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MBA 507: MANAGEMENT ACCOUNTING

SCHOOL OF BUSINESS

INSTRUCTIONAL MATERIAL FOR DISTANCE LEARNERS

REVISED EDITION 2013

PUBLISHED BY KENYA METHODIST UNIVERSITY

P.O. BOX 267 – 60200, MERU

Email:odlm.meru@kemu.ac.ke

TEL: 254 – 064 – 30301, 31146/0736752262

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INTRODUCTION TO MANAGEMENT ACCOUNTING

There are various definitions of management accounting;

American Association of Accountants (AAA):

Managerial accounting is the application of appropriate techniques and concepts in processing

historical and projected economic data of an entity to assist the management in establishing plans

for reasonable economic objectives and in the making of rational decisions with a view to

achieving its objectives.

Institute of Chartered Management Accountants of London:

Managerial accounting is the application of professional knowledge and skills in the preparation of

accounting information in such a way as to assist the management in the formation of policies and

in the plan and control of operations.

Institute of Chartered Management Accountants of England and Wales:

Managerial accounting is the preparation of accounting information in such a way as to assist the

management in creation of policies and the day to day operations of the undertaking.

From the above definitions, we can conclude the following:

i) Management accounting is concerned with providing information to the managers.

ii) Management accounting deals in the principles of Financial Accounting to satisfy the

reporting needs of the financial managers.

iii) Any study of management accounting must be preceded by some study of management

process and the organization in which the managers work.

Two branches of accounting reflect the needs of internal and external users of information.

Management accounting is concerned with the provision of information to people within the

organization to help them make better decisions and improve the efficiency and effectiveness of

existing operations whereas financial accounting is concerned with the provision of information to

external parties outside the organization.

Differences between MA and FA

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1. Legal requirements

It is a statutory requirement for public limited companies to produce annual financial accounts.

Management accounting, by contrast, is entirely optional and information should be produced only

if it is considered that the benefit to management exceeds the cost of collecting such information.

2. Focus on individual parts or segments of the business

FA reports describe the whole of the business whereas MA focuses on small parts of the

organization. MA also measures the economic performance of decentralized operating units such

as divisions or departments.

3. Generally accepted accounting principles

FA statements must be prepared to confirm with legal requirements and the GAAPS established by

regulatory bodies such as FASB and Accounts standard Board.

4. Time dimension

FA reports what has happened in the past in an organization whereas MA is concerned with future

information as we as past information. Decisions are concerned with future events and

management therefore requires details of expected future costs and revenues

5. Report frequency

Detailed set of financial account are published annually and less detailed accounts are published

semi-annually. Management accounting reports on various activities may be prepared daily,

weekly or monthly as the need arises.

Functions of management accounting

A cost and management accounting system should generate information to meet the following

requirements.

1. Allocate costs between cost of goods sold and inventories for internal and external profit

reporting.

2. To provide relevant information to help managers make better decisions

3. To provide information for planning, control and performance measurement.

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THE DECISION – MAKING PROCESS

1. Identifying objectives

The first stage in the decision- making process is the specification of goal or objective of the

organization. The goals should ensure the organizations survival in the future and should be

achievable. Goals of a firm include shareholders wealth maximization and profit maximization.

2. The search for alternative course of action

This involves the search of a range of possible course of action or strategies that might enable the

objectives to be achieved. It also involves the acquisition of information concerning future

opportunities and environments. e.g developing new products for sale in existing markets.

3. Gather data about the alternatives

When potential areas of activity are identified, management should assess the potential growth rate

of activities, the ability of the company to establish adequate market shares and the cash flows for

each activity for various states of nature. States of nature are uncontrollable factors such as

economic boom, high inflation, recession, competitors etc. Data must be gathered both for long run

or strategic decision as well as short term or operating decisions.

4. Select the appropriate alternative course of action

The alternative are ranked in terms of their net cash benefits and those showing the greatest

benefits are chosen subject to taking into account any qualitative factors.

5. Implementation of the decisions

Once the courses of action have been selected, they should be implemented as part of the

budgeting process. A budget is a financial plan for implementing management decisions. The

budgeting process communicates to everyone in the organization the part they are expected to play

in implementing managements decisions.

6. Comparing actual and planned outcomes and responding to divergences from plan.

The managerial function of control consists of measurement, reporting and subsequent correction

of performance in an attempt to ensure that the firm‟s objectives and plans are achieved. To

monitor performance, accountants produce performance reports and present them to the

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appropriate managers who are responsible for implementing the various decisions. Performance

reports consist of a comparison of actual outcome (budgeted costs of revenues) should be issued at

regular intervals and provide feedback by highlighting those activities that do not conform to

plans. This enables managers to devote their scarce time on focusing on these items i.e. application

of management by exception.

CHANGING COMPETITIVE ENVIRONMENT

Prior to the 1980s, many organizations both manufacturing and service operated in protected

competitive environment due to barriers of communication, geographical distances and sometimes

protected markets. There was little incentive for firms to maximize costs as cost increases could

often be passed on to customers. Today, virtually all type of organizations have faced a major

change in their competitive environment. The following factors have greatly influenced the change

in competitive environment.

1. Globalizations of world trade – restrictions on market entry have been lifted and this

has increased the level of competition between firms.

2. Privatization of government controlled companies and deregulation in various

industries. Pricing and competitive restrictions were virtually eliminated.

3. Changing products life cycles – A product life cycle is the period of time from initial

expenditure on research and development to the time at which support to customers is

withdrawn. Intensive global competition and technical innovation combined with

increasingly discriminating and sophisticated customers demands have resulted in a

dramatic decline in product life cycles. large fraction of a products life cycle costs are

determined by decisions made early in its life. This has created a need for management

accounting to place greater emphasis on providing information at the design stage

became many of the costs are committed or looked in at this time.

4. Changing 0customers‟ tastes that demand ever- improving level of service in costs,

quality, reliability, delivery and the choice of new products. To provide customer

satisfaction, organizations must concentrate on those key success factors that directly

affect it such as cost efficiency, quality, time and innovation. All these could easily be

addressed by management accounting.

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5. The emergence of e-business – this is the use of IT to support business activities which

has led to development of electronic barrier communication technologies. E-Commerce

has provided the potential to develop new ways of doing things that have enabled

considerable costs savings to be made from streamlining businesses process and

generating extra revenues from the adapt use of on-line safer facilities.

COST OBJECTIVES AND CLASSIFICATIONS

In financial accounting ,cost is defined a as the sacrifice made to obtain goods or services , such as

sacrifice of materials , labour, etc.In management accounting, cost is used in many different ways,

the reason is that there are many different types of costs and these costs are classified differently

according to the immediate needs of the management.

Basis of classification of costs:

1) Manufacturing cost or non-manufacturing costs

Manufacturing costs.

Manufacturing cost include the cost of direct materials, direct labour and direct factory overheads.

Direct materials-these materials become an integral part of a company‟s finished product and can

be conveniently traced into it. Direct labour-are those labour costs that can be physically traced to

the creation of a product without a due cost or inconvenience. Manufacturing overheads-this

includes all costs of manufacturing other than direct materials and direct labour e.g

Indirect labour-labour cost that cannot be physically traced to production or involve alot of

expenses in tracing them.

Indirect materials-this can only be traced into the product at great costs or inconvenience e.g. paint

to furniture

Other costs of operating the factory e.g. electricity, insurance, maintenance and all other costs

incurred to operate the manufacturing process in a company.

Non-manufacturing costs

Non-manufacturing costs can be classified into two categories

i) Selling and marketing costs

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This costs include all the necessary costs to secure customer orders and get the finished goods into

the customer‟s premises .They include sales commissions, sales travel , salaries of salesmen,

advertising,etc.

ii) Administrative costs

These include all executive, organizational and clerical costs that cannot logically be included in

either manufacturing or marketing. They include executive salaries, general accounting,

secretarial, public relations and similar costs having to do with the overall administration of the

organization.

2) Classifying costs according to cost behaviour

Costs can be classified according to how they react to changes in the level of business activity i.e.

how they react to the number of goods sold, number of hours worked , etc.

As the activity, level rises or falls, a particular cost may rise or fall as well or may remain constant.

Thus, we have fixed cost and variable cost.

Fixed cost

Are those costs that remain constant in total regardless of the changes in the level of business

activity within the relevant range. However, beyond some range, these costs may cease to be fixed.

Variable costs

These vary in total in proportion to changes in the level of activity but within the relevant range.

Semi-variable costs

These costs have an element of fixed as well as variable costs. They are also called step costs.

3) Classifying costs as period costs and product costs

Product costs

These consist of costs in the purchase or manufacture of goods. They are also known as inventorial

costs. This is because they are first classified in the inventory stage until they are expensed.

They are only treated as expenses (cost of goods sold) in the time period during which the related

products are sold.

Period costs

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These are costs that are matched against revenue on a time period basis and are therefore not

included as part of costs of the product.

They are treated as expenses and deducted from the revenue in the time which they are incurred.

4) Classifying costs as direct and indirect costs

Direct costs

Is a cost that can obviously and physically be traced to the particular segment under consideration

i.e. can be traced to a particular segment.

Indirect costs

These are costs that must be allocated in order to be assigned to the segment under consideration

.They are also known as common costs e.g. manufacturing overhead cost.

5) Classifying costs as controllable and non – controllable costs

Controllable cost

A cost is said to be controllable at a particular level of management if that level has the power to

authorize its incurrence.

Where there is no power to authorize its incurrence then the cost is non - controllable

6) Classifying costs according to time

Under this classification, we have:

Predetermined costs

These are established costs that are computed in advance in the production process taking into

consideration the previous period and factors affecting such costs.

Historical costs

Are those costs that are ascertained after they have been incurred and are available only when the

production is complete.

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7) Classifying costs according to planning and control

These include,

Budgeted costs

These are estimates of expenditure at different phases of business operations such as

manufacturing, administration, sales, research and development coordinated in a well-concealed

framework.

Standard costs

These are budgeted costs which are translated into actual operations.They are scientifically pre-

determined cost of every business activity and are control tools.

8) Other costs

They include: -opportunity costs

-differential costs

- sunk costs

Opportunity costs

The potential benefit, a cost of sacrifice when the selection of one course of action makes it

necessary to give up another course of action. It is the cost of foregone alternative. It is therefore

the maximum alternative earnings that might have been achieved if the production capacity of

services had been put into alternative use.

Differential costs

Is any cost that is present in one alternative but is absent in the other alternative. Differential costs

are changes in cost due to changes in the level of activity or method of production

Sunk costs

A sunk cost is a cost that has already been incurred and cannot be changed by any decision made

now or in the future .It is an irrecoverable cost.

Sunk costs are not relevant to decision making.

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COST ESTIMATION

The analysis of fixed and variable costs is very important in planning and control of operation.

The fixed portion of a mixed cost represents the basic minimum charge for just having a good or

service ready and available for use.

The variable portion represents the charge made for the actual consumption of a service.

There is therefore the need to break down costs to their fixed and variable elements.

There are four methods used to estimate costs.

Accounts classification method

This involves examining each cost item and categorizing them as fixed, variable and semi –

variable.

Advantages

1. It is a quick method of determining fixed and variable costs.

2. It is relatively inexpensive

Disadvantages

1. It is subjective and usually uses the rule of thumb estimate (non-scientific estimate).

2. It arbitrarily deals with variable costs.

3. Step up costs are likely to be forced into either fixed or variable costs with subsequent loss

of accuracy.

4. It uses historical data that may not reflect future conditions.

Industrial engineering approach

This method involves an estimation of the required production inputs for certain output by the

engineers. The engineers will calculate the cost of raw material inputs based on the estimated or

the material content of the product specification, labour input may be based on time and motion

studies and an estimate of the capital input needed for production. A through observation by the

expert engineers of the relation between inputs and outputs can lead to very accurate predictions of

future costs and may yield results that will benefit the overall planning system of the firm.

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The main disadvantage of this method is that it is costly. The production process is complex, the

preparation of a full specification of inputs will require much expert work entailing a large cost

which will be worthwhile only if the additional net benefits created surpassed the cost involved

.However the industrial engineering approach or at least some variation of it, may be used if there

are no past records on which to base an analysis.It is appropriate where there is a physical

relationship between a cost and a cost driver.

High – low or range method

The high-low method is the cheapest and the easiest to use.

It attempts to segregate total past costs by examining only two observations i.e. those representing

the highest and the lowest past activity over the relevant range.

The difference in cost observed at the two extremes is divided by the change in activity in order to

determine the amount of variable cost involved.

Example

Assume that the maintenance cost for Unga Ltd have been observed as follows within the relevant

range of 5000 – 8000 direct labour hours:

Month Direct labour hours maintenance cost „ shs‟

January 5500 shs745

February 7000 shs850

March 5000 shs700

April 6500 shs820

May 7500 shs960

June 8000 shs1000

July 6000 shs825

Required:

Determine the fixed and the variable cost elements of the mixed cost.

The visual inspection method or the scatter graph method

This method entails plotting all the relevant observation on a scatter graph then fitting on a line on

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the data by visual inspection. This is a more accurate way of estimating costs than the high–low

method since it includes all the points of observed cost data in the analysis using a graph.

Cost is shown on the vertical axis and the volume or the rate of activity is shown on the horizontal

axis. The line fitted to the plotted points is known as the regression line. The regression line in

effect is a line of averages with the average and the variable cost per unit of activity represented

by the slope of the line and the average fixed cost per unit represented by the point where the

regression line intersect the cost axis.

The least square method or linear regression analysis

Linear regression analysis refers to the measurement of the average amount of change in one

variable such as manufacturing cost that is associated with unit increases in the amount of one or

more other variables such as output, labour hours, etc.

It is a method of replacing Y (the independent variable) on X (the independent or predictor

variables).

The regression analysis fits a line of best fit to the data so as to minimize the sum of squares of the

vertical distances from the regression line to the plotted points of the actual observations so that

the sum of the squares of this deviations is less than the sum of the square deviations from any

other line.

Thus, it is a method of line fitting which is free from subjectivity.

The least square method is based on computations that find their foundation in the equation of a

straight line.

Y = a + bx

Where:-

Y- Dependent variable

a - fixed element

b - degree of variability (variable element)/slope of line

X - Independent/ predictor variable

From this basic equation under a given set of observations, two mathematical equations known as

normal equations which must be solved simultaneously to derive values of a and b for inclusion in

the total cost function can be developed.

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i) Σ y = na + bΣx

ii) Σxy = aΣx + bΣx2

Example

The following data relates to Mr Kamotho‟s business for the period Jan – June 2003:

Month Output (units) Total manufacturing costs (shs)

(x) (y)

January 80 10200

February 90 10900

March 100 12100

April 80 10800

May 120 13700

June 110 12500

Required:

Determine the business fixed and variable cost for manufacturing cost.

Test of reliability

Reliability is based on the size of the deviations of the actual observations y from the estimated

values on the regression line (y) y estimates

The size of the deviations can be ascertained by squaring the difference

The average of these deviations is known as residue variation or variance (Q2)

This variance is computed as follows:

Q2

= Σ ( y-yˆ )2

N

This only signifies the unexplained variation but not the total variation from the average. The

dispersion of the actual observation around the average is as follows:

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Q2

=

2

)(

N

yy

1) Co-efficient of determination ( r2 )

This explains the extent to which variation in the dependent variable y is explained by the

variation in the predictor variable x.

r2

= 1 - Σ ( y-y)2/N

Σ (y- y )2/N

2) Correlation co-efficient(r)

This is the square root of r.2

. It measures the degree of association between two variables. If the

association is so close, r and r2

will be near 1 and it will be almost possible to plot the observation

on a straight line.

3) Standard errors of estimates.

This gives us an estimation of the absolute size of the probable deviations from the regression line

.The standard error of estimates is computed as follows:

Se = 2

)^( 2

N

yy

The standard error of estimate enables us to establish a range of values of the dependent variable y

within which we may have some degree of confidence that the true value lies e.g. at 90%

confidence level the true value lies at y estimate (yˆ)

= yˆ + 1.812 (Se)

Thus, the standard error of the estimate is similar to a standard deviation in normal probability

analysis. It is a measure of variability along the regression line.

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4) The standard error of the coefficients

This measures the reliability of the regression line coefficient “b” of the variable cost.

Sb=

2)( xx

Se or Sb=

)( 2 xxx

Se

Example

The following information relates to XYZ Ltd for the year ended 31st Dec 2003

Hours Maintenance costs (shs)

90 1500

150 1950

60 900

30 900

180 2700

150 2250

120 1950

180 2100

90 1350

30 1050

120 1800

60 1350

Required

a. Determine the company‟s fixed and variable cost using the least squares method.

b. Determine the coefficient of determination

c. Determine the correlation coefficient.

d. Determine the standard error of the estimates

e. Determine the confidence interval of the true maintenance cost at 180 hours given at 90%

confidence level

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f. Determine the standard error of the coefficient

g. Determine the confidence interval of the true variable cost at 90% confidence level.

COST VOLUME PROFIT ANALYSIS

This is a managerial technique used to determine how costs and profits are affected by the changes

in the levels of this activity. It is a systematic method of examining the relationship between

changes in activity (i.e. output) and changes in total sales revenue, expenses and net profit. It gives

a deterministic analysis and seeks to evaluate the relationship between investment outlays, activity,

volumes and profitability. Of particular interest in where sales revenues are able to cover all the

costs. It called the break-even point (shows minimum scale of operation so as to stay in business).

As a model of these relationships, CVP analysis simplifies the real world conditions that a firm

will face. The objective of CVP analysis is to establish what will happen to the financial results if a

specified level of activity fluctuates.

Assumptions of Cost Volume Profit Analysis

1) The unit sales price and unit cost remains constant in the review period

2) All costs can be classified and identified as either fixed or variable with a reasonable amount of

accuracy.

3) Variable costs should change proportionately with volume.

4) The fixed cost should remain constant.

5) The relationship between revenue, cost, volume and profits is linear over the relevant range.

6) The volume of production equals the volume of sales or changes in the beginning and ending

inventory levels are insignificant in amount.

7) Volume is the only relevant factor affecting cost.

8) Whenever more than one product is sold, total sales will be some predictable portion also

known as the sales mix

9. The analysis applies only to a short-term time horizon.

Therefore cost volume analysis is used by the management to evaluate the inter-relationship of

selling price, sales volume, sales mix and costs and profits so that acceptable profits can be

achieved. In order to plan for profits, managers must estimate the selling price of each product, the

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variable cost required producing it and selling it and the fixed cost expected of each period. This

information is combined with the estimates concerning the expected sales volume and sales mix to

arrive at a good profit plan.

BREAK-EVEN POINT

The BEP is the sales volume at which revenues and total costs are equal. At this level all the

variable and fixed costs are covered by the sales revenue. It defines minimum production and sales

level required to stay in the business. It also allows us to evaluate profitability associated with

various output levels. In new markets e.g. we are able to compare the volume demanded in the

market with break even point. From this comparison we determine whether it is worthwhile to

venture into such markets.

Graphical Analysis of BEP (Break-Even- chart)

Mathematical determination of BEP

Profits =TR –TC

))(()( FCVCXQSPXQ

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= (SPXQ) –(VCXQ)-FC

At BEP,π =0

BEP , SPX Q – VC X Q – FC =0

Q(S.P – VC)=FC

Q(SP-VC) = FC

(SP –VC) (SP-VC)

Q= FC

(SP-VC)

Where:

Q-Break even quantity

FC –Fixed cost

SP –selling price

VC – Variable cost

(SP-VC) – Contribution margin per unit.

BEP in Revenue = FC

CM Ratio

CM Ratio – contribution /unit ratio

S.P

NOTE:

- While the BEP is not the desirable performance target because of the lack of profit, it does

indicate the level of activity necessary to avoid incurring a loss. As such the BEP will

represent a target of minimum sales revenue that must be achieved by a business.

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Example 1

A summarized income statement of XYZ LTD for the year 2007 is given below:

Shs

Sales (8000 units @shs50 per unit) 400000

Variable cost 280000

Contribution margin 120000

Fixed cost 150000

Net profit / loss 30000

Required: BEP in units and revenue.

Margin of safety:

The margin of safety indicates by how much sales may decrease before a loss occurs

Is the excess of the actual sales over the break-even sales.

Margin of safety = Actual sales – Break Even sales

Margin of safety is useful for a firm facing a declining market share .It shows the extent to which

revenue can fall before contemplating a shut down decision.

The BEP gives an indication of the level of sales that is required below which the firm will suffer

the risk of insolvency. In such a situation the units to attain the cash BEP is given as:

= FC – Non-cash expenses

CM/units

Non –cash expenses include depreciation, amortization, etc.

Target profit

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The units to produce to meet the target profit level:

Level of sales to result in target profit = fixed costs + Target Profit

Contribution margin per unit

Where there n is a given tax level units to produce and sell in order to attain a given π level

Target Profit

Level of sales to result in target profit = fixed costs + 1-Tax Rate

Contribution margin per unit

Example 2

Assume that the manager of XYZ Co-Ltd wants to earn a net profit before tax of shs200000 in the

year 2007 and expects the same selling price and cost as the already experienced.

Required:

What sales volume will achieve this target profit?

Example 3

ABC company produces and sells a certain product at shs800 each with VMC of shs380/per unit

and FMC of shs1million.In addition the company incurs selling and administration expenses of

2.5% of sales revenue and FSC of Ksh 200000.

Required :

i) Determine the BEP in units and in revenue.

ii) Determine the units that should be sold to earn an income of shs500, 000.

iii) If the company was in the 35% bracket, how many units will have to be sold to achieve the

shs500000 targeted?

iv) Management is considering a policy which will increase the FMC by shs400, 000 but cut

down on VMC by 20%.

a) What is the BEP in units and revenue under this policy?

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b) Taking into a/c the 35% tax level, how many units will have to be sold to earn the

target shs500000 under this policy?

v) At what sales level will the management be indifferent under the two policies?

Example 4

Guerba enterprises operate in the leisure and entertainment industry and one of its activities is to

promote concerts at locations in the city of Nairobi. The company is examining the viability of a

concert in the Hurlingham area of Nairobi. The estimated fixed costs are Sh 600,000, which

include fees paid to performers, the hire of the venue and advertising costs. Variable costs consist

of a pre-packed buffet, which will be provided by a firm of caterers at a price, which is currently

being negotiated, but is likely to be in the region of Sh 100 per ticket. The proposed price of the

sale of ticket is Sh 200. The management of Guerba has requested you, as a management

accounting trainee in the company to provide the following information.

i) The number of tickets that must be sold to break-even

ii) How many tickets must be sold to earn a target of sh.300, 000

iii) What profit would result if 8,000 tickets were sold?

iv) What selling price would have to be charged to give a profit of Sh 3000,000 on

sales of 8,000 tickets, fixed costs of Sh 600,000 and variable costs of sh100 per

ticket?

v) How many additional tickets must be sold to cover the extra cost of television

advertising of sh80, 000?

SALES MIX

Refers to the relative combination in which a company‟s products are sold or the relative

combination of quantities or product that comprise total sales. Managers try to achieve the sales

mix that yields the greatest amount of products. Profits will be higher if higher margin products

make up a relatively large proportion of total sales unless if sales consists mostly of low margin

products.

Example 5

ABC company produces 2 products A and B and has the following budget:

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A B Total

Expected sales in units 240000 80000 320000

Sales in revenue (A@shs5/unit,B@shs10/unit) 1200000 800000 2000000

Variable costs(A@shs3/unit,G@shs6/unit) 720000 480000 1200000

Contribution margin 480000 320000 800000

Fixed costs 500000

Net income 300000

Required:

Compute the company‟s BEP.

EXAMPLE SIX

The Super Bright Company sells two types of washing machines-a de-luxe model and a standard

model. The financial controller has prepared the following information based on the sales forecast

for the period:

De-luxe Standard

Machine machine Total

Sales volume(units) 1200 600 .

Shs shs

Unit selling price 300 200

Unit variable cost 150 110

Unit contribution 150 90

Total sales revenue 360,000 120,000 480,000

Less: total variable cost 180,000 66,000 246,000

Contribution to direct and common 180,000 54,000 234,000

Fixed costs

Less:direct avoidable fixed costs 90,000 27,000 117,000

Contribution to common fixed costs 90,000 27,000 117,000

Less: common (indirect) fixed costs 39,000

Operating profit 78,000

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The common fixed costs relate to the costs of common facilities and can only be avoided if neither

of the products is sold. The managing director is concerned that sales may be less than forecast and

has requested information relating to the break-even point for the activities of the period. Assume

that the actual sales volume for the period was 1200 units consisting of 600 units of each machine

what would be the BEP?

PRODUCT COSTING METHODS

There are basically 2 types:

a) Variable /marginal/direct/contribution costing methods.

b) Absorption/Full costing/Functional/Traditional costing method.

- However these methods differ in only one conceptual state.FM O/H costing is excluded

from the cost of products under direct costing but included in the cost of product under

absorption costing.

1) Direct costing:

- This method signifies that FM O/H /Fixed factory overhead is not inventory. FM O/H is

regarded as an expired cost to be immediately charged against sales.

FM costs are not applied to any product but are regarded as expenses as actually incurred.

- The cost of product under this method will therefore consist of direct materials, direct

labour and indirect cost known as VM O/H.The costs of the product are therefore

accounted for by applying all variable manufacturing costs to the goods produced.

- This method is usually used for internal auditing, performance measurement and cost

analysis.

2) Absorption costing

- This method signifies that fixed manufacturing O/H is inventory.FM O/H is treated as

unexpired cost to be hold back to inventory and charged against sales later as part of goods

sold.

- The cost of product under this method therefore consists of raw materials ,direct labor ,VM

O/H and unapplied amount of FM O/H.

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Example :

ABC company had the following operating data in 1994 and 1995

Basic production data at standard cost :

Direct materials shs1.30

Direct labour shs 1.50

Variable manufacturing O/H shs0.20

Standard variable cost/unit shs3.00

FM O/H was shs150000 and expected production for each year was 150000 units sales price

was shs5/unit,selling and administration expenses were all fixed at shs65000 annually except

for sales commission of 5% on sales.

In units : 1994 1995

Opening inventory 30000

Production 170000 140000

Sales 140000 160000

Ending inventory 30000 10000

There were no variances on the standard variable manufacturing cost and FM O/H incurred

was exactly shs150000 per year.

Required :

a) Prepare income statements for the year 1994 and 1995 under direct costing.

b) Prepare income statements for the year 1994 and 1995 under absorption costing.

c) Prepare a reconciliation of the direct and absorption costing net profit figures .

a) Direct costing

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1994 1995(shs)

sales 700000 800000

opening inventory 90000

Add:COGM 510000 420000

COGAS 510000 510000

Less :ending inventory 90000 30000

VMC of goods sold 420000 480000

Add : variable expenses 35000 40000

455000 520000

contribution margin 245000 280000

fixed cost factory O/H 150000 150000

Fixed selling expenses 65000 65000

Total fixed expenses (215000) (215000)

Operating income 30000 65000

b) Absorption costing

1994 1995

Sales 700000 800000

Opening inventory - 120000

Add: COGM 680000 580000

COGAS 680000 680000

Less: ending inventory 120000 40000

Total goods sold ( 560000 ) (640000)

Gross profit at standard 140000 160000

Production volume variance 20000 (10000)

Gross profit at actual 160000 150000

Selling and administration expenses

Variable selling expenses 35000 40000

26

Fixed selling expenses 65000 65000

(100000) (105000)

Net income 60000 45000

c) Reconciliation

Net income reported under the direct costing 30000 65000

Add :fixed manufacturing O/H difference

In ending inventory under absorption 30000 10000

60000 75000

less fixed manufacturing O/H difference

in opening inventory under absorption - 30000

Net profit reported under absorption costing 60000 45000

NOTE:

1) When production and sales are equal the net profit reported under absorption costing and

direct costing will generally be the same. This is because there‟s no chance for the FMC to be

in closing inventory or released in the opening inventory in the current period.

2) When production is greater than sales the net income reported under absorption costing will

generally be greater than the Income reported under direct costing. The reason being that when

production is greater than sales, part of the fixed manufacturing cots absorbed into the products

is differed in the closing inventory to the subsequent period when the related products are sold.

3) When sales is greater than production , the net profit reported under absorption costing will

generally be less than the net profit reported under direct costing.

The reason being that when more are sold than produced inventories are drawn down and fixed

manufacturing cost earlier differed is released from opening inventory and charged against

income for the period.

27

Activity-Based Costing Systems

Primary underlying concept of ABC is that activities cause costs to be incurred.

Therefore, the primary focus of Activity Based Management is to manage (control) costs by

managing activities.

Please note that in its simplest form, ABC is an acceptable method for assigning/allocating

manufacturing costs to products for purposes of valuing inventory under absorption costing.

28

ABM often applies ABC techniques beyond manufacturing costs. In such cases the resulting

information can and is used for decision-making purposes, but it CAN NOT be used for

inventory valuation in accordance with GAAP.

ABC versus Traditional Costing

Activity causes costs to be incurred.

Traditional costing uses broad cost drivers that do not reflect cause and effect.

1 hour of activity A has different costs than 1 hour of activity B

Accordingly, under traditional costing, cost targets (products, jobs, customers) involving complex

(costly) activity tend to be under-costed while products involving simple (less costly) activities

tend to be over-costed.

ABC, therefore, assigns costs to cost targets based on the specific activity that is used for a

particular cost target.

Steps in designing an ABC System

Step 1: Identify and classify the activities related to the company’s products

Alternative methods for identifying activities

Top-Down – Senior Management identifies what is done

Participative Approach – the “doers” identify what is done

Recycling Approach – using what is already documented

Time/Motion studies – outside consultants observe what is done

Classification of Activities

Value Added versus Non-Value Added Activities (JIT Processing)

Unit Level

Batch Level Note that as we move away from

Product-level unit level we begin to take in

Customer Level non-manufacturing costs

Facility Level

29

Step 2: Determine the Estimated Cost of each Activity identified in step 1.

This step assigns/allocates total costs incurred during a particular observation period to the

activities incurred during that observation period.

Step 3: Calculate a Cost-Driver Rate for the Activity

Total cost of activity (from step 2)

Divided by the number of Cost Driver occurrences

Equals the cost per occurrence or Cost-Drive Rate

Step 4: Assign Activity Costs to Cost Targets (jobs, products, customers)

Actual number of activity occurrences

Times the Cost Driver Rate (from step 3)

Equals Assigned (Traceable) Costs

Note that in this step the “costing systems” requires input (actual activities & target) and has an

output, assigned or traceable cost of cost target.

The levels are explained below:

1. Unit level. Unit level drivers are triggered for every unit that is being produced. For

example, for a man and a machine that produces one unit at a time, the associated

direct labor will be a unit level cost driver. This is therefore a volume related driver

similar to the traditional allocation bases.

2. Batch level. Batch level drivers are triggered for every batch produced. A good

example of that is production planning, because the planning is done for each and

every batch regardless of the size of the batch. Here, number of batches can be a good

driver.

3. Product level. Product level drivers are triggered for every product regardless of the

number of units and batches produced. These drivers occur by the sole existence of a

product. A good example of a driver is the number of product development hours per

30

product so that the more product development hours a product triggers, the more

product development costs should be assigned to that product.

4. Facility level. Facility level driver are drivers that are not related to the products at

all. Costs that are traced by such drivers will therefore be allocated to products and

not traced. The difference between allocation and tracing is that allocation is quite

arbitrary whereas tracing is based on 'cause and effect' relations.

ABC Output – ABM Decision Making Tools

Product and Customer Profitability

Revenues

Less Traceable Costs

Excess Revenues over Traceable Costs

Less Untraceable Costs (Total Costs less Traceable Costs)

Operating Income

Departmental Efficiency

Actual Costs Incurred versus Traceable Costs Assigned

If Traceable > Actual, department was efficient

If Traceable < Actual, department was inefficient

Activity Based Costing – Pro’s & Con’s

Pro’s

Identifies Non-Value Added Activities

Identifies cost savings opportunities (untraceable costs)

Provides very detailed cost/profitability information

Differentiates complex versus simple processes

More data can lead to more information = better decisions

Con’s

Very costly to implement and maintain

Historical in nature (same as traditional absorption costing)

31

Detail versus Accuracy (GIGO)

Discourages novel approach‟s to processes

Encourages activity

Assumes equal and proportionate benefits result from common activity

Activity Based Costing - Example

The following information provides details of the costs, volume and transaction cost drivers for a

period in respect of XYZ Ltd:

Products

A B C Total

Sales and production (units) 90,000 30,000 15,000 135,000

Raw materials usage (units) 10 7 14 1,320,000

Direct materials cost (£) 30 40 15 4,125,000

Direct labour hours 2.5 3 1.5 337,500

Machine hours 5 3 7.5 652,500

Direct labour cost (£) 20 30 10 2,850,000

Number of production runs 5 10 50 65

Number of deliveries 18 7 50 75

Number of receipts 50 70 700 820

Number of production orders 45 25 60 130

Overhead costs £

Set up 75,000

Machines 1,000,000

Receiving 900,000

Packing 650,000

Engineering 750,000

32

Total 3,375,000

You are required to;

(a) calculate the total costs for each product if all overhead costs are absorbed on a labour hour

basis;

(b) calculate the total costs for each product, using activity based costing;

(c) calculate and list the unit product costs from your figures in (a) and (b) above to show the

differences between them and to comment briefly on any conclusions which may be drawn which

could have pricing and profit implications.

Solution to the worked example

We will be working through these data three times. Firstly to see how traditional cost accounting

methods might deal with them; secondly to look at the multiple volume based overhead method;

and, finally, to look at the ABC method itself. Of the three approaches we will be looking at, only

ABC will be using all of the data in any great detail. This is consistent with the general nature of

the traditional method, and the only slightly more advanced multiple volume method.

Traditional direct labour hours basis

The direct labour hour rate is £10, calculated by dividing the total overheads by the total number of

direct labour hours:

total overheads

total number of direct labour

hours

3,375,000

337,500

£10 per dlh

33

Since we are using the direct labour hour rate method for the absorption of all overheads, the

product costs per unit must be:

A B C

Direct Materials 30 40 15

Direct Labour 20 30 10

Overheads 30 15 15

Total Product Cost 25 30 40

The overheads recovered are, of course:

Direct labour hour rate x number of direct labour hours per product

For product A, for example, the calculation is:

£10 per dlh x 2.5 dlh = £25

Multiple volume based allocation method

The multiple volume allocation method is an advance on the traditional allocation method in that it

does make some allowance for activities to influence the absorption of overheads. In this example,

we have two absorption rates to apply here: the receiving department overhead rate, and the

"other" overhead rate

The reasoning here is that the organisation we are simulating is using a two rate basis of

apportioning overheads: firstly, a material handling overhead rate is used to assign overhead to a

separate cost centre and then charge it to production on the basis of the number of receipts;

secondly all of the other overheads are assigned using a general machine hour rate on the basis that

the number of machine hours far exceeds the number of labour hours.

Notice here, the rate we are using to assign the materials handling overheads is based on the

number of receipts of materials into a department. The reason we are using this rate is that the

activity of receiving dominates the reason for the existence of the overhead. Drury uses an

overhead rate expressed as a percentage of direct materials cost. This is not a rate to be

recommended particularly since tying the assignment of an overhead to the cost of a material is not

34

realistic. As we know, merely because a material is expensive does not mean that its attendant

overheads will vary in proportion to it.

The receiving overhead rate is

Total receiving overheads

Total number of receipts

£900,000

820

£1,097.56 per receipt

Using this rate as a constant allows us to evaluate the product overhead apportionments:

overheads per receipt x receipts per product group

For product A:

£1,097.56 per receipt x 50 receipts

£54,878

Product

A B C

Receiving overheads

apportionment £54,787.0 £76,829.3 £768,292.7

We then divide these product apportionments by the number of units made for each product, to

derive the cost per unit for receiving goods. The calculations here give the following results:

Product

A B C

Receiving cost per unit £0.60976 £2.5610 £51.2195

35

Notice, when compared with Drury's method of using the overhead rate as a percentage of direct

materials cost, the version presented here gives a radically different result. Had we applied Drury's

method, the product receiving cost per unit would have been:

Overhead absorption rate:

£900,000 x 100 = 21.82%

= £4,125,000

Applying this rate to each product's material costs gives:

Product

A B C

£6.55 8.73 3.27

The method we have used applies the full spirit of ABC by identifying and using fully the ABC

approach. The other overhead rate, the Machine Hour Rate, is £3.79. This is calculated by dividing

the total other overheads by the number of machine hours applied, or worked. In this case:

£3,375,000 – 900,000 = £3.79103

652,000 machine hours

When multiplied by the number of machine hours per product, this then gives us the cost per unit

for other overheads. For example, in the case of product A, the calculation is:

£3.79103 x 5 machine hours per unit = £18.9655

Once all the calculations have been completed, the product cost analysis per unit of each product

is:

Product

A B C

36

Direct materials 30.0000 40.0000 15.0000

Direct labour 20.0000 30.0000 10.0000

Materials overheads 0.6098 2.5610 51.2195

Other overheads 18.9655 11.3793 28.4483

Total Product cost £69.5753 83.9403 104.6678

ABC method

As we said above, to apply the ABC method, we need to identify cost drivers for two stages:

1 cost drivers tracing the costs of inputs into cost pools; and

2 cost drivers tracing the cost pools into product costs

The workings that follow illustrate clearly how such cost drivers work through the ABC system in

these two stages: an initial overhead rate or amount being further subdivided according the needs

of the situation.

workings:

The calculations for each of the rates to be used are:

The machine hour rate is the only rate that is what we might call a traditional rate. All of the other

rates we are about to use involve a two stage process. We will see the elements of these two stages

as we get to them.

machine hour overhead rate

£1,000,000 = £1.5326

652,500 machine

hours

This rate is used as normal.

For the set up costs, we first devise a rate to tell us the cost per set up: total set up overheads

divided by the number of set ups: in this case, this is

£75,000 = £1,153.85

65 production

37

runs

We will return to this rate shortly.

All of the other rates are calculated similarly. Hence they will be presented now without further

comment.

Receiving rate £900,000 = £1,097.56

820 receipts

Packing rate £650,000 = £8,666.67

75 deliveries

Engineering rate £750,000 = £5,769.23

130

production

orders

All of this information can now be put together into a cost per unit statement as follows.

The final stage in the whole ABC procedure, as far as product cost determination is concerned is to

find out the costs per unit. The cost per unit statement follows, and then we will work through the

calculations.

Unit costs A B C

£ £ £

Direct materials 30.0000 40.0000 15.000

Direct labour 20.000 30.000 10.000

Machine overheads 7.6628 4.5977 11.4943

Set up costs 0.0641 0.3846 3.8462

Receiving costs 0.6098 2.5610 51.2195

Packing costs 1.7333 2.0222 28.8889

Engineering costs 2.8846 4.8077 23.0769

38

Total Costs £62.9546 £84.3732 £143.5257

workings:

Machine overheads are found by multiplying the machine hour rate by the number of machine

hours per product per unit:

machine hour rate £1.5326 x

machine hours 5 3 7.5

gives £7.6628 4.5977 11.4943

The set up costs rate we have already is the rate per machine set up, the cost per unit is calculated

by multiplying the rate per set up by the number of set up per product and then dividing the results

by the total number of units per product:

Set up cost per set up £1153.85 x

No of set ups 5 10 50

gives £0.0010 0.0059 0.0592

Set up cost per set up £1,153.85 x

No of set ups 5 10 50

gives £5,769.25 11,538.50 57,692.50

These values are then divided by the number of units per product to give us the cost per unit:

£0.0641 0.3846 3.8462

The receiving, packing and engineering costs are all calculated in the same way as the set up costs.

There is no need to repeat these calculations, but check that they are understood.

Summarising each of these methods now we can see the impact of the different methods on

product costs, Assuming that the ABC method is really more effective than the traditional

approach, product A shows a cost difference of £42.1085 per unit.

39

Summary 1: Total costs per unit using each of the three methods

Product

A B C

DLH 75.0000 100.0000 40.0000

Mult 69.5753 83.9403 104.6678

ABC 62.9546 84.3732 143.5257

Summary 2: Overheads per unit using each of the three methods

Product

A B C

DLH 25.0000 30.0000 15.0000

Mult 19.5753 13.9403 79.6678

ABC 12.9546 14.3732 118.5257

Summary 3: Overheads as a percentage of total costs

Product

A B C

DLH 33.33% 30.00% 37.50%

Mult 28.14% 16.61% 76.11%

ABC 20.58% 17.04% 82.58%

Example Two

Having attended a recent course on activity-based costing (ABC) you decide to experiment by

applying the principles of ABC to the four products currently made and sold by your company.

Details of the four products and relevant information are given below for one period.

Product A B C D

40

Output in units 120 100 80 120

Cost per unit shs shs shs shs

Direct material 40 50 30 60

Direct labour 28 21 14 21

Machine hour (per unit) 4 3 2 3

The four products are similar and are usually produced in production runs of 20 units per run.

The production overhead is currently absorbed by using a machine hour rate, and the total of the

production overhead for the period has been analyzed as follows:

Shs

Machine dept cost (rent, business rates, depreciation and supervision) 10,430

Set-ups costs 5250

Stores receiving 3600

Inspection/Quality control 2100

Materials handling and dispatch 4620

You have ascertained that the cost drivers to be used are as listed below for the overhead costs

shown:

Cost cost driver

Set up costs Number of production runs

Stores receiving Requisitions raised

Inspection/Quality control Number of production runs

Materials handling and dispatch Orders executed

The number of requisitions raised on the stores was 20 for each product and the number of orders

executed was 42 each order being for a batch of 10 of a product. You are required:

(a) To calculate the total costs for each product using conventional costing if all overhead costs

are absorbed on a machine hour basis;

(b) To calculate the total costs for each product, using activity-based costing;

(20 marks)

41

42

BUDGETING

Definition :

- There are various definitions of a budget.

1) A quantity expression of a plan of action for a specified period of time.

2) A financial and/ or a quantity statement prepared prior to a defined time to serve as abasis

for the implementation of a policy to be followed during that period for the purpose of

obtaining a given objective.

43

- The main purpose of a budget is to implement the policies implemented by management

for attaining the company‟s objectives.

- A budget can be independent on a particular unit of the organization or for the entire

organization.

Master budgets

It is prepared for the entire organization.

- It is a summary of all phases of the company‟s plans and goods for the future

- It sets specific targets for all sub-units of the organization such as production,

distribution, finance e.t.c

Functions of budgets

1) Planning

budgeting requires managers to give planning top priority among their duties

-Planning involves the development of future objectives and the preparation of various

budgets to achieve this objectives.

- The budget brings out the firm‟s requirements and expectations in terms of inputs and the

outputs and in this way many unforeseen contingencies may be anticipated in advance.

2) Communication.

- Budgets are devices for communication..The plans summarized in the budget are read and

interpreted throughout the firm ,thus budgets are important channels of communicating

certain types of information that will enable the managersin different parts of the organization

to co-ordinate their activities more efficiently

3) Motivation

- Budgets often serve as a means of motivating managers to strive towards the achievement of

organisation‟s objectives

-They do this by acting to internal standards that vill be accepted by the manager and his own

target thus providing a motivating force.

- Etrinsic rewards or penalties may also be attached to budget achievement to increase its

motivational effects.

44

4) Controlling

-Budgets can serve as standards against which management performance is evaluated.The

budget offers the only available quantity reference against which performance can be assessed

- A danger to this situation is that performance which is relatively reported can become the

dominant measure of the overall performance yet the budget itself represents an imperfect

standard.

- A strong stress on budget attainment is likely to give budgets that are net but after the

expense of worse long run performance with various harmful side-effects.

- Nevertheless ,properly planned budgets can be a vital tool in monitoring and controlling

managerial and business performance.

5) Co-ordinating

- A budget is important for effective co-ordination.The various departmental managers will

expect to co-ordinate one another so as to be able to determine man-power needs ,facilities

and and other resources in the organization..This can be done using the relevant budgets.

Limitations of budgets

1) Budget plan is based on estimates and therefore absolute accuracy is not possible in

budgeting.

- The strength and weakness of a budgeting system depend to a large extent on accuracy with

which the estimates are made.

2) Danger of rigidity –the budget programme must be dynamic and continuously deal with

changing conditions.

- Budgets will loose much of their usefulness if they acquire rigidity and aere not revised with

increasing circumstances

3) Budgeting is only a tool of management but cannot take the place of management .

Execution of the budgets will not occur automatically.It is therefore necessary that the entire

organization participate in the budget program if the budgeting goals have to be achieved.

TYPES OF BUDGETS

45

1) Sales budget

-Starting point when preparing a master budget.

- Constructed by X expected sales units by selling price.

2)Production budget

- Follows the sales budget.

- Determine the no. of units to be produced

Units to be produced will be made as follows:

Budgeted sales units XX

Add : desired inventory finished goods. XX

XX

Less: finished goods inventory. XX

Units to be produced XX

- Production required is for the coming budget period is determined and organized in form

of production budgets.

- Sufficient goods will have to be available so that to meet sales needs and to provide for

the desired ending inventory.

- A portion of these goods will already exist in form of beginning inventory and the

remainder will have to be produced.

3)Direct materials purchase budget

- Shows materials required in production process.

- Sufficient raw materials will have to be available to meet production needs and provide for

the desired raw materials ending inventory. For budget period, part of this raw materials

required will already & form of beginning raw materials inventory.Remainder will have to

be purchased from the suppliers.

46

4) Direct labour cost budget

-This shows direct labour required for the company by knowing in advance what will be

needed in terms of labour time throughout the budget period.The company may adjust labour

force as the the situation may require.To compute direct labour required , no. of units of

finished products to be produced each period is X no. of direct labour required to produce a

single unit.

5) Cash budget

- Plans for an adequate but not an excessive cash balance.

- The goal of the cash budget is to ensure that the business has sufficient liquidity to pay its

bills as they fall due.

- It has 3 sections:

i) Cash receipt section –has opening balance and all expected cash receipts

ii) Cash payment (disbursement) section- cash payment plans and disbursements are shown.

iii) Ending balance section – Has difference between receipt total and payment total.It can

show a deficit or a surplus.

Example

A company has the following data from which a master budget has to be prepared for the

coming year.

Current year Coming year Year after

4th

quarter 1st 2

nd 3

rd 4

th 1

st quarter

Expected

sales units 1800 1000 2000 1500 2000 1000

Expected sales per unit- shs200

Inputs Requirements Cost /unit

47

Direct materials 2kg shs5/kg

Direct labour 3hours shs10/hour

- Beginning inventory of finished goods of each quarter must be equal to 10% of the sales

for the previous quarter.

- Raw material inventory at the end of any quarter must be equal to requirements to produce

units for sale in the next quarter.

- Variable manufacturing O/H are based on direct labour cost at the rate of 20%.

- In addition fixed manufacturing O/H of shs20000 will be included each quarter including

depreciation of shs2000 per quarter.

Required :

1) Prepare sales budget

2) Prepare production budget

3) Prepare raw material purchase budget

4) Prepare direct labour budget

5) Manufucturing overheads for the year on a quarterly basis

Sales Budget

1st 2

nd 3

rd 4

th Total

Sales units 1000 2000 1500 2000

Selling price per unit 200 200 200 200

Expected sales revenue 20000 40000 30000 40000

Production budget

1st 2

nd 3

rd 4

th

Sales units 1000 2000 1500 2000

Add: desired inventory

finished goods 100 200 150 200

1100 2200 1650 2200

48

Less: beginning inventory 180 100 200 150

Units to be produced 920 2100 1450 2050

Raw materials purchase budget

1st 2

nd 3

rd 4

th

Units to be produced 920 2100 1450 2050

Req. per unit (kg) 2 2 2 2

1840 4200 2900 4100

Add :ending inventory req.(kg) 4000 3000 4000 2000

5840 7200 6900 6100

less required beginning inventory 2000 4000 3000 4000

Units to be purchased 3840 3200 3900 2100

Price per unit (kg) 5 5 5 5

Budgeted raw materials cost 19200 16000 19500 10500

Direct labour cost

1st 2

nd 3

rd 4

th

Units to be produced 920 2100 1450 2050

Required per unit (hrs) 3 3 3 3

2760 6300 4350 6150

Cost / unit 10 10 10 10

Required labour cost 27600 63000 43500 61500

Manufucturing O/H budget

1st 2

nd 3

rd 4

th

Budgeted labour

cost

27600 63000 43500 61500

Variable overhead 0.8 0.8 0.8 0.8

49

application rate

22080 50400 34800 49200

Budgeted fixed

O/H

20000 20000 20000 20000

42800 90400 54800 69200

Compute manufacturing cost per unit ( Assume variable cost approach)

Input item Quantity Cost per unit Total

Direct materials 2kgs 5 10

Direct labour 3hrs 10 30

Variable manufacturing

O/H

3hrs 8 24

Manufucturing cost per

unit:

shs64

In addition to manufacturing ,selling and administration costs of shs32000 are incurred per

month. Sales are made of cash and credit items as follows:

-In any quarter 30% are cash while 70% are credit.

Credit sales are collectible in quarter following the quarter of sales and 2% sales are

considered uncollectible.

Raw materials are paid for in purchase month.

Wages overheads and administration expenses are paid in the month they are incurred.

-Equipment worth shs380000 was bought in the 4th

quarter of coming year.The company

requires a minimum cash balance of shs25000 and cash balance at the beginning of 1st quarter

is expected to shs27000

Required :

a) Prepare a projected income statement .

50

b) Cash budget for the company for the year on quarterly basis

Projected income statement for the year ended…

1st 2

nd 3

rd 4

th

Sales 200000 400000 300000 400000

Less: variable cost 64000 128000 96000 128000

Contribution

margin

136000 272000 204000 272000

Less:fixed

manufucturing cost

20000 20000 20000 20000

selling and

administration

cost

96000 96000 96000 96000

20000 156000 88000 156000

Cash budget

1st 2

nd 3

rd

4th

Cash sales 60000 120000 90000 120000

Collection

from credit

sales

246960 137200 274400 205800

Cash form

sales

306960 257200 364400 325800

Cash budget for the 4 quarters

51

Opening balance 1st 2

nd 3

rd 4

th

Opening balance 27000 151080 164880 317480

Cash from sales 306860 257200 364400 325800

Total cash 333960 408280 529280 643280

Disbursements

Raw materials 19200 16000 19500 10500

Wages from direct

labour

27600 63000 43500 61500

O/H less

depreciation

40080 68400 52800 67200

Selling and

administration

expenses

96000 96000 96000 96000

Equipment - - - 380000

(182880) (243400) (211800) (615200)

Cash balance 151080 164880 317480 28080

Minimum balance 25000 25000 25000 25000

Surplus /deficit 126080 139080 292480 3080

52

VARIANCE ANALYSIS

It is typically performed for the production cost of manufactured goods.However ,conventional

procedures for decomposing a cost variance into its quantity and price components can be

extended to explain deviation of the actual from the planned profitability.

Standard cost

- A standard is a benchmark of norm for measuring performance.In MA the standards used

relates to quantity and cost used in manufacturing goods or providing services.

- Managers set standards for the 3 elements of cost input in materials ,labour and overheads.

53

Quality standards

They indicate how much of a cost element e.g labour ,time or raw materials should be used in

manufacturing a unit of a product or in providing a unit of a service.

Costs standards

They indicate what cost of input such as labour time or raw materials should be.

- By comparing actual quantities and costs of inputs with this standards ,we can tell whether

operations are proceeding within the limits set by the management.

(1) (2) (3)

Actual Qty of inputs

at actual price(AQ X

AP)

Actual Qty of input

at std price (AQ X

SP)

Std qty allowed for

output at std price

(SQ X SP)

Price Variance (1-2) Qty variance (2-3)

Material PV material QV

Labour rate PV Labour efficiency

PV

Variable O/H

spending variance

Variable O/H

efficiency variance

Total variance

- The above model provides a base for various variance analysis.It deals with variable costs.

- Isolates PV from QV and shows how each of these variance is computed.

Reasons for separating standards into prices and quantities

1) Control decisions relating to relating to price paid and quantity used will generally fall at

different points in time e.g. for raw material control for price comes at the time of purchase

while control of quantity used doesn‟t until raw materials are used in production.

2) Control over prices paid and quantity used will generally be the responsibility of two

different managers and need to be assessed independently.

54

i) Price and quantity variance

A variance is the difference between standard price and quantity‟s and actual price and quantity.

PV and QV can be computed for the entire 3 variable cost elements i.e. materials, labour and

manufacturing overheads.

Standard quantity /hours allowed

This is the amount of direct materials, direct labour and variable manufacturing overheads that

should have been used to produce what was produced during the period.

Material Price variance

Measures the difference between what is a given quantity and what should have been paid

according to the set standards.

MPV = (AQ X AP) – (AQ X SP)

= AQ(AP – SP) = AQP(A – S)

Ordinarily the responsibility of PV is with purchasing agent. However this may not hold in all

circumstances e.g. when plan schedules have been changed to affect methods of delivery.

Common causes of Material Price Variance

1) Size of lots purchased.

2) Delivery method used.

3) Quantity discount available.

4) Rush orders

5) Quantity of materials purchased.

Material Quantity Variance

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Measures the difference between the quantity of materials used in production and the quantity that

should have been used according to standards that should have been set.

MQV = (AQ X SP) - (SQ XSP)

= SP(AQ –SQ) = SP(SQ –AQ) *

It is the best isolated at the time materials are placed into production. Ordinarily the responsibility

of the an MQV is with the production managers.

Common causes

1) Faulty machines.

2) Inferior quantity of materials.

3) Untrained workers.

4) Poor supervisors etc

Labour Rate Variance.

Measures any deviation from std in average hourly rate paid to direct labour workers.

LRV = ( AH XAR) – (AH XSR)

= AH (AR-SR)

Rates variances in terms of amount paid to workers tend to be non-existent since in most

organization set by the workers are set by the union contracts.

Responsibility will lie with the supervisors in charge of effective labour time.

Labour Efficiency Variance

Measures the productivity of labour time:

LEV = (AH XSR) – (SH X SR)

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= SR (AH-SH) = SR (SH-AH)

Common causes

1) Poorly trained workers.

2) Poor quality materials requiring more time in processing.

3) Faulty equipment and break-down causing work interruptions

4) Poor supervision.

Vairable O/H Spending Variance

Measures deviations in the amount spent for O/H inputs e.g duplicants and utilities.

= (AH X SR) – (AHXSR)

= AH (AR –SR) or AH( SR-AR)

Variable Overhead efficiency Variance

Measures of difference between actual quantity of a period and standard activity allowed x by

variable part of pre-determined O/H rate.

= (AH XSR) - (SH XSR)

=SR(AH-SH) or SR( SH-AH)

Example:

Genious company produces and sells a single product . Standard costs for a one unit of a product

are as follows:

Direct materials 121L @ SHS1/L shs12

Direct labour 3.6hours @ sh20/hour 72

Variable overhead 3.6hours @ shs10/hour 36

120

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During June 2003 ,2000 units were produced and costs associated with the month are as follows:

Materials purchased 36000 L @shs1.20/Litre shs43200

Materials used in

production

28000L - -

Direct labour 8000 hours @19.50/hour 156000

Variable overhead

costs incurred

41600

Required: a) MPV and MQV

b) LRV and LEV

c) Variable overhead spending and efficiency variance.

MPV= AQ(SP-AP)

= 36000(1-1.20)

= 7200 U or A

MQV = SP( SQ –AQ)

= 1(24000 -28000)

=400 U or A * Check!

LRV = AH(SR-AR)

= 8000(20 -19.50)

= 4000 F

LEV = AH( SH –AH)

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= 20(7200 – 8000)

=16000 U or A

V O/H (E) = SR( SH-AH)

=10 (3.60 X2000 -8000)

= 8000 U or A

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Information for decision making

The need for a decision arises in business because a manager is faced with a problem and

alternative courses of action are available. In deciding which option to choose he will need all the

information which is relevant to his decision; and he must have some criterion on the basis of

which he can choose the best alternative. Some of the factors affecting the decision may not be

expressed in monetary value. Hence, the manager will have to make 'qualitative' judgements, e.g.

in deciding which of two personnel should be promoted to a managerial position. A 'quantitative'

decision, on the other hand, is possible when the various factors, and relationships between them,

are measurable. This chapter will concentrate on quantitative decisions based on data expressed in

monetary value and relating to costs and revenues as measured by the management accountant.

Elements of a decision

A quantitative decision problem involves six parts:

a) An objective that can be quantified Sometimes referred to as 'choice criterion' or 'objective

function', e.g. maximisation of profit or minimisation of total costs.

b) Constraints Many decision problems have one or more constraints, e.g. limited raw materials,

labour, etc. It is therefore common to find an objective that will maximise profits subject to

defined constraints.

c) A range of alternative courses of action under consideration. For example, in order to

minimise costs of a manufacturing operation, the available alternatives may be:

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i) to continue manufacturing as at present

ii) to change the manufacturing method

iii) to sub-contract the work to a third party.

d) Forecasting of the incremental costs and benefits of each alternative course of action.

e) Application of the decision criteria or objective function, e.g. the calculation of expected profit

or contribution, and the ranking of alternatives.

f) Choice of preferred alternatives.

Relevant costs for decision making

The costs which should be used for decision making are often referred to as "relevant costs".

CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management

decisions'.

To affect a decision a cost must be:

a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are

common to all alternatives that we may choose.

b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a

decision. Any costs which would be incurred whether or not the decision is made are not said to be

incremental to the decision.

c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant.

Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant.

Other terms:

d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates

on a factory would be incurred whatever products are produced.

e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed

assets, development costs already incurred.

f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is taken

now, e.g. contracts already entered into which cannot be altered.

TYPES OF DECISIONS

1) Make / Buy decisions

A decision to produce a component part internally rather than to buy the component externally is

make/buy decision.

Example 1:

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Assume that XYZ Company is now producing a small component pat that is used in the company

main product lines. The company accounting department reports the costs of producing the

component part internally is:

RELEVANT COSTS Per unit 8000 units

Direct material shs6 48000

Direct labour shs4 32000

Variable overheads 1 8000

Supervisor‟s salary 3 24000

SUNK COSTS

Depreciation of special

equipment

2 16000

Allocated general

overheads

5 40000

21 168000

It has received an offer from outside supplier that it will provide 8000 units of small component

parts per year @shs17.

Required:

should XYZ Company purchase the component from outside or produce it internally?

Example 2

Assume that space how being used to produce small component part will be used to produce a

new product like that will segment a product margin of shs50000 p.a.

Required :

Should they accept the offer of supplier or not?

2) Sell /Process further decision

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Deals with joint products .

Joint products : These are 2 or more products produced from the same input.

Joint costs: Are manufacturing costs incurred in producing joint products up to the split off point.

Split off point: Point in manufacturing process at which joint products can be recognized as

individual units /output.Are irrelevant in decision making.

- As a general rule it will always be important to continue processing joint products at split

off points so long as the incremental revenue is of from such process is of processing

costs.

Costs and revenue data relating to 3 products are as follows:

A (shs) B (shs) C ( shs)

Sales value at splitting

off point

120000 150000 60000

Sales value at further

processing

160000 240000 90000

Costs of further

processing

50000 60000 10000

Allocated joint product

costs

80000 100000 40000

Which products should be processed further?

3) Limiting factor decisions /utilization of scarce resources

- Firms are always faced with the problem of deciding how scarce resources can be utilized.

- Firms should select the course of action that will maximize the total contribution margin.

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- Total contribution margin will be maximized by promoting those products or accepting

orders that promise highest CM in relation to the scarce resources of the firm.

Example :

Assume that a firm has 2 products A and B .Cost and revenue characteristics of the 2 lines of

products are as follows:

It takes 2

machine

hours to

produce 1

unit of A and 1 hour to produce 1 unit of B.The firm has only 18000 machine hours available in

the factory per period .

Required :

If demand is high which order should the firm accept?

A B

Sales price per unit shs25 shs30

Variable cost per unit shs10 shs18

Contribution margin per unit 15 12

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65

MANAGERIAL ACCOUNTING PRACTICE QUESTIONS

QUESTION ONE

a) Describe the assumptions underlying cost-volume-profit analysis. (8 marks)

b) The summarized profit and loss statement for Exciter Company Ltd for the last year is as

follows;

Sh‟000 shs‟000

Sale(50,000 units) 1000

Direct materials 350

Direct wages 200

Fixed production overhead 200

Variable production overhead 50

Administration overhead 180

Selling and distribution overhead 120 1100

Profit/(loss) (100)

At a recent board meeting the directors discussed the year‟s results following which the chairman

asked for suggestions to improve the situation.

You are required as a management accountant to evaluate the following alternative proposals and

comment briefly on each:

(i) pay salesmen a commission of 10% of sales and thus increase sales to achieve break- even

point. (5 marks)

(ii) reduce selling price by 10%, which it is estimated would increase sales volume by 30%

(3 marks)

(iii) increase direct wage rate form sh 4 to shs 5 per hour, as part of a productivity/pay deal.it

is hoped that this would increase production and sales by 20%, but advertising costs

would increase by shs 50,000. (4 marks)

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QUESTION TWO

a) Under what circumstances can the engineering method be used to estimate cost.(4 mark)

b) Explain why the linear regression analysis is a better method of cost estimation than the

high-low or range method. (5 marks)

c) A hospital‟s records show that the cost of carrying out health checks in the last five

accounting periods have been as follows:

Period Number of patients seen Total cost

Shs

1 650 17,125

2 940 17,800

3 1260 18,650

4 990 17,980

5 1150 18,360

Required;

i) Using the high-low method and ignoring inflation, find the estimated cost of carrying out health

checks on 850 patients in period six. (7 marks)

ii) Using linear regression analysis, find the estimated cost of carrying out health checks on 960

patients in period seven. (9 marks)

QUESTION THREE

a) Explain why activity based costing is more preferred by businesses today as compared to

conventional costing. (5 marks)

b) Having attended a recent course on activity-based costing (ABC) you decide to experiment by

applying the principles of ABC to the four products currently made and sold by your company.

Details of the four products and relevant information are given below for one period.

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Product A B C D

Output in units 120 100 80 120

Cost per unit shs shs shs shs

Direct material 40 50 30 60

Direct labour 28 21 14 21

Machine hour (per unit) 4 3 2 3

The four products are similar and are usually produced in production runs of 20 units per run.

The production overhead is currently absorbed by using a machine hour rate, and the total of the

production overhead for the period has been analyzed as follows:

Shs

Machine dept cost (rent, business rates, depreciation and supervision) 10,430

Set-ups costs 5250

Stores receiving 3600

Inspection/Quality control 2100

Materials handling and dispatch 4620

You have ascertained that the cost drivers to be used are as listed below for the overhead costs

shown:

Cost cost driver

Set up costs Number of production runs

Stores receiving Requisitions raised

Inspection/Quality control Number of production runs

Materials handling and dispatch Orders executed

The number of requisitions raised on the stores was 20 for each product and the number of orders

executed was 42. You are required:

(c) To calculate the total costs for each product using conventional costing if all overhead costs

are absorbed on a machine hour basis;

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(d) To calculate the total costs for each product, using activity-based costing;

(20 marks)

QUESTION FOUR

(a) Discuss the need for managers to understand management accounting possibilities in their

organizations. (8 marks)

(b) Explain five assumptions of cost-volume profit analysis. (5 marks)

(c) M Ltd manufactures three products which have the following revenue and costs

Product 1 2 3

Selling price 292 135 283

Variable costs 161 72 96

Fixed cost:

Product specific 49 35 62

General 46 46 46

Unit fixed costs are based upon the following annual sales and production volumes

Product 1 2 3

Volume 98,200 42,100 111,800

Required

(i) Calculate:

(a) The break even point sales for each product

(b) The break-even sales for the company based on the current product mix.

(c) The number of units of product 2 at the break-even point of (b) above.

(ii) Comment upon the viability of product 2 (12 marks)

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QUESTION FIVE

a) Explain three similarities and differences between job order and process costing systems.

(6marks)

b) A Nairobi company uses job order costing system to allocate costs to products. The company

uses pre-determined overhead rates in applying manufacturing costs to individual jobs. The pre-

determined overhead rate in department X is based on direct material cost and the rate in

department Y is based on machine hours. The company had the following estimates at the

beginning of the year 2005.

Dept X Dept Y

Machine hours 42,000 160,000

Direct labour hours 130,000 70,000

Direct material cost shs 800,000 shs 380,000

Direct labour cost shs 1,060,000 shs 560,000

Manufacturing overhead shs 1,440,000 shs832, 000

A particular job number 13Z was started on 1st January 2005 and completed on 3

rd July 2005.

The following particulars relates to the job

Dept X Dept Y

Machine hours 140 170

Direct labour hours 260 160

Direct material cost shs 2400 shs 1880

Direct labour cost shs 1960 shs 1420

Required:

(i) Compute the pre-determined overhead rates that should be used during the year in both

departments.

(ii) Compute the total overhead cost applied to job number 13Z

(iii) Compute the total cost of job number 13 Z.

(iv) Find any under or over application of overheads. (19 marks).

QUESTION SIX

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a) Explain the main functions of budget to management of a firm. (5marks)

b) View park limited wishes to calculating an operating budget for the forthcoming period

.Information regarding products costs and sales level are given below.

Product A B

Material required

X (kg) 2 3

Y (litres) 1 4

Labour hours required

Skilled (hours) 4 2

Semi-skilled (hours) 2 5

Sales level (units) 2000 1500

Opening stock (units) 100 200

Closing stock of materials and finished goods will be sufficient to meet to 10% of demand.

Opening stocks of materials X was 300kg and for materials Y was 1000 litres. Material prices are

sh 10 per kg of material X and sh 7per litre of material Y.Labour costs are sh 12 per hour for the

skilled workers and sh 8 per hour for the semi-skilled workers.

Required:

i. Prepare the following budget

ii. Production(units)

iii. Material usage in kg and litres

iv. Material purchases in kg ,litres and shillings

v. Labour budget in hours and shillings

(20 marks)

DLM ASSIGNMENT

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QUESTION ONE

a) Identify and describe briefly five methods of cost estimation. ( 10 marks)

b) Explain three reasons why management need cost data (6 marks)

c) Mzee Rono has maintained monthly recordings for output and maintenance costs in his

floor tiles making factory as shown below;

Month volume of production maintenance costs

Units shs

January 6,000 25,000

February 7,000 27,000

March 5,000 24,000

April 3,000 25,000

May 4,000 22,000

June 5,000 26,000

July 6,000 28,000

August 8,000 32,000

September 10,000 33,000

October 9,000 34,000

November 7,000 30,000

December 8,500 25,000

Required;

i) Using the linear regression analysis, find the total cost equation for the above data

ii) Use the equation to estimate the maintenance cost of producing 5,850 units.

(14 marks)

QUESTION TWO

a) Explain the following terms as used in cost-volume profit analysis

i) Break-even point

ii) Relevant range

iii) Contribution margin.

iv) Marginal cost (6 marks)

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b) Wananchi limited manufactures leather purses and has the following information for the next

financial period.

Selling price per unit shs 11.60

Variable production cost per unit shs 3.4.

Selling commission 5% of selling price

Fixed production costs shs. 430,000

Fixed selling and administration costs shs198, 150

Sales 90,000 units

Required;

i) Find the firms break-even point in units and in shillings

ii) Calculate the margin of safety.

iii) The manager is targeting a profit of shs 300,000. How many units must be sold to meet

this target?

iv) The marketing manager has indicated that an increase in the selling price to shs 12.25 per

unit would not affect the number of units sold, provided that the sales commission is

increased to 8% of the selling price. Calculate the break-even point if this happens.

(12 marks)

QUESTION THREE

(d) Discuss the need for managers to understand management accounting possibilities in their

organizations. (8 marks)

(e) Explain five assumptions of cost-volume profit analysis. (5 marks)

(f) M Ltd manufactures three products which have the following revenue and costs

Product 1 2 3

Selling price 292 135 283

Variable costs 161 72 96

Fixed cost:

Product specific 49 35 62

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General 46 46 46

Unit fixed costs are based upon the following annual sales and production volumes

Product 1 2 3

Volume 98,200 42,100 111,800

Required

(ii) Calculate:

(a) The breakeven point sales for each product

(b) The break-even sales for the company based on the current product mix.

(c) The number of units of product 2 at the break-even point of (b) above.

(ii) Comment upon the viability of product 2 (12 marks)