACCOUNTING

Question 1: Payback
An asset costing $120 000 is to be depreciated over ten years to a nil residual value. Profits after
depreciation for the first five years are as follows:
Year
1
2
3
4
5

$
12 000
17 000
28 000
37 000
8 000

How long is the payback period to the nearest month, assuming that cash flows occur at an even rate
during each year?
A 3 years
B 3 years 6 months
C 3 years 7 months
D The project does not payback in five years
(The answer is at the end of the chapter)

3.2 DISADVANTAGES OF THE PAYBACK METHOD


There are two serious drawbacks to the payback method:
a. It ignores the timing of cash flows within the payback period, the cash flows after the end of the
payback period and therefore the total project return.
b. It ignores the time value of money which is a concept incorporated into more sophisticated
appraisal methods. This means that it does not take account of the fact that $1 today is worth more
than $1 in one year's time. An investor who has $1 today can either consume it immediately or
alternatively, can invest it at the prevailing interest rate, say 10%, to get a return of $1.10 in a year's
time.
There are also other disadvantages:
a. The method is unable to distinguish between projects with the same payback period.
b. The choice of any cut-off payback period by an organisation is arbitrary.
c. It may lead to excessive investment in short-term projects.
d. It takes account of the risk of the timing of cash flows but does not take account of the variability of
those cash flows.

3.3 ADVANTAGES OF THE PAYBACK METHOD


The use of the payback method does have advantages, especially as an initial screening device:
a. Assesses period for which capital is tied up.
b. Focus on early payback can enhance liquidity.
c. Investment risk is increased if payback is longer.
d. Shorter-term forecasts are likely to be more reliable.
e. The calculation is quick and simple.
f. Payback is an easily understood concept.

CAPITAL EXPENDITURE | 285

4 THE ACCOUNTING RATE OF RETURN METHOD


Section overview
Like the payback method, the accounting rate of return method is popular despite its
limitations, because it involves a familiar concept of a percentage return.
The accounting rate of return (ARR) method of appraising a project is to estimate the accounting
rate of return that the project should yield. If it exceeds a target rate of return, the project will be
undertaken. The accounting rate of return (ARR) is also called the return on capital employed
(ROCE) method or the return on investment (ROI) method.
Profits rather than cash flows are used to measure the size of returns.
Formula to learn
Unfortunately there are several different definitions of ARR.
ARR =

Average annual profit from investment


100%
Average investment

ARR =

Estimated total profits


100%
Estimated initial investment

Or ARR =

Estimated average profits


100%
Estimated initial investment

The measurement of ARR is different according to whether 'average annual profit' or 'total profits over
the asset life' is the figure above the line. Similarly, ARR differs according to whether 'average
investment' or 'initial investment' is used below the line.
Note: Average investment = [(Initial cost + Estimated residual value)/2].
Whichever method of measuring ARR is selected (assuming that the ARR method is used as a decision
criterion) the method selected should be used consistently. For examination purposes we
recommend the first definition (average profit as a percentage of average investment) unless the
question clearly indicates that some other one is to be used.
Note that this is the only appraisal method that we will be studying that uses profit instead of cash
flow. If you are not provided with a figure for profit, assume that net cash inflow minus depreciation
equals profit.
Worked Example: Target accounting rate of return

A company has a target accounting rate of return of 20%, using the first definition above, and is now
considering the following project.
$80 000
4 years
$20 000
$25 000
$35 000
$25 000

The capital asset would be depreciated by 25% of its cost each year, and will have no residual value.
Assess whether the project should be undertaken.

CHAPTER 10

Capital cost of asset


Estimated life
Estimated profit before depreciation
Year 1
Year 2
Year 3
Year 4

286 | MANAGEMENT ACCOUNTING

Solution

The annual profits after depreciation, and the mid-year net book value of the asset, would be as
follows.
Year
1
2
3
4

Profit after
depreciation
$
0
5 000
15 000
5 000

Mid-year net
book value
$
70 000
50 000
30 000
10 000

ARR in the
year
%
0
10
50
50

As the table shows, the ARR is low in the early stages of the project, partly because of low profits in
Year 1 but mainly because the NBV of the asset is much higher early on in its life. The project does not
achieve the target ARR of 20% in its first two years, but exceeds it in years 3 and 4. Should it be
undertaken?
When the ARR from a project varies from year to year, it makes sense to take an overall or 'average'
view of the project's return. In this case, we should look at the return over the four-year period.
$
105 000
25 000
6 250
80 000
40 000

Total profit before depreciation over four years


Total profit after depreciation over four years
Average annual profit after depreciation
Original cost of investment
Average net book value over the four-year period ((80 000 + 0)/2)

The project would not be undertaken because its ARR is (6 250/40 000) 100% = 15.625% and so it
would fail to yield the target return of 20%.

4.1 THE ARR AND THE COMPARISON OF MUTUALLY EXCLUSIVE


PROJECTS
The ARR method of capital investment appraisal can also be used to compare two or more projects
which are mutually exclusive. The project with the highest ARR would be selected, provided that the
expected ARR is higher than the company's target ARR.
Question 2: The ARR and mutually exclusive projects

Arrow wants to buy a new item of equipment. Three models of equipment are available, differing
according to cost, size, reliability and supplier. The expected costs and profits of each item are as
follows:
Equipment item

Capital cost
Life
Profits before depreciation
Year 1
Year 2
Year 3
Year 4
Year 5
Disposal value

X
$80 000
5 years
$
50 000
50 000
30 000
20 000
10 000
0

Y
$150 000
5 years
$
50 000
50 000
60 000
60 000
60 000
0

Z
$200 000
5 years
$
60 000
70 000
90 000
70 000
60 000
50 000

ARR is measured as the average annual profit after depreciation, divided by the average net book
value of the asset. The investment with the highest ARR will be selected, provided that its expected
ARR is more than 30%.

CAPITAL EXPENDITURE | 287

Which of these items of equipment should be purchased?


A Item X
B Item Y
C Item Z
D None of them
(The answer is at the end of the chapter)

4.2 THE DRAWBACKS AND ADVANTAGES TO THE ARR METHOD OF


PROJECT APPRAISAL
The ARR method has the serious drawback that it does not take account of the timing of the profits
from a project. Whenever capital is invested in a project, money is tied up until the project begins to
earn profits which pay back the investment. Money tied up in one project cannot be invested
any